Karex’s 9MFY19 core PATAMI of RM3.7m (-70.8% YoY) was below ours and consensus expectation. The results were below due to lower sales volume recorded from the sexual wellness segment due to (1) sluggish tender market and (2) social audit by their distributors due to the foreign worker issues- which we have highlighted previously. We reduce our FY19/20/21 earnings forecast downward by -53%/-38%-39% to reflect the lower volumes and operating leverage. We are changing our valuation methodology from P/E to P/B. We feel that the P/E based valuation methodology no longer does justice to reflect the value of the world’s largest condom producer. Our TP decreases to RM0.36 (from RM0.37). Our TP is a function of 0.75x (-1.25 SD below its 2 year mean) FY19 BVPS of 48.2 sen.

Below expectations. 9MFY19 core PATAMI of RM3.7m (-70.8% YoY) came in below expectations, accounting for 36.0% of HLIB’s and consensus full year estimates. The results were below due to lower sales volume recorded from the sexual wellness segment due to (1) sluggish tender market and (2) social audit by their distributors due to the foreign worker issues, which we have highlighted previously.

QoQ. Revenue declined -25.0% QoQ to RM85.1m (from RM113.6m) on lower volumes sold from the sexual wellness division. GP margins improved marginally by 3.2ppts QoQ (24.6% vs. 21.4%) on the back of improved ASP from the tender division and higher sales from the OBM segment. Distribution costs (freighting) declined with the lower volumes sold QoQ (-15%) whilst admin expenses was relatively well contained (+0%). Despite this, core PATAMI declined -79.3% QoQ to RM0.5m on lower volumes

YoY. Revenue declined by -11.8% due to lower volumes from the sexual wellness division on the back of the social audits being undertaken by Karex’s distributors. Consequently, core PATAMI declined by -84.2% YoY (from RM3.2m).

YTD. Revenues declined by -7.6% YoY due to on lower contributions from the sexual wellness division (-8% YoY) on the above mentioned factors. The decline in volumes coupled with loss in operational leverage resulted in core PATAMI declining by -70.8% YoY to RM3.7m (from RM12.6m).

Outlook. In light of the foreign worker issues, we understand that some orders have been suspended pending an audit by their distributors. We understand that Karex is working hard to remedy this negative perception. We understand that the audits will only complete by June 2019 (end 4Q19). We thus can expect a slower 4Q19 as a result.

Forecast. Post earnings revision we reduce our FY19/20/21 earnings forecast downward by -53%/-38%-39% to reflect the lower volumes and operating leverage.

Maintain SELL, TP: RM0.36. In view of Karex’s weak earnings delivery despite exhibiting consistent revenue growth since its IPO, we are changing our valuation methodology from P/E to P/B. We feel that the P/E based valuation methodology no longer does justice to reflect the value of the world’s largest condom producer. While we remain long term positive on Karex’s ambition to capture the huge upside in margin expansion from the OBM segment; near term prospects remain pressured by sticky ASP and volatilities in the tender market. Our TP decreases marginally to RM0.36 (from RM0.37). Our TP is a function of 0.75x FY19 BVPS of 48.2 sen (-1.25 SD below its 2 year mean).

Source: Hong Leong Investment Bank Research - 31 May 2019