We came back from a visit to Kossan Rubber Industries (Kossan) feeling optimistic that its new gloves capacity expansion plans for FY14 are on track. We understand that the first plant with an estimated installed capacity of 1.5b-1.8b pieces is on track to commence commercial production by Jan 14. We believe Kossan’s new plant gloves production scheduling and strategy offer potential margins expansion. We are raising our FY14 earnings forecast by 13% taking into account slight margin expansion emanating from the new plant and also introducing our FY15 numbers. Our FY14 forecast is 10% above consensus as we believe the market is under appreciating Kossan’s ability to improve margins. Correspondingly, our target price is raised by 13% from RM3.93 to RM4.46 based on 16x FY14 revised EPS. Reiterate our OUTPERFORM rating.

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.

New plants on track to deliver earnings and growth in FY14. 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 from its clients. The three new glove production plants will have a total capacity of 5bn pieces of which one plant is expected to commence commercial production by early 1Q2014. This will boost installed capacity by 31% from 16bn to 21bn pieces of gloves. We understand that the first plant with an estimated installed capacity of 1.5b-1.8b pieces is on track to commence operations by Jan 14. The remaining two plants are expected to be commercially ready by May 2014. For illustrative purposes, assuming 8% net profit margin, ASPs of RM95/1000 pieces and utilisation rate of 80%, this new capacity could generate a total net profit of RM30m or 17% of our FY14 forecast.

New plant to drive future earnings growth beyond FY14. Recently, Kossan has proposed to buy a piece of land measuring approximately 3.7493 hectare in Mukim Kapar, Klang, Selangor for RM20m. With a net debt of RM70m and net gearing of 11% as at 30 Sept 2013, funding is not an issue. We understand that the land purchase which is expected to complete in 1Q2014 is for a plant with a targeted capacity of 5b pieces p.a. or 23% to 26b pieces p.a. (taking into account the additional 5b pieces from 16b to 21b in FY14). This new plant is expected to drive future earnings growth beyond FY14.

Raising our FY14E net profit by 13%. We are raising our FY14 earnings forecast by 13% taking into account margin expansion (EBITDA margin raised from 15.8% to 17.8%) emanating from the new plant’s production scheduling strategy and introducing our FY15 numbers. Correspondingly, our target price is raised by 13% from RM3.93 to RM4.46 based on 16x FY14 revised EPS. We maintain our OUTPERFORM rating.

We like Kossan because: (i) of its superior net profit growth of 32% and 16% in FY14E and FY15E respectively compared to the average of 15% and 12% for Top Glove and Hartalega, respectively, (ii) Kossan’s unprecedented earnings growth over the next two years underpinned by rapid capacity expansion, and (iii) the fact that Kossan is not just a rubber glove play but a bet on its TRP division, which is growing over the past few quarters.

Key risks. Delay in commissioning of production lines.
 

Source: Kenanga