Malaysia Construction - Optimism piling up

We upgrade our call on the construction sector to OVERWEIGHT due to: a) more mega projects awarded, b) sustained margin recovery, and c) regional property prospects have improved. Top picks are Gamuda and WCT.

Contract awards to pick up. The government’s fiscal spending (for the Ninth Malaysia Plan (9MP) 2006-10 and the two fiscal stimulus packages) has lagged, having spent only RM140.3b of RM230b (61%) allocated under 9MP. As we approach the end of the 9MP period and planned fiscal stimulus timeline, we expect the government to expedite contract awards over the next two years as construction typically forms 3-4% of total GDP.

Several mega projects in the offing. Following the award of mega projects such as Pahang-Selangor interstate water transfer tunneling job and Medini infrastructure work, tenders for three key mega projects, namely, work on the a) remaining portion the RM6b Pahang-Selangor interstate water transfer, b) RM2b LCCT terminal in Sepang and c) RM7b-10b extension of two LRT lines would follow suit. With the bulk of the construction and infrastructure jobs to be awarded in 2009-10, the sector’s orderbook is projected to double to RM43b by end-10. We also foresee plenty of jobs in the pipeline in Sarawak and Iskandar Malaysia, South Johor.

Margin recovery amid lower building material costs and variation order claims. We expect operating margins to recover from as low as 3% in 3Q08 to 8% this year as steel prices have halved to RM2,000/tonne from a peak of over RM4,000/tonne in 3Q08, as well as recent successful variation order claims from overseas and local projects such as Gamuda and WCT JV project, New Doha International Airport (NDIA), and MRCB’s power transmission jobs. Furthermore, we believe the sector’s earnings are sustainable through 2010-11, supported by a sufficient domestic orderbook (our RM13.0b cumulative orderbook assumption for construction companies under our coverage accounts for one-third of the RM43.4b estimated domestic construction jobs).

Recovery of property demand, positive development in water sector and gradual recovery in Vietnam economy spell better times ahead for selected construction players with interests in these segments. Key beneficiaries include IJM (via its 66%-owned IJM Land) and Gamuda where 20% of its FY08 revenue was contributed by its property development division. The possible resolution of water concession will see Gamuda receiving RM632m cash offer and Gamuda and WCT are expected to benefit from Vietnam’s economic recovery with projects such as Yenso Park and Platinum Plaza.

We upgrade our rating on the construction sector to OVERWEIGHT. The above-mentioned catalysts suggest that the construction business will trade at a peak cycle PE valuation of 23x against current PE of 18x. Our top sector picks are Gamuda (BUY/Target: RM3.70) and WCT (BUY/Target: RM3.00). Positive newsflow will also support IJM (HOLD/Fair: RM6.35) and Sunway Holdings (HOLD/Fair: RM1.55).