Investment Highlights

• We cut our FY18-20F net profit forecasts by 7%, 9% and 9% respectively, and reduce our FV by 13% to RM10.42 (from RM11.96) but maintain our BUY call. Our FV is based on DCF with a discount rate equivalent to its WACC of 6.4% (raised from 6.2% previously to reflect an increased risk premium) and a terminal growth rate of 2.5%. At our FV, the implied CY19 P/E is 24x.

• During an analyst briefing yesterday, Top Glove elaborated on its legal action against the vendors of Aspion Sdn Bhd (Aspion), claiming for RM714.9mil arising from fraudulent misrepresentations by the vendors pursuant to the deal. To recap, Top Glove in Apr 2018 acquired the surgical glove maker from the vendors for RM1.37bil, satisfied by RM1.23bil cash and 20.5mil new Top Glove shares at an issue price of RM6.68.

• The RM714.9mil claim comprises the discrepancy in:

1. Inventories amounting to RM57.5mil (due to nonexistence, obsolescence and over-valuation);

2. Plant & machinery amounting to RM16.9mil (due to them being non-operational, de-commissioned, nonexistent or capitalised despite being operating expenditures); and

3. Earnings-based valuation for the business amounting to RM640.5mil (due to earnings projections being overly aggressive).

• Due Diligence not thorough? - This was carried out via a widely accepted method called Virtual Data Room (VDR) where potential bidders are only given access to very limited and basic operational, financial, tax and legal information on the business that is up for sale. It is a common practice that the vendor does not reveal too much information during the due diligence process due to competitive reasons (in the absence of certainty that a deal will be reached). However, in the event of a deal is reached, the discrepancy (for instance, the actual physical inventory being lower than what is recorded in the books), will be covered by a “seller’s warranty”. In the case of Aspion, the vendors provided a seller’s warranty of up to RM50mil, backed by an actual bank guarantee of RM72.3mil (the bank guarantee is also meant to co-cover the profit guarantee amounting to RM80.9mil for FYOct18 and RM108.3mil for FYOct19).

• Taking over management control – Top Glove uncovered the substantial discrepancies in inventories and plant & machinery after it took physical control of the business following the completion of the deal in Apr 2018. It also became doubtful on Aspion’s ability to meet the RM80.9mil net profit in FYOct18 as guaranteed by the vendors, when Aspion only managed to make only about RM25mil in the first seven months of the FY (Top Glove consolidated two months’ net profit contribution of RM7mil from Aspion in its recently released 3QFY18 results).

• Top Glove was left with two options: (1) Allow the vendors to continue to run Aspion below its potential over the next two financial years (with a projected net profit of RM40mil annually), with the shortfall in earnings being met with the vendors’ profit guarantee; or (2) Take over the management of Aspion and immediately embark on restructuring towards realising its full potential (with a projected net profit of RM80mil annually after two years). Top Glove holds the view that its shareholders’ interest could be better safeguarded via the second option. Top Glove is mindful of the risk of the vendors’ profit guarantee being no longer enforceable via the second option as the vendors could argue that they no longer have control of the day-to-day running of Aspion, and hence its profitability.

• No product issue – The saving grace is Top Glove said that it had no issues with Aspion’s technology, branding and products. In other words, the issue is with the inflated P&L and balance sheet, and hence the valuation of Aspion.

• While the latest development is a setback to Top Glove, particularly, in relation to its expansion strategy via acquisitions, we are more inclined to see this as an isolated event (Top Glove had successfully executed more than ten similar acquisitions prior to Aspion, albeit smaller in terms of size). We believe value has emerged after a steep correction in share price yesterday. Having adjusted down earnings contributions from Aspion, we project Top Glove’s FY18-20F EPS will still grow at 36.5%, 16.4% and 11.1% respectively, backed by sustained growth in demand for gloves globally.

Source: AmInvest Research - 10 Jul 2018