Maintain OVERWEIGHT as we are comfortable with favourable macro-economic fundamentals such as the stable USD/MYR exchange rate at 4.10 and resin cost of USD1,100-1200/MT, in line with our expectations. Plastics stocks under our coverage have also continued to fare better than the market, appreciating by 28% to 36% YTD vs. the FBMKLCI (-2% YTD) and the FBM Small Cap (-4% YTD), implying that the sector remains a preferred haven for investors, and we believe there are more upsides for the sector, especially in coming quarters due to expectation of QoQ improvement in margins and earnings on better product mix. We also recently initiated coverage on SCGM (OP; TP: RM3.81) as its share price has retreated to Jan 2016 levels with 0% YTD while SLP retreated from its maximum YTD gains of 61% to 29% currently vs. its peers’ 28-36% YTD gains after both SCGM and SLP were sold down in Aug 2016, in line with the FBM Small Cap index on profit-taking activities. As such, we believe it is an opportune time to accumulate both stocks as fundamentals and growth prospects remain largely intact. We like SCGM for its solid earnings growth of 15-30% in FY17-18E and long-term outlook as the company plans to boost capacity by 2.5x to 62.6k metric tons/year by Dec 2018, in a series of expansions that will further broaden its market share in the F&B packaging business. We reiterate our view that the sector will continue to re-rate, driven by strong demand, evident from capacity expansions as well as margin growth through higher value products and improved product mix. We make no changes to earnings or our valuations basis, and maintain OUTPERFORM call on SLP (TP: RM3.11), SCIENTX (TP: RM7.57) and SCGM (TP: RM3.81), and a MARKET PERFORM call on TGUAN (TP: RM4.49).

The sector’s macro-economic fundamentals remain stable. We maintain our in-house FY16-17E estimates of USD/MYR at 4.10 (vs. YTD average of RM4.08). Notably, the Ringgit has been weakening recently against the USD, down by 2.7% since Jul 2016 (from RM3.99/USD in Jul 2016 to RM4.10/USD currently). Although the sector is a beneficiary of a weaker Ringgit to USD, the impact is not overly significant as our sensitivity analysis indicates that a 2% decline to the Ringgit would result in a 1-4% increase to bottom line. Going forward, future earnings growth will be more dependent on margin expansions but a weakening Ringgit bodes well for the sector.

Resin cost stable, detached from crude oil prices. Resin cost has also remained stable over the past one year at the current level of c.USD1,100-1,200/MT on ample supply of resin due to excess supply from China. This has resulted in resin prices becoming detached from volatile crude oil prices. That said, we do not expect recent news of an OPEC cut in production to have any significant effect on resin cost as; (i) major OPEC member producers such as Iran, Libya and Nigeria are exempted from the production cuts, (ii) non-OPEC members such as USA and Russia are likely to continue drilling, and (iii) production is only expected to be reduced by 1.2-1.5% a day (from 33.4m barrels per day).

TGUAN is the top gainer YTD, while the sector continued to outperform the market. TGUAN was the top gainer YTD, up by 36% to RM4.28 at of our report cut-off date (15th Sep 2016) as the company delivered sequential quarterly improvements in margins, expanding from 12% in gross margin to 17% with core net margins expanding from 3% to 9% by 1Q16 result. We upgraded our call to an OUTPERFORM (from MARKET PERFORM) on 26th Feb 2016 during the 4Q15 results on expectations of stronger margins going forward. The share price rallied by 35% since then, while we have downgraded our call to MARKET PERFORM (on 26th Aug 2016) on value realisation. SLP, SCIENTX and SCGM appreciated by 29%, 28% and 0% YTD, respectively, beating the overall market (FBMKLCI -2% YTD) and the FBM Small Cap (-4% YTD).

SLP and SCGM slowly recovering from the sharp August sell-down, with more room for upside. Recall that in our report (dated 7th Sep 2016, ‘Fundamentals Remain Intact’), we highlighted that SLP and SCGM saw sharp sell-downs in August with the bulk of their year-to-date gains erased with 20% and -6% YTD gains for SLP and SCGM, as at 6th Sep 2016 vs. 58% and 11% YTD gains before the sell-down began on 12th Aug 2016 in line with a correction of the FBMSC by 1.2% over the past one month in August and 0.3% decline during that same period as profit-taking activities were seen on well performing stocks. However, we believe fundamentals are intact on stable macro conditions, while sales are expected to be stronger in coming quarters, evident from capacity expansion plans. Since our report (on 7th Sep 16, ‘Fundamentals Remain Intact’), we note that SLP and SCGM’s share prices have recovered slightly, increasing by 7% and 2%, respectively. However, we expect more upsides from current levels, by 26% for SLP and 20% for SCGM based on our FY17E valuations.

We recently initiated coverage on SCGM (OP; TP: RM3.81) on strong upside potential (23% total returns). We recently initiated coverage on SCGM and are positive on the company’s growth prospect. SCGM is the largest thermo-form packaging player in Malaysia, and is a prime beneficiary of recent multi-state ban on polystyrene food containers. We expect SGCM to see strong FY17- 18E revenue growth at 20-22%, beating its 5-year average revenue growth of 12%, thanks to its pipeline of capacity expansions and a focus on higher margin value-add products such as food containers and disposable cups. Meanwhile, we expect sustainable core net margins at FY17-18E at 14-15%, an improvement on its 5-year average margin of 11% on the back of new product innovations and improving manufacturing efficiency by upgrading to high-speed manufacturing equipment. In the long-term, the company plans to boost capacity by 2.5x to 62.6k metric tons (MT)/year by Dec 2018, in a series of expansions that will further broaden its market share in the F&B packaging business. We expect solid earnings growth of 15-30% in FY17-18E and decent dividend yield of 2.5-3.1% with a 40% dividend policy. Our Target Price of RM3.81 is based on 19.9x Fwd. PER applied to CY17E EPS of 19.2 sen. Valuation-wise, we apply a slight discount to fellow consumer packager SLP’s 21.5x PER, as SLP enjoys slightly better margins and export exposure. However, both are on par in terms of earnings growth, dividend policy, ROE and balance sheet strength (net cash position as of FY16).

SLP’s fundamentals remain intact. We believe the recent sell-down was overdone as SLP’s fundamentals remained intact. Thus, we think this is an opportune time to accumulate SLP as valuations appear compelling at current levels. We continue to like SLP for its: (i) strong EBIT margin of 16% vs. peers’ 8-9%, (ii) consistent net cash position, (iii) 40% dividend policy, which provides consistency of returns to shareholders, and (iv) high ROE of 24% vs. peers’ 9-21%. Channel checks with SLP’s management also confirmed our view that fundamentals remain intact. The group expects sales to be stronger in 2H16, as orders tend to pick up after August, based on historical trends, which bode well for earnings, while SLP’s new factory will be completed in Oct 2016. This new factory will add to SLP’s downstream processing capabilities, resulting in higher margin products, while capacity expansion plans are still set for FY18 for an additional 14k MT (+58% to its existing capacity of 24k MT p.a.). Our earnings estimates already reflect the improved margins in FY16-17E at 15.4-17.8% from the inclusion of downstream machinery, as well as capex allocations of RM15-9m, respectively. At current levels, SLP is commanding total returns of 29% to our TP of RM3.11. We make no changes to our OUTPERFORM call and TP of RM3.11 which is based on an applied PER of 21.5x FY17E EPS of 14.5 sen.

We believe TGUAN will be able to maintain its current margins of c.8-9% on the following factors; (i) the Group is selling off machinery for lower margin products such as jumbo rolls (est. <5% gross margins), while (ii) top line growth and better margins products are mostly from Maxstretch stretch film on better pricing due to improved product quality, (iii) PVC food wrap and (iv) organic noodles. Our TP is based on a Target PER of 14.6x on FY17E FD EPS of 30.8 sen.

Valuations. We have in our 3Q16 Sector Strategy Report titled ‘Valuation Re-Rating’ (dated 8th Jul-16) re-rated the plastic sector’s valuations which we believed were overdue then as the sector was able to command strong growth rates with a 3-year CAGR of 20- 32% for companies under our coverage, on the back of stable dividends (minimum 30% pay-out ratio) and long-term earnings growth through expansion and product development, resulting in higher margins. We re-based our valuations against DAIBOCI as its valuations have remained sticky at 18.0x average Fwd. PER since CY14 on above-average margins and ROE vs. its peers back then, and despite earnings declines (-13%) in CY14 while other plastic manufacturers had since been playing catch-up in terms of margins and earnings growth. Our applied Fwd. PER took into account the following factors; (i) margins, (ii) dividend pay-outs, (iii) ROE, (iv) 3- year CAGR, (v) balance sheet strength, (vi) market cap, (vii) export revenue, and (viii) exposure to consumer segment. Based on our analysis and using DAIBOCI (18.0x PER) as a base, we awarded SLP richer valuations of 21.5x FY17E PER, SCGM at 19.9x CY17E PER, TGUAN at 14.6x FY17E PER, and SCIENTX at 17.6x PER on CY17E PER. We remain confident of our valuations as the stocks’ underlying fundamentals are unshaken while we expect earnings growth to stay resilient in coming quarters as risk to earnings are limited and have been accounted for.

We make no changes to our Calls and TP. We leave our calls and TPs for SCIENTX (OP; TP: RM7.57), SLP (OP; TP: RM3.11) and TGUAN (MP; TP: RM4.49) unchanged and initiate coverage on SCGM (OP; TP: RM3.81). SCIENTX’s earnings going forward will be driven by margin improvements in the consumer segment as consumer packaging capacity is expected to make up c.50% of total capacity post expansion in 2H17, from 38% currently, whilst overall earnings will be bolstered by the property segment which tends to command strong operating margins of 25-30%. Our TP is based on an applied PER of 17.6x PER for manufacturing segment based on Sum-of-Parts (SoP) methodology for CY17, and applied PER of 4.0x for the property segment to CY17 RNAV.

Reiterate OVERWEIGHT on the plastic sector as it is expected to fare well in coming quarters. The plastics packaging sector will continue to see margin expansions over the next two years as packagers under our coverage continue to up their game through product innovation moving towards selling more niche and higher-margin products for specific customers. This coupled with the fact that macro fundamentals remain intact, i.e. weak Ringgit and low cost environment which we have accounted for in our estimates, bode well for sentiment. Risks to our calls include: (i) slower-than-expected demand for plastic products, especially from importing countries, (ii) higher-thanexpected resin prices, and (iii) a sector de-rating due to weaker valuations from unfavourable macroeconomic situation.

Source: Kenanga Research - 5 Oct 2016