We came back from a company visit feeling optimistic that the company’s new capacity expansion plans for FY14 are on track. Elsewhere, we expect Kossan Rubber Industries (Kossan) 1QFY13 results due out by end of the month to register a solid 1QFY13 net profit of RM33m (+50% YoY/ +10% QoQ) equivalent to 27%-28% of ours and market consensus full-year net profit forecasts due to a higher-than-expected utilization rate from its new capacity expansion, which came on-stream in 4QFY12.  We are raising our FY13 and FY14 net profits by 6% and 5% respectively taking into account its better-than-expected utilisation rate.  In tandem, our target price has also been raised by 15% from RM4.23 to RM4.88. Apart from the higher earnings, the upgrade in our target price also reflected a slightly higher 1-year forward PER rating of 11x assigned (at +0.5 standard deviation above the 6-year forward average PER) from 10x previously. The revised target PER of 11x is still well below the recent M&A PERs for Adventa and Latexx Partner at between 13.0x and 16.0x despite Kossan’s bigger market capitalisation and earnings base. We maintain our OUTPERFORM rating.  

1QFY13 results preview.  We expect Kossan 1QFY13 results due out by end of the month to register a solid 1QFY13 net profit of RM33m (+50% YoY/ +10% QoQ) equivalent to 27%-28% of ours and market consensus full-year net profit forecasts due to a higher-than-expected utilization rate from its new capacity expansion, which came on-stream in 4QFY12.  Its FY13 earnings growth is expected to come from: i) its nine-lines production plant, producing 1.3b nitrile gloves p.a., which had been commercially ready in 4Q2012 and ii) the completion of the production lines for the remaining balance of the 700m surgical gloves in Feb 2013. Kossan has managed to secure buyers for more than 80% of the new capacity. 

Building new lines once capacity hit 80% instead of 90%. Going forward, Kossan is building new lines once its capacity utilisation hit 80% instead of 90% in the past. This strategy will allow Kossan to have spare capacity in order to capitalise on potential new enquiries as well as specific requirement needs from its clients.  Plans to build two new plants are on track targeting nitrile gloves, which are expected to boost its capacity by an additional 2.2b to 2.4b pieces of gloves or 16%, bringing its total installed capacity to 17.2b pieces p.a. The first and second plants are expected to be completed by 1HFY2014 and 3Q2014 respectively. We have factored in RM60m in capex p.a. over the next two years into our earnings model. For illustrative purposes, assuming net profit margin and utilisation rate of 8% and 80%, respectively, this new capacity will fetch a total net profit of RM13.7m or 9.8% of our FY14 forecast. We have factored in the 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 had 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. 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. 

We like Kossan because (1) its valuations are undemanding with the stock trading at just 9.2x its CY14 EPS or at a 38% discount to its larger peers (like Top Glove’s 14.5x and Hartalega’s 14.2x for CY14), (2) it is gradually raising its dividend payout ratio (Kossan recently declared a final seven sen tax-exempt dividend. This brings its total full-year FY12 DPS to 12.5 sen, implying a 38% payout ratio – well ahead of its <20% payout ratios in the past three years) and (3) the fact that Kossan is not just a rubber glove play but a bet on its TRP division, which is growing strongly at a rate of >20% QoQ at the pre-tax profit level over the past few quarters.

Source: Kenanga