Karex’s 9MFY18 PATAMI of RM8.6m (-65% yoy) came in below both our and consensus expectations, constituting only 60% and 44% of our respective forecasts. Although the GP margin has improved for four consecutive quarters to 26.9%, it was still below its 3-year average of 31% and not sufficient to cover the higher distribution cost. As such, we have lowered our margin recovery expectations, and cut our FY18-20 EPS forecasts by 14-23%, and lowered our DCFbased TP to RM0.40 (from RM0.60) while maintaining our SELL rating.

Tender Market Remains a Drag

Karex’s margin improvement was mainly due to the change in sales mix, with a higher sales proportion of 65% in 3Q from the higher-margin OBM and OEM segment, up from 61% in 1Q. The tender market continued to be a drag on its margin, as the overcapacity coupled with higher production costs limited its ability to raise prices. As prices had been negotiated earlier, the recent strengthening of the RM and increase in production cost have only worsened the situation.

Looking to Increase Exposure to Higher-margin Segment

Karex’s management is working on higher-margin products to offset the impact of the higher production costs. Apart from an increase in sales to the OEM and OBM market, management is increasing Karex’s exposure to lubricants and catheters, which carry higher margins. Although the growth potential of these products remains attractive, the current contribution is still relatively insignificant. Nevertheless, we concur with management’s current strategy, although this business will likely take time to grow.

Lowering Our Forecasts; TP Reduced to RM0.40 and SELL Maintained

We have lowered our DCF-based 12-month TP to RM0.40 (rolled forward to 2019E), on the back of lower margin assumptions and an updated WACC based on the latest beta, given the cloudy near-term earnings visibility. We reiterate our SELL call on Karex. Assuming that Karex’s fair valuation is at 20x PER (long-term average for the glove sector), investors would be paying for earnings 3 years ahead, hence we believe that the current valuation is lofty. Upside risks: better-than-expected recovery in tender orders; cost-effective distribution and marketing.

Source: Affin Hwang Research - 1 Jun 2018