We assign an OVERWEIGHT call on the Plastics and Packaging sector as we expect 4Q14 to be another strong quarter on the back of: (i) sustained demand for diverse plastic products and (ii) lower raw material prices that would promote better profit margins for plastic producers. Whilst M&A activities might not have an immediate impact on the sector; we nonetheless think that it is a step in the right direction to garner greater global plastic market share in the long-run. We like TGUAN (OP; TP: RM3.70) within the sector due to: (i) its 2-year CAGR earnings growth of 17.5%, (ii) undemanding FY14-15E Fwd PER of 6.5x-5.8x, and (iii) decent FY14-15E net dividend yield of 4.6%-5.2%.

Satisfactory 2QCY14 results, but better 3QCY14. The sector turned in a satisfactory 2QCY14 performance with: (i) SCIENTX’s (OP; TP: RM7.63) 4Q14 result coming above our expectations on better-than-expected product-mix (due to the increase in sales of consumer packaging film) which resulted in higher margins and lower effective tax due to a tax rebate entitlement for the ongoing capacity expansion and (ii) TGUAN’s (OP; TP: RM3.70) 2Q14 results coming in within our expectations. We expect a better 3QCY14 reporting season, as we foresee QoQ earnings growth due to the lower raw material cost and increase in order books as the upcoming festive seasons spur demand for packaging products.

Sustained growth in demand of Malaysia’s diverse plastic products continues to support future sector sales. Data provided by Department of Statistics of Malaysia, showed that sales value of plastics products have increased 41.8% YoY, (from Jun-13 to Jun-14) indicating that the demand for plastics products has been growing. This was illustrated by plastic film producers like TGUAN and SCIENTX (which saw YoY revenue growth of 10% and 12%, respectively, in 2QCY14 (versus 2QCY13); and plastics converters like DAIBOCI and SLP (which saw YoY growth of 15% and 25%, respectively, in the same period). We expect Malaysian plastic product sales to continue growing due to: (i) positive long-term demand from export market such as Japan and Europe and; (ii) value-added products offered by Malaysian players could spur new orders.

Weaker crude oil prices = lower resin costs = better profit margins? About 60-70% of the sector‘s operating costs are in raw materials such as LLDPE, LDPE and HDPE. Our analysis suggests that the relationship between crude oil prices and resin prices are positively correlated (more than 90% correlation over a 10-year period), and this is fairly evident from the QoQ trends for crude oil (Brent and WTI prices dropped by 14.3% and 13.8% respectively) and resin prices (LLDPE -1.9%; LDPE -0.6%; and HDPE -1.3%). According to our economic team, crude oil prices could continue to be uninspiring in the near-term (Kenanga Economic Team forecasts Brent and WTI crude oil prices to be USD105.2/bbl-USD101.89/bbl for FY14-15E) due to weakening global demand and increased Libyan oil exports. Thus, we foresee resin price trend to also stay flat or drop further in the medium-term; conducive for margin improvement for plastic companies.

Industry M&A; a step in the right direction. We note that the sector has been busy with M&As in the past few years (e.g. Scientex Bhd’s acquisition of GW Plastics Holdings Bhd in Oct 2012 and Can-One Bhd buying a stake in Kian Joo Can Factory Bhd in Sep 2009) as the Malaysian packaging industry has recognised that there is need for production efficiency and stronger manufacturing capabilities to garner greater global market share. Whilst this might not have an immediate impact on the sector; we nonetheless think that it is a step in the right direction as the enlarged entities would be in a better position to compete regionally and garner greater global plastic market share in the longer-term. SCIENTX recently announced that it was entering into a strategic alliance agreement with Futamura Chemical Co Ltd to build a new consumer packaging manufacturing plant which will increase its capacity to 120,000MT p.a. (from 30,000MT p.a.) with a targeted completion date of 2016, making it one of the largest film producers in Southeast Asia region in term of capacity.

OVERWEIGHT call on the sector. We assign OVERWEIGHT rating on the sector driven by: (i) lower raw materials price and; (ii) increase in sales volume which will lead to better profit margin and earnings going forward, while M&A activities may put local plastics players in a better position to compete regionally on the back of stronger manufacturing capability and higher economies of scale in the long run. We like TGUAN (OP; TP: RM3.70) within the sector due to: (i) its 2-year CAGR earnings growth of 17.5% backed by capacity expansion in the PVC food wrap segment, (ii) undemanding FY14-15 Fwd PER of 6.5x-5.8x (note that conversion of ICULS will only take place after two years, hence, there is no immediate dilution in the short-term), and (iii) decent FY14-15E net dividend yield of 4.6%-5.2%. Risks to our call include: (i) volatility of raw materials price and (ii) currency risk.

Source: Kenanga