1H17 NP came in below expectations due to weaker-than- expected margins from new revolutionary products. Absence of dividend was expected. We reduced our FY17E/FY18E NP by 14%/15% to account for the abovementioned. That said, medium-term prospect remains decent, driven by continual ramp-up production for new and existing products alongside easing labour costs. Maintain OUTPERFORM with an unchanged TP of RM1.48 (implying 13.5x FY18E PER).

Below expectations. The group reported 2Q17 net profit (NP) of RM22.7m (+25% QoQ; +23% YoY), bringing 1H17 NP to RM41.0m (13% YoY) which made up 31%/33% of our/consensus’ full-year estimates. The lower-than-expected EBIT margin in 2Q17 (-1ppts QoQ to 6.6%) was a negative surprise to us as we expected 2Q17 EBIT margin to be higher, if not equal to 1Q17 on better operational efficiency (alongside easing labour issues). We gather that this was caused by the weaker- than-expected margins (lower profitability and greater complexity) from new revolutionary products. As expected, no dividend was declared for the quarter under review.

YoY, 1H17 revenue recorded an impressive growth of 54% mainly driven by the contribution from second tranche of household electrical appliances (floor cleaning) contracts secured in Sep’2015 and partial contribution from the new revolutionary products (beauty tools) started in April. However, EBIT recorded a smaller growth quantum of 12% as margin (-2.6ppts to 7.0%) was corroded by the short-term cost pressures resulting from the hiring of higher-cost contract workers to meet high orders (due to policy changes of foreign workers hiring) coupled with weaker margins (lower profitability and greater complexity) from the new revolutionary products.

QoQ, 2Q17 revenue soared 42% mainly on the back of higher ramp-up of the second tranche of household electrical appliances (floor cleaning) contracts as well as the new revolutionary products (beauty tools). However, PATAMI recorded a smaller growth quantum of 25% on lower EBIT margins (-1ppts to 6.6%) due to the weaker margins from the new revolutionary products.

Earnings momentum building up. Looking beyond the hiccups that have affected 1H17 earnings, the group’s medium-term earnings prospect remains decent, underpinned by the two long-term contracts awarded by its UK customer (sales contributions from existing and new products, amounting to RM1.1bn/year). While we gather that the new products are yielding slightly lower margins (of -c.1ppts at the NP margins) due to the lower profitability as well as greater complexity, all these will still anchor the robust 2-year NP CAGR of 30%, even after registering 94% growth YoY in FY16. Beyond that, we also do not discount the possibility of more contracts being awarded for revolutionary products in the long-term (which are in line with its UK customer’s vision), given its solid reputation in the industry with world-class manufacturing capability. Note that the group still has ample free capacity (of 70%) to take in more contracts.

Post-results, we reduced our FY17E/FY18E NP by 14%/15% to account for the lower margins arising from higher components costs from the new revolutionary products. Meanwhile, we made no changes to our major sales assumption (contract value). 2H17 should see better earnings underpinned by the ramp-up production from its new and existing products, alongside easing labour costs.

Maintain OUTPERFORM with an unchanged TP of RM1.48 (implying 13.5x FY18E PER). While we maintain our TP of RM1.48 for now, we might relook into our earnings assumptions, TP and rating again with downside bias if and when the group underperformed with another quarter of earnings disappointment. Risks to our call include: (i) loss of orders from its customers, (ii) higher input costs, and (iii) weaker-than- expected consumer sentiment.

Source: Kenanga Research - 29 Nov 2016