1H16 net profit of RM24.2m (-48.5% YoY) missed our expectation (at merely 30.5% of forecast). 1H16 DPS of 10.0 sen was below expectation due to the lower-than-expected earnings. FY16E-FY17E earnings forecast cut by 29.2%-18.6% to take higher costs into account. While we believe the investment in incentive and marketing programmes might bear fruit in the longer run, the related costs will exert a heavy toll on near term profitability. Downgrade to UNDERPERFORM with lower Target Price of RM8.04, based on unchanged 19x PER FY17E.

Result below expectation. 1H16 net profit of RM24.2m (-48.5% YoY) was below our expectation by accounting for 30.5% of our forecast. Consensus comparison is not available as the stock is not widely tracked. The negative deviation can be attributed to higher-than-expected selling and administrative expenses arising from higher incentive and operating expenses with regards to its 40th Anniversary. Second interim DPS of 5.0 sen was declared, lifting 1H16 DPS to 10.0 sen (vs 1Q15: 20.0 sen), which is below our expectation due to the lower-than-expected earnings.

YoY, 1H16 revenue grew by 12.7% to RM574.8m driven by strong pre-price increase purchase in February and April 2016, further supported by the strong buying momentum of its distributors in response to the 40th Anniversary sales and marketing programmes. Meanwhile, 1H16 gross profit only inched up marginally by 2.9% to RM138.1m, lower than the top-line growth, mainly due to higher product costs on weaker ringgit. However, the big uptick in selling and administrative expenses (+55.6%) due to the reasons mentioned above dragged net profit down by 48.5% to RM24.2m.

QoQ, 2Q16 revenue declined by 12.1% to RM268.9m as 1Q16 was boosted by strong buy-up in response to the price increase. 2Q16 gross profit declined at a milder fashion as margin expanded by 0.7ppt to 24.4% led by the price increase which in turn mitigated the effect of lower revenue. However, the Group spending on selling and administrative expenses continued to spike (+16.3%) due to investment in incentive and marketing, which caused 2Q16 net profit to dip by 65.8% to RM6.2m.

Short-term pain. While we believe the investment in incentive and marketing programmes might bear fruit in a longer run in view of the strengthening in relationship with existing distributors and the appeal of rewarding incentive programmes to attract potential new distributors, the related costs will take a heavy toll on its near-term profitability. Meanwhile, the saving grace is the price increases which will mitigate the impact of higher products costs without deterring sales volume and thus sustaining its growth at the gross profit level.

Earnings forecast slashed. Our FY16E and FY17E net profit forecasts were cut by 29.2% and 18.6%, respectively, after assuming higher selling and administrative expenses.

Downgrade to UNDERPERFORM from MARKET PERFORM with lower Target Price of RM8.04 (from RM9.84). Correspondingly with the earnings cut, our TP is revised down to RM8.04, based on unchanged 19x PER FY17E. The valuation is in line with -0.5 SD over the 5-year mean. Our negative rating is premised on the potential second consecutive annual profit decline in FY16 and in turn reducing the dividend pay-out and yield, which was one of the attractive selling points of the stock. The heavy investment the Group is embarking on, could potentially benefit or reward distributors more than shareholders in the short run.

Source: Kenanga Research - 18 Aug 2016