Karex reported a lackluster performance: 1HFY19 PATAMI of RM3.4m (-54.3% yoy) fell short of both our and consensus expectations, delivering only 25% and 27% of our respective full-year forecasts. The weakness was due to intensifying competition within the tender market, where margins continued to be under pressure despite the increase in sales volume. As such we are reducing our TP to RM0.35 on the back of 15-24% EPS cuts for 2019-21E, while keeping our SELL call unchanged.

Record Revenue But Not Profit

Despite delivering record revenue for the quarter, PATAMI for 2QFY19 is lower by 29% qoq and 56% yoy, due to a decline in gross profit margin. The improvement in revenue during the quarter was boosted by the fulfillment of a tender order which was delayed from 1QFY19. However, we believe there is still downside risk to margins as management reckons that the overcapacity issue would only improve if the industry consolidates. The GP margin for the tender market has fallen from c.20% to less than 15% currently.

Controlling A&P Cost to Maintain Profits

Management has also taken a more conservative approach in controlling its A&P spending in regards to its OBM segment, and has guided that the expenses would likely hover around RM22m/quarter or around 20-30% of segment revenue. Karex will not slow down its expansion into new markets but engage in different marketing approaches to increase its exposure. We believe that management would likely stick to the self-imposed cap, due to its declining net cash position as profit margins continue to deteriorate. Karex is in a net cash position of RM4.6m (2QFY18: RM20.4m).

Maintain SELL With a Lower TP of RM0.35

While the long-term outlook of Karex venturing into OBM remains attractive, we believe that the short-term outlook for Karex remains challenging due to weak demand from the tender market and also the elevated cost from the OBM segment. We are cutting our FY19-21E earnings by 15-24% to factor in the current-quarter performance and lower our DCF-based TP to RM0.40 from RM0.35, while maintaining our SELL call unchanged.

Source: Affin Hwang Research - 26 Feb 2019