Kossan is deferring its capacity expansion plan for now as it is still operating at a low utilization rate of ~60%. Should there be a sudden uptick in orders, we believe that its excess capacity would be sufficient to meet demand. Instead, the group will be focusing on upgrading old machineries and plants to achieve greater automation and operational efficiency during this downcycle. In the near term, management expects margin to be eroded further mainly due to i) lack of economies of scale as the utilisation rate is expected to drop to ~50%, ii) increase in gas costs in 2HFY22 due to surge in fuel price in 1HFY22 and iii) downward pressure on ASP due to oversupply condition. However, we note that Kossan is currently sitting on huge cash reserves of RM2.2bn and given a low capex commitment on plant and machinery upgrades, we believe there is still room for Kossan to pay higher dividend. Although its cash reserves look attractive relatively to its current market capitalization, Kossan is likely to remain a listed entity of the holding company. We cut our FY22-24F earnings forecast by 10-17% to reflect margin erosion as well as deferment of expansion plan. We maintain our Neutral call and our TP is subsequently revised to RM1.23, pegged to 16x forward PER which is near its 5-year historical average.

• Margin compression. Given the surge in fuel prices in 1HFY22 and the time lag effect, Kossan’s gas costs are expected to increase in 2HFY22. Additionally, the low utilisation rate could further erode its margin due to lack of economies of scale. Couple with a falling ASP, though at a slower rate of decline, we expect further margin compression in the coming quarters. Raw material prices, however, are expected to trend downward in 2HFY22, which could partially cushion the adverse effect. Kossan’s current capacity is 33.5bn pieces pa and we understand that it has placed its near term expansion plan on hold amid oversupply issue as well as high construction costs due to high steel prices.

• Automation and digitalisation. Labour shortage remains an ongoing issue for most of the manufacturing companies while the rising minimum wages should further elevate manpower cost. However, Kossan’s effort to continuously develop automated production lines could help to reduce its reliance on manual labour, improve efficiency and productivity as well as quality of its products. Hence, as Kossan achieves greater automation, we expect to see a gradual improvement in operational efficiency, which should lead to lower cost.

• Kossan’s cash balance stood at RM2.2bn as at 1HFY22, equivalent to 87sen per share. Although management intends to maintain its regular dividend payout ratio at 30%, we believe there is still room for special dividend. Given the delay in capacity expansion while its automation and transformation plan is not likely to cost more than RM100m a year, Kossan has sufficient reserves to reward its shareholders.

Source: PublicInvest Research - 4 Aug 2022