We maintain our OUTPERFORM rating on Kossan Rubber Industries (Kossan). However, we are raising our TP by 16% from RM3.64 to RM4.23 as we roll forward our 12-month TP valuation from 10.0x FY13 EPS to 10.0x FY14 EPS (at -0.5 standard deviation below the 6-year forward average PER). For the YTD, Kossan’s share price has appreciated 11%, outperforming its peers which rose an average 5% only. We believe Kossan will be further re-rated, fuelled by the positive news flows from its maiden foray into Indonesia to expand its technical rubber products (TRP) division there also its gloves expansion following its new land acquisition. New cases of bird flu virus traced in China could further underpin the importance of hygiene and thus potentially increase the demand for examination rubber gloves, which would augur well for Kossan. Its valuations are undemanding with the stock trading at 8.9x FY14 EPS (vs. Top Glove’s 14.2x and Hartalega’s 14.6x for FY14). Despite the run-up in the share price, note that Kossan is still trading at a 40% discount to its larger peers above.

New capacity expansion to boost FY14 earnings. We understand that Kossan plans to build two new plants targeting nitrile gloves which are expected to boost capacity by an additional 2.2b to 2.4b pieces of gloves or 16% bringing total installed capacity to 17.2b pieces. The first and second plants are expected to be completed by 1HFY2014 and 3Q2014 respectively. We have factored in RM60m capex p.a. over the next two years into our earrings model. For illustrative purposes, assuming a net margin of 8% and 80% sales utilisation rate, this new capacity will fetch a total net profit of RM13.7m or 11% of our FY14 forecast. We have factored in contribution from this capacity expansion into our earnings forecast.

Major expansion beyond FY14. The solid volume growth and potential uptick in demand for rubber gloves is a timely boost for Kossan as it is looking to expand its production capacity. Recall that in a recent announcement to Bursa Malaysia, Kossan said that 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, the purchase of which is expected to be completed by 1QFY2014. This acquisition is in line with Kossan’s strategy to replenish its land bank to build more gloves production lines as the company’s production is presently running at full capacity. With the strong demand for nitrile gloves, the land is highly likely to be used to house production plants. Note that Kossan’s recent new nitrile capacity of 1.3b pieces of gloves has been mostly taken up by confirmed buyers. Note that the RM35.4m acquisition will not have a material impact on Kossan’s net debt and net gearing of RM89m and 0.1x respectively as at 31 Dec 2012. Based on our estimate, the size of the land can cater to between six and seven plants or 60 to 70 lines with a production capacity of 9.0m 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.

Resilient demand as sales volume grew 15% YOY. According to the Malaysian Rubber Export Promotion Council (MREPC) in 2012, the total combined exports of rubber gloves, synthetic rubber (SR) and natural rubber (NR) rose 14.9% YoY. The overall demand for rubber gloves in 2012 remained resilient led by the solid double digit volume growth from nitrile gloves and a rebound in the sales volume of latex gloves due to the low latex price input. Moving into 2QCY13, the overall demand for rubber gloves is expected to be resilient, led by NR gloves although SR gloves, which had consistently been taking up the former’s market share, will continue to show better growth prospects.

Two bets for the price of one. Kossan is not just a rubber glove play but a bet on its TRP division which is growing strongly and expected to contribute positively to overall earnings. 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’s pre-tax profit compared to 12% in FY11. We are positive on Kossan’s potential investment in expanding its TRP division into Indonesia. Recall that Kossan has recently incorporated a new wholly-owned subsidiary namely PT. Kossan Setia Jaya in Indonesia with an issued and paid-up capital of Rp11,610,000,000 or RM3.7m. We understand that the company will be used as Kossan’s maiden foray into Indonesia’s booming automotive sector, which is expected to have a high demand for engine parts, under its TRP division. 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 for the 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’s valuations are undemanding with the stock trading at 8.9x FY14 EPS (vs. Top Glove’s 14.2x and Hartalega’s 14.6x for FY14). Despite the run-up in the share price, Kossan is still trading at a 40% discount to its larger peers above.

Source: Kenanga