- We reaffirm our BUY call on Kossan Rubber Industries with a higher fair value of RM8.40/share, to reflect our upward revised FY15F-FY17F earnings estimates and higher FY15F PE target of 27x (on par with Hartalega Holdings’ PE given its comparable operational and financial performance).

- Our BUY recommendation on Kossan is premised on:- (1) its superior earnings growth and track record (3-year CAGR of 22%); (2) margin expansion on the back of an improving product mix and operating efficiencies; (3) favourable USD:RM exposure; and (4) upcoming restructuring of its TRP division.

- While there was a slight commercial production delay in the group’s newly constructed Plant 2 and 3 (to June 2015, capacity of ~2bil pcs each), we do not expect this to significantly impact earnings as it should be more than offset by its margin improvements. The new capacity, which will be commissioned progressively, will result in a stronger 2HFY15 for Kossan and help boost full-year FY15F earnings by 40% YoY.

- Bearing in mind the higher base, we are projecting an FY16F earnings growth of 12% backed by the full commissioning of its three new plants and overhauls at its older facilities. These should collectively add 3.5 bil pcs (+16%) to Kossan’s capacity. We understand that the group has plans to build two new plants (Plant 4 and 5, with combined capacity of 4.5bil pcs p.a.) at its land in Meru with contribution expected at end-2QFY17F.

- Kossan’s earnings further out (FY18F-FY22F) will hinge on the expansion of its 57-acre land in Batang Berjuntai. The land, which will be developed over five phases of 10 acres each from FY18- FY22, can accommodate ~10 plants of 4.5bil pcs each. These will effectively double the group’s installed capacity from the current 22bil pcs p.a.

- Demand for Kossan’s products remains robust, with the capacity from all its plants having been contracted for. With current cost headwinds still manageable, we envisage Kossan’s margins to enlarge by 2-3ppts for FY15F-FY17F. This will also be supported by its better product mix (nitrile:natural rubber glove split of 80:20 in FY16F from 60:40 presently), higher automation and greater efficiency and productivity from the revamp of older lines.

- Management remains optimistic of its TRP business in view of healthy demand for its infrastructure products. Margins should be more reflective moving forward, too, as the accounting regulations plaguing the division would be solved through group restructuring.

- Although Kossan’s share price had performed exceedingly well YTD (outperforming its peers and market by 17% and 63% respectively), we believe that the stock has further upside given the imminent US rate hike as well as potential moves by management to reward its shareholders given its improving cash flows (expected to be net cash in FY15F). The stock is currently trading at an FY15F PE of 23x.

Source: AmeSecurities Research - 28 Jul 2015