The strategy a business chooses to pursuit decides how much cash flow it can generate over its entire lifetime, and that in turn determine the value of the business. Karex started out as a pure OEM condom manufacturer and gradually allocate more resources to establish their own brands under Carex throughout the 90s. The reason for that is it gives them a better margin and less reliance on the commercial and tender markets. Therefore in the long term, a large portion of Karex’s value is going to come from the future cash flow generated from these acquisitions and less about their OEM market that currently contributes bulk of their earnings.

One thing to ask when trying to understand Karex’s strategy is why do they choose to be aggressive in pursuing OBM market now? Karex started marketing their own brand since 1989 and trademarked Carex in Singapore in 1990, that’s 23 years of opportunity to establish their own brand yet it only contributes 4% (2013) of total profit. The main reason is capital. They choose to go aggressive now because pursuing this strategy was never an option prior to listing in 2013. The only way for them to access this amount of capital for acquisitions is through equity market. And we can infer that establishing a brand is going to cost huge amount of money and these acquisitions are just the beginning.

To understand how Karex becomes the largest condom manufacturer, it is good to start thinking from the customer's point of view. If you work for Durex and you are going to choose a condom manufacturer to supply your brand, what would you look for? Naturally, you want someone that has a consistent track record to supply the kind of product quality you desired. As a brand owner, your reputation hinges on your supplier so there’s no room for error. You want someone that can produce quality products every time at a massive scale and preferably, achieve these at the lowest possible production cost. Because if they can’t, there’s plenty of contract manufacturers out there that will.

Karex proved they are capable of doing through manufacturing excellence and production efficiency. Their achieve economies of scale at a lower cost per unit while maintaining production quality. But to transform into a reputational brand owner is a different ball game. For a start, Karex chose to acquire existing condom brands instead of building their own (besides Carex & INNO) is because it takes extra effort to convince consumers to use a product they are not familiar with. That’s especially true with personal care products. The last thing a consumer wants is to worry about the reliability of the condom while on the bed. This is also one reason why brand owners command a better margin is that familiarity comes first, the price comes second. So these acquisition is the beginning, the second part is pushing the brand.

The reason that the top 3 brands, Durex (Reckitt Benckiser), Ansell (Ansell Ltd) and Trojan (Church & Dwight) control around 60% of condom market worldwide is because the trust and loyalty developed their products over the decades. Year over year market share consistency is a good indicator how high the barrier of entry is for a given industry. To be fair, Karex is focusing more on niche premium markets instead of going head to head with these brand. However, the amount of advertising these top 3 brands spent in advertising each year is a good indicator how much Karex would have to fork out to establish their presence. So it is not entirely surprising that Karex’s quarterly result shows margin compression due to higher opex in advertising.

The third, which would be the most important, is management execution. To establish, grow and manage a brand is different from running a manufacturing operation. Management depth and experience in branding is vital. Hence they have brought in Global Protection’s Davin Wendel (via 55% stakes in ONE) to focus on product development and marketing, something Karex management probably lack given their background in manufacturing.  

There are no doubt that Karex’s OEM market will continue to generate a steady stream of cash flow for the business but a majority of those are going to flow into assets and expenditure to grow their brands. You’ll have to have a good understanding how these spending (acquisition, capex and opex) are going to help Karex establish their brands, and how much would cash flow would they generate in order to value Karex. At 48x P/E, the market is putting high hopes for Karex to deliver it. If that is a success, the current price will be a steal. But it also carry a huge risk if things turn south. It is going to be very difficult trying to access where they will be in 10 years time because there are too many moving parts.

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