Results

• Below Expectation: 3QFY16 core PATAMI fell by 6% YoY and 16% QoQ to RM14.4m, bringing 9MFY16 to RM53.4m, accounting for 63% and 66% of HLIB and consensus full year estimates, respectively.

Deviations

• Mainly due to lower margin arising from strengthening Ringgit, reduced selling price and rising production cost.

Highlights

• 3QFY16 review… GP margin was reduced from 37.3% in 2QFY16 to 33.7% in 3QFY16 due to strengthening Ringgit, rising production cost (latex and labor) and reduction in selling price. Management expect to see GP margin to normalise at 30-33% going forward.

• Utilisation rate in 3QFY16 dropped from 72.7% to 65.6% QoQ due to shorter production days (CNY holidays & February month. For subsequent quarters, utilisation rate is expected to rebound back to 70-75% levels.

• We understand that the shortage of foreign labour remains the key challenge for the manufacturing industry. Karex had seen its total foreign labour falling from 1.2k to 1k currently and facing di fficulty to find replacement. The recent lifting ban on hi ring foreign workers and increasing effort in factory automation should help to ease the margin pressure.

• In a separate announcement, Karex proposed to acquire 100% equity interest in Pasante Healthcare for GBP6m or RM36m. Pasante Healthcare is a leading sexual wellness and healthcare provider in UK with key customers as NHS, Tesco, Costco, Superdrug and Boots.

• The acquisition price is translated to 8.5x FY16/01 P/E, which we deemed is fair and earning accretive (to contribute circa RM4m to Karex’ bottomline). We are positive on the acquisition as it allows Karex to expand into retail and tender markets in Europe which command better margin and complement Karex’s existing OBM offeri ng. Currently, Europe only comprises 10% of total revenue in 3QFY16. After the ac quisition, Karex’s cash pile remains strong at RM130m, allowing it to continue looking for potential acquisition.

Risks

• Surge in raw material prices, forex risks, revision on foreign labour policy, and successful invention of HIV/AIDS cure.

Forecasts

• FY16, FY17 and FY18 earnings forecasts are reduced by 14%, 13% and 9% respectively after we incorporate lower margin arising from rising production cost (latex and labor) and lower selling price.

Rating

HOLD

• Positives – World’s largest condom manufacturer; Zika virus outbreaks; ever-increasing global condom demand; strong in-house R&D; licensed to export to major part of the world.

• Negatives – High dependency on foreign labour and lack of long-term contracts with customers.

Valuation

We maintain our HOLD recommendation with our TP adjusted from RM2.72 to RM2.42 by pegging on unchanged P/E multiple of 24.5x of CY17 EPS, based on +0.5SD above historical average P/E.

Source: Hong Leong Investment Bank Research - 30 May 2016