Karex’s 4QFY19 core PATAMI of -RM0.5m (-275% QoQ, -127.5% YoY) brought full year 12MFY19 core PATAMI of RM2.5m (-84.3% 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 (2) additional social audit costs due to the foreign worker issues. We reduce our FY20-21 earnings forecast downward -31% and -29% to reflect the lower operating leverage and higher compliance costs moving forward. Maintain SELL and TP of RM0.36.

Below expectations. 4QFY19 revenue of RM85.1m (+4.7% QoQ, -4.6% YoY) with loss of -RM0.5m brought full year 12MFY19 core PATAMI of RM2.5m (-84.3% YoY). This came in below expectations, accounting for 50.6% and 48.4% of HLIB’s and consensus full year estimates respectively. The results were below due to lower sales volume recorded from the sexual wellness segment stemming from (i) sluggish tender market and (ii) social audit costs by their distributors due to the foreign worker issues and the subsequent remediation costs.

QoQ. Revenue increased 4.7% QoQ to RM89.1m (from RM85.1m) backed by record own brand sales in sexual wellness segment. Higher raw material prices as well as the initiation of payments for social compliance costs negatively impacted profitability within the quarter. Subsequently Karex chalked its first loss -RM0.5m since listing.

YoY. Revenue declined by -4.6% due to lower volumes from the sexual wellness division (-6% YoY) from the sluggish tender market environment and additional costs arising from the social audits being undertaken due to the sensationalised foreign worker issues as highlighted by the western media at the expense of Karex. This resulted in Karex becoming loss making.

YTD. Revenue declined by -6.9% YoY due to lower contributions from the sexual wellness division (-8% YoY) on the above mentioned factors – the foreign worker issues resulted in many of their distributors suspending orders pending the completion of the social audits which have been completed at this juncture. The decline in volumes coupled with loss in operational leverage resulted in core PATAMI declining by -84.3% YoY to RM2.5m (from RM16.1m).

Outlook. The global condom industry is expected to remain challenging with shifting trends in condom purchasing patterns and uncertainty surrounding humanitarian aid budgets around the world. Furthermore, rising costs for raw material and more importantly social compliance will continue to affect profitability in the near term.

Forecast. Post earnings revision we reduce our FY20-21 earnings forecast downward by -31% and -29% to reflect the lower operating leverage and higher compliance costs moving forward.

Maintain SELL, TP: RM0.36. 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, volatilities in the tender market and social compliance costs. Maintain our SELL call and TP of RM0.36 and we roll our valuation into FY20 (offsetting lower BVPS projection resulting from earnings cut). Our TP is a function of 0.75x FY20 BVPS of 49.0 sen (-1.25 SD below its 2 year mean).

Source: Hong Leong Investment Bank Research - 29 Aug 2019