We are initiating coverage on Thong Guan Industries Bhd (TGUAN) with an OUTPERFORM rating and a target price of RM3.70. TGUAN has been involved in the cast pallet stretch film and garbage bags industry for more than 30 years, mainly for the export market. TGUAN has two distinct earnings streams: – (i) 95% revenue from plastics products and (ii) the remaining 5% from the F&B segment. We like TGUAN for: (i) its new innovation in stretch film segment providing margin improvement, (ii) earnings growth from expanding PVC food wrap segment, (iii) decent dividend of 3.4%, (iv) strong balance sheet with net cash of RM20.6m as at FY13, and (v) potential growth through M&A activity. We estimate FY14E-FY15E net profits of RM34.4m (+22.2% YoY) and RM38.9m (+13.0% YoY), respectively. In our view, the stock is ripe for a positive PER re-rating driven by its strong potential growth and robust balance sheet.

New innovation to enhance stretch film’s margin. TGUAN is spending a capex of RM4.0m to set up a Newton Research & Development (R&D) Center. The new innovation should enhance TGUAN’s position in securing new contracts from end users like F&B manufacturers and also to further increase its export market share. Moreover, this new avenue could enhance production efficiency leading to margin improvement.

Earnings growth from PVC food wrap segment. TGUAN is currently operating four Purewrap production lines with capacity of 6,000MT p.a. It targets to add another two new Purewrap production lines in August 2014 and two more in 1Q15, which will double its current Purewrap capacity to 12,000MT p.a. This will provide more stable earnings growth in coming years. Imputing this, we assume net profit to grow with 2-year CAGR of 17.5% for the period FY13-FY15 which implies undemanding FY14-FY15 Fwd. PER of 8.9x-7.8x, respectively.

Strong balance sheet and decent dividend yield. TGUAN is in a net cash position of RM20.6m as of FY13 which will provide flexibility to the management to continue expanding its current business by purchase new machinery or through M&A opportunity. Meanwhile, we expect FY14E-FY15E net dividends of 9.8-11.1 sen, representing decent yields of 3.4%-3.8%, respectively, which are on par to close peer such as SCIENTX.

Issue ICULS for expansion. Although TGUAN is currently a net cash company, the upcoming expansion plan will exhaust its cash. As such, in May, TGUAN had proposed a 1-for-2 5-year 5.0% ICULS with 2 ICULS-for-1 free warrants. The fund raising exercise is expected to be completed next month with proceeds of up to RM52.6m. Upon full conversion, it will enlarge the share base to 184.1m from 105.2m, thus diluting its EPS by c.43%.

Initiating with OUTPERFORM and TP of RM3.70. Our valuation methodology is based on a targeted PER of 10.0x on FY15E EPS of 37.0 sen. Our targeted PER of 10x is based on 5% discount to current FBM Small Cap Fwd. PER valuation of 10.5x and only 2% discount to its closest peer SCIENTEX with ascribed PER of 10.2x for its manufacturing segment. The small discount is applied due to its relatively smaller market cap and liquidity issue. Overall, we expect a potential total return of 30.8% from here (Upside of 27.5% and dividend yield of 3.4%).

Risks to earnings are: (i) volatility of plastic resins prices and (ii) foreign currency risk.

Source: Kenanga