Karex reported a very disappointing set of results: 9MFY19 PATAMI of RM3.5m (-59% yoy) fell short of both our and consensus expectations, delivering only 35% and 36% of our respective forecasts. The sharp decline in revenue (-25% qoq; -12% yoy) in 3QFY19 was a big negative surprise to us, as a few clients have suspended their orders pending the outcome of an audit. As such, we are cutting our EPS for FY19- 21E by 47-67% and reducing our TP to RM0.30. Maintain SELL.

Sales Volume Negatively Impacted by Allegations

Apart from the increased competition in the tender segment, Karex’s sales during the quarter were also negatively impacted by the allegations over the treatment of its workers. Revenues from both the tender and commercial segments have contracted sharply during the quarter - sales were down by 47% and 19% qoq. Although management guided that some clients have resumed their orders post the successful audit, we believe that it would take Karex another 6-12 months to recover from the loss in sales. However, it will be difficult to quantify the impact of the allegations on Karex’s competitiveness in the next bidding cycle for tender contracts.

Tightening Credit Terms Help to Improve Cash Flow

Despite only delivering RM0.2m net profit for the quarter, Karex’s net cash has increased from RM4.6m in 2QFY19 to RM17.1m in 3QFY19. The reduction in working capital was due to the declining balance of its trade receivables, post the implementation of new credit controls. We also believe that the decline in sales volume was also part of the contributing factors. Similarly, the reduction in overall distribution costs by 15% qoq (or -22% yoy) was driven by lower sales volume rather than an improvement in its overall cost structure.

Maintain SELL With a Lower TP of RM0.30

We have cut our EPS forecast for FY19-21E by 47-67%, as we believe that volume from the tender market would take at least 6-12 months to recover, while overall margins are also likely to be negatively impacted by the lower operating leverage. We have lowered our DCF-based TP to RM0.30 from RM0.35, while maintaining our SELL call. There could be downside risk to our forecast, if retailers of its OBM product also suspend their orders.

Source: Affin Hwang Research - 31 May 2019