Karex’s 4QFY17 core net profit fell 60% sequentially as it suffered from higher raw material costs, which was locked in at higher prices in early 2017. Original Brand Manufacturing (OBM) expenses remain high, further pressuring its bottom line. We believe the recovery in the tender market is likely to be gradual while lower margins and higher expenses cloud near term earnings visibility. We lower our revenue and margin assumptions and downgrade Karex to SELL with a lower DCF-derived TP of RM1.30.

Below Expectations - Hurt by High Raw Material Cost

Karex’s 4Q17 revenue was flat qoq at RM91.6m as contribution from the commercial and OBM segments was down but offset by improved contribution from the tender segment. 4Q17 EBITDA margin however almost halved qoq as raw materials for the orders delivered during the quarter were locked in at much higher prices in early 2017. Coupled with the high distribution and administrative costs, net profit only came in at RM2.9m for the quarter, bringing FY17 core net profit to RM28.2m (-57.9% yoy), significantly underperforming expectations.

OBM Expenses Remain High

Distribution and administrative costs remains high as Karex continue with its brand-building exercise with planned expansion into Singapore and Thailand by FY18. While management has guided that such expenses may plateau as it consolidates its advertising activities and aims for more targeted distribution, we believe these costs remain disproportionately high in the short term relative to the additional revenue generated. The process to become a serious condom brand owner remains a painful transition for Karex, all while the tender market remains soft.

Lowering Our Forecast; TP Reduced to RM1.30 and Downgrade to SELL

We expect overall margins for FY18 to recover on the back of a gradually recovering tender market and increased contribution from OBM segment. However, we remain cautious on its outlook as significant uncertainties remain in tender budgets and lingering effects from higher raw material prices may spill over to its 1QFY18 results. Elevated distribution and administrative expenses would further pressure its margins. We lower our DCF-derived TP to RM1.30 (from RM1.60) after trimming our revenue and profit margin assumptions, Downgrade to SELL as near-term earnings visibility remains clouded for Karex. Upside risk: better-than-expected recovery in tender orders, cost-effective distribution and marketing.

Source: Affin Hwang Research - 30 Aug 2017