We maintain our OUTPERFORM rating with a target price of RM3.64 based on 10x FY13 EPS (-0.5 standard deviation below its 6-year forward PER average). We believe Kossan Rubber Industries’ (Kossan) re-rating catalysts are gaining momentum via its maiden foray into Indonesia, potentially to expand its technical rubber products (TRP) division there, and its gloves expansion following its new land acquisition, which are positive news flows. Its valuations are undemanding with Kossan trading at 9.3x FY13 EPS (vs. Top Glove’s 14.7x and Hartalega’s 15.4x FY13 EPS). The valuation gap should narrow as: (i) Kossan moves up the value chain by offering higher margin surgical and clean room gloves and (ii) the fact that Kossan’s product mix contains lesser natural rubber glove, which is more sensitive to movements in latex prices.

New capacity with secured buyers. The commercial operations of its new production lines are expected to contribute to earnings growth in 2013. We expect the nine-line production plant, producing 1.3b nitrile gloves p.a., which has been commercially ready in 4Q2012 to contribute to FY13 earnings. The production lines for the remaining balance of the 700m surgical gloves are expected to be completed by Jan 2013. Kossan has managed to secure buyers for more than 85% of the new capacity.

Major expansion beyond FY13. Recall that in a recent announcement to Bursa Malaysia, Kossan said it was buying a piece of freehold industrial land measuring approximately 56 acres located in Batang Berjuntai, Kuala Selangor for RM35.4m or RM14.50 per sq feet, which is expected to be completed by 1QFY2014. This acquisition is in line with Kossan’s strategy to replenish its land bank in order to build more gloves production lines, which are presently running at full capacity. Amplifying the strong demand for nitrile gloves, the land is highly likely to be used to house plants for the production of nitrile gloves. Note that Kossan’s recent new nitrile capacity of 1.3b pieces of gloves has been mostly taken up by confirmed buyers. For illustrative purposes, the RM35.4m acquisition will not have a material impact on Kossan’s net debt and net gearing of RM84m and 0.2x as at 30 Sept 2012. Based on our estimates, the size of this piece of land can cater to between six and seven plants or 60 to 70 lines with a production capacity of 9m pieces per line per month. Conservatively, this means a production capacity of between 6.5b to 7.6b pieces of gloves or 43-51% of its current capacity.

TRP division earnings gathering momentum. We are positive on Kossan’s potential investment in expanding its TRP division into Indonesia. This is because the TRP division has been growing at >20% QoQ at the pre-tax profit level over the past few quarters. For 12MFY12, the division’s pre-tax profit rose 62% YoY and accounted for 14% of the group pre-tax profit compared to 12% in FY11. Recall that Kossan has recently incorporated a new subsidiary namely PT. Kossan Setia Jaya in Indonesia with an issued and paid-up capital of Rp11,610,000,000 or RM3.7m. Kossan Labuan Bhd and Kossan Sdn Bhd hold 99% and 1% respectively in the issued and paid-up capital of PT. Kossan Setia Jaya. We understand that this is expected to be Kossan’s maiden foray into Indonesia’s booming automotive sector under its TRP division, which is expected to have a high demand for engine parts. For the automotive industry, Kossan’s TRP division has experience in producing parts, including anti-vibration application in the forms of mounting bushes and hangers. These products are the engine mounting for damping and anti-vibration, shock absorbing bushes for shock absorbers and chassis, exhaust hanger, under-hood profiles and sponge. Kossan is also looking to market its TRP products in Indonesia used in heavy industries covering construction and infrastructure i.e. bridges which include engineered rubber products such as bridge bearing and railway pads; compression seals and expansion joints.

Compelling valuations. Kossan is trading at just 9.0x FY13 earnings compared to Topglove and Hartalega (vs. Top Glove’s 14.7x and Hartalega’s 15.4x FY13 EPS). The valuation gap should narrow as: (i) Kossan moves up the value chain by offering higher margin surgical and clean room gloves and (ii) the fact that Kossan’s product mix contains lesser natural rubber glove, which is more sensitive to movements in the latex prices. Going by the recent acquisition of both Adventa and Latexx Partner at PERs of between 13.0x and 16.0x, KRI appears more attractive at current valuations. This is because Kossan has a bigger market capitalisation and earnings base compared with both Adventa and Latexx Partner.

Source: Kenanga