We spoke with the management of Eng Kah yesterday to get an update on its business and came away with a cautious view on the company’s outlook. While Eng Kah’s management sees potential  in its China operations, the company has been affected by a string of challenges, including: 1) lower sales orders from its largest customer 2) rising operational expenses 3) a slower than expected outlet expansion by Cosway China and 4) the delay in recognising the earnings from its JV with Cosway China. Even with efforts in place to mitigate the challenges, we believe that the company will not be able to make up for the shortfall in its expected revenues over the coming quarters. As such, we are slashing our FY13-FY14E earnings estimates by 27.7%-26.3% to RM11.2m-RM12.0m and consequently, lowering our TP to RM2.85 (from RM3.63) based on an unchanged FY14E target PER of 16.5x. Given the total return of -2.3%, we are downgrading our call on the stock to an UNDERPERFORM from MARKET PERFORM.

Sharp decline in 1Q13 results.  To recap, 1Q13 earnings came in below expectations (11% of the consensus number and 12% of ours). Correspondingly, the quarter’s revenue declined by 27.3% YoY while net profit dipped 35.4% YoY to RM1.9m. The declines were mainly due to: 1) a substantial RM6.0m reduction in sales orders by the group’s largest customer (Cosway) due to overstocking in the previous quarters, 2) lower PBT margins (-1.8ppt YoY) as a result of a higher proportion of low-margin products mix as well as higher operating expenses subsequent to the change in the minimum wage policy and additional expenses incurred for the upgrading of the company’s software system. 

Single-customer risk exemplified. Efforts have been made to diversify its customer portfolio and secure sustainable orders from the existing multinational companies (“MNCs”) under its clientele. In fact, one of Eng Kah’s top three customers from India has increased its sales orders by 25% YoY to RM3.5m in 1Q13 while Eng Kah is also in the preliminary stage of securing orders from a USbased Fortune 500 company. Management believes that the contribution from the new sales orders will come in by 2H13. However, the group still suffers from a disproportionately large single-customer risk, where Cosway accounts for almost half its revenue. The recent 1Q13 results has exemplified this risk (a -RM6m reduction in sales orders) and more worryingly, our recent conversation with management gave us the sense that the overall group’s sales are likely to remain slow in the coming quarters.

Slower than expected expansion plans. Meanwhile, Eng Kah’s 30:70 JV manufacturing plant with Cosway China (“CC”) is running at just 10% capacity, underpinned by a slower than expected outlet expansion by the latter. The initial plan by CC to open 375 outlets in CY12 and another  750 outlets in CY13 (CC plans to open 30k-50k outlets over the next 10 years) seem distant to us, particularly when viewed against its only 40 outlets opened thus far. Even if Eng Kah could finally get to remit its contribution back from China by as early as this month, we believe that the additional RM2.0m in profits from the associate will be insufficient to make up for the loss of the sales orders from Cosway.

Lowering earnings estimates. In view of the headwinds mentioned above, we have lowered our FY13-FY14E revenue estimates by 20.4%-16.7% to RM78.3mRM86.0m. At the same time, we have also assumed higher operating expenses and a lower margin product mix, which in turn resulted in a 1.5-1.8 ppt decline in our net margin estimates. Hence, FY13-14E net profit is trimmed by 27.7%-26.3% to RM11.2m-RM12.0m. 

Lower our TP to RM2.85 (from RM3.63) based on an unchanged target PER of 16.5x even while rolling over our valuation base year to FY14E. Our applied target PER is based on the 5-year Fwd PER mean. Given total return of -2.3%, we downgrade the stock from MARKET PERFORM to UNDERPERFORM.

Source: Kenanga