Karex’s 1HFY18 net profit of RM7.4m (-59% yoy), came in below both ours and consensus expectations, delivering only 26% and 23% of our respective forecasts. Despite the recovery in sales volume and gross profit margin in 2QFY18, net profit has contracted by 25% qoq, due to higher distribution and administrative cost. As the overall outlook for Karex remains challenging, we are maintaining our SELL call on Karex with a lower DCF-derived TP of RM0.80.

Tender Market Remain Soft; Margins Remain Compressed

Despite Karex managed to achieve record revenue of RM110.5m in 2QFY18, its net profit was at its second lowest since IPO. Although Karex was able to improve its gross profit margin in 2QFY18, reversing the declining GP margin trend, we believe it was mainly due to a more favourable sales mix (higher OBM), rather than the sharp recovery in tender market margin. Although demand for the tender market has improved, selling still fail keep up with the rising production cost, as overcapacity remains an issue for the industry.

Expenses Will Only Keep Going Up

Although we agree on management’s strategy to diversify into the higher margin OBM segment, it will take some time before they are able to reap the benefits. The overall cost (distribution and administrative expense) to revenue ratio will likely remain at alleviated levels, as we believe Karex needs more time to achieve the economies of scale in their existing markets, while working to expand its sales point. However, as Karex is working on penetrating more markets, we are not expecting for cost increases to normalised anytime soon.

Lowering Our Forecast; TP Reduced to RM0.80 and Maintain SELL

We lower our DCF-derived TP to RM0.80 (from RM1.30) after trimming our revenue and profit margin assumptions, while maintaining our SELL call, 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 - 1 Mar 2018