We came back from a company visit feeling optimistic that the company’s new capacity expansion plans for FY14 are on track. Due to pent-up demand, Kossan Rubber Industries (“Kossan”) is adding yet another new plant to its earlier expansion plan of two plants raising the number of total new plants to three in FY14. Meanwhile, its 1HFY13 results are due to be announced soon and we are expecting a solid 1HFY13 net profit of RM66m (+45% YoY) equivalent to 52% of ours and market consensus full-year net profit forecasts driven by its new capacity expansion, which came onstream in 4Q12.  We are keeping our FY13 earnings forecast unchanged. However, we are raising our FY14 net profit by 10.7%, taking into account the additional capacity from the latest guidance from Kossan.  Correspondingly, our target price are also raised by 10.9% from RM6.20 to RM6.88 based on 14x FY14 revised EPS. We maintain our OUTPERFORM rating.  

1H13 results preview.  We expect Kossan 2Q13 results to be announced by early next week with a solid 2Q13 net profit of RM33m (+40% YoY/ flat QoQ). This would bring the 1H13 net profit to RM66m (+45% yoy) equivalent to 52% of ours and market consensus full-year net profit forecasts driven by new capacity expansion, which came on-stream in 4Q12. Its FY13 earnings growth is propelled by: (i) its nineline production plant, producing 1.3b nitrile gloves p.a., commercially operational in 4Q2012 and; (ii) the completion of the production lines for the remaining capacity of 700m surgical gloves in Feb 2013. Kossan has ready clients for more than 80% of the new capacity. 

Potential margins expansion from new gloves production lines due to revised production scheduling.  We believe Kossan’s new gloves production lines could potentially lead to higher margins due to improved productivity and efficiency as the lines are designed to focus on larger orders with fewer clients (compared to previous production scheduling model) for a single  product type and specification, thus reducing idle downtime from frequent machinery setting adjustments to accommodate diverse specifications. This could lead to an output of 35,000 pieces of gloves per hour, which is higher than its existing average production line speed of 29,000 gloves per hour, a robust 20% enhancement. Its current production style comprises shorter production lines catering to a large customer base with diverse products, which reduces reliance risk on few larger clients. However, such an arrangement limits margin expansion due to more downtime on frequent machinery setting adjustment.

Additional new plant makes three.  Going forward, Kossan will build new lines once its capacity utilisation hit 80% instead of 90% as in the past. This strategy will allow Kossan the spare capacity to capitalise on potential new sale enquiries as well as meeting specific requirement needs from its clients.  We were given to understand that the three new glove production plants will have a total capacity of 5bn pieces compared to previous guidance of two new plants with a total capacity of 2.2bn pieces.  This will boost installed capacity by 31% from 16bn to 21bn pieces of gloves. The first plant is expected to be completed by end 4Q13 and the remaining two by May 2014. For illustrative purposes, assuming 8% net profit, ASPs of RM95/1000 pieces and utilisation rate of 80%, this new capacity could generate a total net profit of RM30m or 19% of our FY14 forecast. 

Raising our FY14E net profit by 10.7%.  Due to the new guidance, we are raising our FY14E net profit by 10.7% on higher capacity after imputing the additional new plant as guided. Correspondingly, our target price is also raised by 10.9% from RM6.20 to RM6.88 based on 14x FY14E revised EPS. We maintain our OUTPERFORM rating. 

We like Kossan because: (i) of its superior net profit growth of 18% and 27% in FY13E and FY14E respectively compared to an average of 13% and 12% for Top Glove and Hartalega in FY13E and FY14E, (ii) Kossan’s unprecedented earnings growth is underpinned by rapid capacity expansion over the next two years, (iii) it is gradually raising its dividend payout ratio (Kossan recently declared a final 7.0 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 (iv) 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. 

Key risks. Delay in commissioning of production lines.

Source: Kenanga