Higher Cost Impacted Profitability

Karex reported another weak set of results, 1QFY20 core loss of RM0.2m is significantly below both consensus and our estimates, as consensus and Affin were forecasting PATAMI of RM5.0m and RM8.5m respectively for FY20E. We were expecting Karex to turn profitable in 1QFY20, but the increased competition in the tender market has impacted its profit margin negatively. We are cutting our EPS for FY20-22E by 23%-65% to factor in the lower margin, and cut our DCF-based TP to RM0.25. Maintain SELL.

Tender Market Continues to be Competitive

Although revenue increased by 3.9% yoy to RM95.7m, gross profit has dropped by 18% to RM20.2m. We believe that the decline was mainly from the tender market, as profit margin was negatively impacted by lower pricing and higher production cost. As demand from the tender market remains weak, we are not expecting the price competition to ease anytime soon. Revenue contribution from the tender market has dropped from 35% in 1QFY19 to 29% in 1QFY20. Although orders from OEM has increased post the social audits, the gain has been insufficient to compensate for the decline in the tender market.

Needs to Start Charging More

Post the completion of the social audits, management guided that orders are now being resumed. However, the overall cost continues to be at elevated levels due to the changes in their remuneration package for foreign workers to comply with international standards. Karex will need to start increasing its selling prices on its OEM products, to help compensate for the higher cost. However, we believe that the price increases can only be done gradually across a few quarters, as buyers can opt for different manufacturers, as there is ample capacity available.

Maintain SELL With a Lower TP of RM0.25

We have cut our EPS forecast for FY20-22E by 22.5%-65.1%, as we believe that production cost will likely remain elevated, and it will take at least 6-12 months to pass on the higher cost. We have also cut our DCF-based TP to RM0.25 from RM0.30, but maintain our SELL call. There could be downside risk to our forecast, if competition from the tender market continues to intensify.

Risks to Our Call

Upside risks: better-than-expected recovery in tender orders; cost-effective distribution and marketing.

Source: Affin Hwang Research - 29 Nov 2019