Investment Highlights

• We downgrade Kian Joo Can (KJC) from a BUY to a HOLD, cutting our FY18F-FY20F earnings forecasts by 30-43% as cost pressures continue to escalate and erode KJC’s margins. We have lowered our fair value to RM2.15/share (previously RM3.25/share), pegged to an FY19F PE of 11x.

• KJC’s 2QFY18 core net profit came in way below our expectations at RM5mil, tumbling 71% YoY and 60% QoQ. This brings 1HFY18 core net profit to RM16mil which accounts for 22% of our full-year forecasts.

• 1HFY18 core net profit declined 54% YoY amid escalating raw material costs which hurt margins. Additionally, the group recorded a lower gain on derivatives of RM3.9mil compared to RM9.8mil last year. KJC uses derivative financial instruments to hedge for the pricing risk of aluminum and foreign currency exchange risks.

• Meanwhile, 1HFY18 turnover marginally improved by 0.2% YoY attributed to adjustments to selling prices to reflect higher material costs, which were offset by a decrease in sales for its cans division.

• KJC’s raw material costs are the main cost components of its manufacturing businesses, i.e. tin plates to produce tin cans, aluminum coils for aluminum cans, and paper rolls for corrugated cartons. When analyzing the movement of raw material prices, the average prices of aluminum, tin plates, and corrugated paperboard increased by 8%, 7% and 10% respectively from 1HFY17 to 1HFY18.

• KJC’s cans division reported a 29% lower EBIT in 1HFY18 due to higher costs of tin plate and aluminum. Meanwhile, this division also recorded a loss on derivative financial instruments of RM1.4mil in 1HFY18 compared to a gain of RM0.3mil in 1HFY17. Revenue shrank 5% as the demand for tin and aluminum cans in Vietnam fell.

• As for its cartons division, revenue increased 11% due to higher sales tonnage and upwards adjustments in selling prices in Malaysia and Vietnam. The division posted a loss before taxation of RM8mil in 1HFY18 vs. RM9mil in 1HFY17 as margins were compressed due to pre-operating expenses in Myanmar and higher marketing and finance costs.

• The group’s contract manufacturing division saw revenue rising 17% due to higher beverage sales and milk powder manufacturing. However, its loss before tax increased due to higher packaging material costs. Meanwhile the trading division saw a 21% lower EBIT in 1HFY18 despite revenue improving by 10%.

• KJC is a net beneficiary of the strengthening MYR as approximately 20% of its revenue and 36% of its costs are USDdenominated. The MYR appreciated against the USD by 10% from US$1.00 : RM4.3884 in 1HFY17 to US$1.00 : RM3.9372 in 1HFY18. Despite this positive, KJC’s margins had been impacted by faster-than-expected climb in raw material prices.

• The group has shared that its new plants in Myanmar are expected to commence operations in 2HFY18. Despite its encouraging top-line potential, we do not foresee positive bottom line contributions within the first 2 years of operations due to: 1) high marketing expenses, 2) production inefficiencies from small initial customer orders (lack economies of scale), and 3) language barriers. We await further details on the progress of its Myanmar ventures as well as the group’s plans to overcome its near-term challenges.

• Moving forward, we expect continued volatility in raw material prices amid global uncertainty following US sanctions, China’s supply-side reforms and tensions between major economies. Key challenges faced by the group include: 1) rising costs of direct materials such as tin plate, aluminum and paper rolls, 2) increase in production costs, especially labour costs as KJC’s manufacturing and contract packing services are labour intensive, and 3) intense competition in its corrugated cartons space.

• We are concerned that these factors, coupled with initial losses expected in its Myanmar ventures, would impact KJC’s profitability in the short term. However, we believe the company’s long-term prospects are bright as its Myanmar ventures are set to bear fruit from FY20F onwards, given Myanmar’s young demographic profile and manufacturing cost advantage. We believe the company is fairly valued, with the aforementioned near-term challenges factored in.

Source: AmInvest Research - 23 Aug 2018