Gamuda likely to face earnings risk from outcome of MRT2 renegotiation

Gamuda Bhd (Oct 24, RM2.35) 

Reduce with a lower target price (TP) of RM2.18: Mass rapid transit (MRT) 2 underground contract MRT Sungai Buloh-Serdang-Putrajaya Line (MRT2) underground (UG) contract (RM15.5 billion original value awarded) had a termination order by the finance ministry (MoF) on Oct 7. Our checks reveal that the termination was not on grounds of a default by the joint-venture (JV), but on the basis that MMC-Gamuda JV had failed to commit or agree on the quantum of the reduction in cost. The MoF proposed to reduce the balance RM9.6 billion MRT2 UG scope (40% completed at end-July) by 44% to 60% (or by RM4.1 billion to RM5.8 billion).

No termination is a relief, but Gamuda is ultimately a price taker. We are relieved that the government has agreed to renegotiate with MMC-Gamuda JV on the final cost reduction. However, this implies that the cost rationalisation could eventually benefit the government more than the contractor. The government’s aggressive stance in extracting maximum savings from ongoing mega rail projects would leave Gamuda as a price taker, in our view. Our base-case assessment is negative for Gamuda: a 60% cut to balance contract value significantly lowers profits. 

Order book risks mitigated by MRT2 above ground (AG) turnkey conversion. The 92% downside risk to end-July order book of RM6 billion is mitigated by the conversion of the remaining RM12.2 billion balance of works (cost reduced by 23%) for MRT2 AG scope into a turnkey contract versus project delivery partner (PDP) previously. Gamuda’s 50% share of RM6.1 billion does not necessarily mean that the original PDP margin of 6% can be maintained as the PDP advantage no longer applies, in our view. 

We feel that the fundamental risk of retaining the MRT2 UG contract at the maximum 60% cost reduction for the balance RM9.6 billion value (lower margin), conversion of the MRT2 AG PDP to a turnkey contract (23% cut in cost) would limit further upside to the share price. We foresee earnings risk from every outcome for MRT2 (AG and UG). 

We expect the outcome of MRT2 UG cost renegotiation to be net negative to Gamuda. We cut FY19 to FY21F earnings per share (EPS) forecasts, adopting our base-case assumption. Retain “reduce” with a lower end-calendar year 2019 (CY19) TP of RM2.18 (40% discount to fully diluted (FD) revised net asset value of RM3.63 per share). 2019’s contract outlook is subdued. Upside risk: revival of deferred/cancelled rail contracts. Downside risk is a protracted renegotiation of MRT2 UG contract price. — CGSCIMB Research, Oct 23

This article first appeared in The Edge Financial Daily, on Oct 25, 2018.

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