Lack of tender love

Lacklustre demand in the tender segment continued to dampen Karex’s earnings as 1Q disappointed with lower volume sales and margin compression. OBM segment picked up strongly after the consolidation of recent acquisitions but higher operating expenses on marketing efforts crimped margins. 2H17 earnings should trend higher once the tender segment ramps up the production volume but expect another bumpy quarter in 2Q. Maintain HOLD.

Revenue propped by Pasante consolidation

1Q revenue was surprisingly flat despite lower production volume on weaker tender demand. Utilisation rate fell to a low of 60%, in line with the sluggish tender market. At the same time, higher commercial mix with higher customisations led to longer production lead time, which dragged volume sales growth and capacity utilisation. Overall 1Q revenue was propped up by the consolidation of Pasante accounts after 4Q completion, which contributed approximately RM11m to the topline, which cushion the fall in tender sales. While ongoing weaknesses in tender segment does come as a surprise, this also reaffirms Karex’s strategy in diversifying its revenue mix away from the tender market via strong focus in the OBM segment to reduce the volatility and cyclicality of the tender orders.

Margin compression

1Q core net profit unexpectedly fell to RM8m (-35% qoq; -64% yoy). Key culprit was the markedly higher operating costs, which were impacted by: (i) lower volume sales leading to higher unit costs; (ii) less than favourable revenue mix in line with lower tender orders; (iii) higher latex prices which increased by approximately 10% yoy; and (iv) higher marketing expenses to ramp up brand equity recognition for its OBM segment. On top of that, 1Q was also impacted by one-off transaction costs arising from the acquisition of Pasante. On the whole, 1Q earnings missed both ours and consensus expectations. Looking ahead, we are expecting earnings to be progressively stronger in 2H17, as management guided that tender orders should resume once current inventories have been exhausted.

Maintain HOLD

We maintain our earnings for now, but downside risk to earnings prevails should the expected recovery in tender orders fail to materialise in coming quarters. The strong ramp-up in OBM is commendable, and should place Karex well on its transformation path into an OBM-centric hybrid player. That said, near-term margin squeeze is to be expected, given longer gestation period to build up its brand equity recognition. Our 12M DCFderived TP is unchanged at RM2.50. Maintain HOLD.

Source: Affin Hwang Research - 30 Nov 2016