We are upgrading Kossan to BUY with an unchanged TP of RM8.40 as we roll over to 22x 2019E PER, despite lowering our 2018-20E EPS by 6.4-13.3% due to slower-than-expected plant expansion. In our view, the recent fall in the shares has priced in the capacity delays. Management is confident that the current setback will be resolved soon, and they will be able to achieve full production by July. There is also no change to their long-term expansion target.

Long-term Targets Remain Unchanged Despite Setbacks

Despite the setback, management targets for Plant 16 (3bn pieces/year) to operate at full capacity by July 2018, which will add around 13% to current capacity. Although Kossan has missed our initial schedule, management has guided that they are still on track to achieve 47.5bn pieces/year by 2023, starting with completion of Plant 17 by end-2018, followed by Plant 18 by mid next year. As subsequent expansions are based on Plant 16, we expect limited delays in the completion of Plants 17&18.

New Capacity Will Likely Help to Drive Earnings Growth

Earnings growth for 1H18 is likely to remain flat, as operating levels are already above the 85% utilisation rate, while the new capacity would only start full production by July. Management is confident that their new capacity will be fully taken up, as they believe that current demand growth still outstrips capacity growth, due to conversion from vinyl gloves to other alternatives like latex or nitrile gloves. As such, we believe that earnings growth at a low-mid (high) teens level for the next 3-years is sustainable.

Delay Looks Priced In; Upgrade to BUY With Unchanged TP of RM8.40

We are maintaining our 12-month TP for Kossan at RM8.40 (post subdivision RM4.20), based on an unchanged 22x PER now applied to our EPS for 2019E (from 2018E), while upgrading our call to BUY (from HOLD) after the recent share-price drop. We believe valuation is undemanding and prices in the capacity delays. However, our preferred sector picks remain Supermax (SUCB MK, RM2.90, BUY) (valuation) and Top Glove (TOPG MK, RM9.80, BUY) (earnings surprises). Key risk to our call: management’s inability to ramp up the utilisation rate of the new capacity.

Growth to Resume With New Capacity

New Capacity Coming on Stream in July

Despite the completion of Plant 16 in December 2017, raising capacity by 3bn pieces/year (+13% increase in total capacity), the new capacity is yet to be fully operational as the line is still undergoing testing to assure that it achieves full efficiency when it starts production, as the future plant expansion will be modelled after Plant 16. Management has indicated that the future expansion could achieve optimal utilisation sooner, as the settings are tested on Plant 16. The current problem with Plant 16 is with their glove formers, which management is still awaiting new delivery from its supplier.

Since Kossan is already operating at full capacity (>85% utilisation rate) since early 2017, and the new capacity from Plant 16 has yet to achieve full production, earnings growth for 1H18 is likely to maintain flattish, on our estimates. We are assuming that Plant 16 will achieve full capacity by 3Q18. We have also cut our 2018-20E earnings by 6.4-13.3%, mainly due to the changes in our expectation on the utilisation rate, as we were expecting Plant 16 to achieve full capacity in 2Q18. If Plant 16 fails to achieve full utilisation by 3Q18, there is also the possibility that Plant 17&18 might also be delayed

Still Aiming for 47.5bn Pieces/year Capacity by 2023

Although the current timeline has fallen behind our initial target, management is still confident that Plants 17&18 will be completed by end of 2019, which will add another 4.5bn pieces/year as construction work has already started. The plan is to achieve a total capacity of 47.5bn by 2023, by adding around 4.5bn pieces/year capacity a year. The new plants (post- 2018) will be built on the 56-acre land in Bestari Jaya which they currently own, with the required infrastructure (water and natural gas) already in place.

Delay Already Priced In, in Our View

Maintaining TP at RM8.40; Upgrading to BUY on Valuation

We are maintaining our 12-month TP of RM8.40, as we roll forward our valuation basis to 2019E EPS (from 2018E) and use an unchanged 22x target PER. With 27% upside potential to our TP, we upgrade our call to a BUY. Our valuation methodology is consistent among our coverage universe, and based on +1 STD over its historical average. We believe that the current valuation has already priced in the slower growth rate for the 1H18, as the stock is now only trading at a 20x 2018E PER.

Closing in on the Discount Gap

We believe that the valuation gap relative to Top Glove and Hartalega (HART MK, RM5.83, HOLD) is likely to stay until management starts delivering their volume growth in 2H18. Nevertheless, we do not believe investors will be surprised to see Kossan deliver flat qoq earnings growth (in 1Q18), as problems from the delays have been well flagged to investors in advance. Hence, the catalyst for the stock re-rating will likely be dependent on their ability to delivery that earnings growth in 2H18.

No Change in Dividend Payout

We believe that there will be no change to the current dividend payout structure, as there is still room on the balance sheet to gear up assuming that management needs to expedite its expansion target, as they have around 323.75ha of land in Bidor, Perak. Management mentioned that they are comfortable with the current gearing level, but plan to keep a balance between cash flows for dividends and operation needs, which we believe is an indication that the current dividend payout will continue.

The key downside risk to our call would be management’s inability to ramp up the utilisation rate at its new capacity.

Source: Affin Hwang Research - 8 May 2018