Downgrade to NEUTRAL (from OW). 2Q17 results were mostly below, save for TGUAN, which came in within. YTD, most packagers saw decent gains of 4-42%, save for TGUAN at -5%. Macro fundamentals such as USD/MYR forex are fairly stable while resin cost increased in 1H17 which we have accounted for. However, the possibility of lower resin prices in FY18 would be a re-rating catalyst for the sector if it materialises. All in, most earnings estimates are unchanged, but we lowered SLP’s by 9-8% for FY17-18E on lower margins from higher cost and delayed sales of high margin products. We are re-valuing all plastic packagers under our coverage as our previous valuation method of rebasing against DAIBOCI is no longer justifiable due to its high PER which is above the sector average and close to rubber gloves. Instead, we are using the rubber gloves sector as a benchmark for toppish valuations and awarding plastic packagers a discount to rubber gloves’ PER based on respective quantitative and qualitative factors. Based on our analysis, we are applying a slightly lower PER of for all plastic packagers under our coverage save for TGUAN. SCGM is awarded the highest PER at 19.6x, SLP at 19.0x, TOMYPAK at 18.7x, SCIENTX at 17.4x and TGUAN at 15.3x on FY18E. No changes to calls but we lower most TPs by 1-19%, and increase TGUAN’s TP by 5%. Our Top Pick is TGUAN (OP; TP:RM5.67) which is a laggard despite its solid earnings and fundamentals as its share price has yet to play catch up (-5% YTD).

2Q17 mostly below expectations. Most plastic packagers’ results came in below expectations this quarter, except for TGUAN, which came in within expectations. The weaker 1HCY17 results were due to: (i) lower export sales and conversion rates, which eventually affected margins (i.e. SLP and TOMYPAK), (ii) lower-than-expected utilisation rates for SCIENTX’s new plants in Rawang and Ipoh, while almost all plastic packagers (save for SCIENTX) noted (iii) higher raw material cost, similar to 1Q17. Evidently, most top-lines were within but bottom-lines came in below due to margin compression (i.e. SCGM, SLP, TOMYPAK). As a result, we have lowered earnings estimates for most plastic packagers under our coverage by 6-21% in FY17-18E and 0-15% in FY18-19E, except for TGUAN, which was unchanged.

TOMYPAK, the top gainer YTD at 42%. The sector has done well year-to-date recording mostly positive growth of between 4% and 42%, save for TGUAN, which declined by 5% YTD. TOMYPAK was the top gainer at 42% YTD on strong 1Q17 results (released on 18th May 17) which saw its share price rallying then. On the flipside, TGUAN was the only decliner YTD, but we believe TGUAN is a laggard as its fundamentals remain intact, and the only plastic packager under our coverage which met expectations.

Demand for plastic products expected to remain stable. We expect demand for plastic products under our coverage to remain resilient as; (i) plastic packagers are continuously aiming to penetrate new markets (i.e. China, United States, Canada and Africa), (ii) their niche products (i.e. FMCG or plastic bags) are client-specific and cater to detailed or stringent requirements (ex: TOMYPAK, SLP), (iii) a large portion of plastic packagers (TGUAN, SLP and SCIENTX) sales are driven by loyal Japanese clienteles who rarely change suppliers, and (iv) SCGM is benefiting from the multi-state ban on polystyrene (replaced by SCGM lunch boxes). Evidently, plastic packagers under our coverage saw stable revenue growth in the recent quarterly results season (2-12%), driven by both local and export demand.

Maintaining Ringgit to USD assumptions. We expect future earnings growth to be more dependent on capacity expansions. However, a weakening Ringgit will bode well for share price sentiment. Our sensitivity analysis suggests that a 2% increase in the Ringgit results in c.1-4% decline to earnings, implying the impact is not overly significant. We are comfortable and maintain our USD/MYR assumption at 4.25 in CY17-18, which is slightly lower vs. the YTD average of 4.36 as we choose to remain conservative.

Correlations with macro factors more detached post 2015. The plastic sector began to thrive in CY15 when crude oil prices fell, leading to lower resin cost, while the Ringgit also weakened against the USD in 2015, benefiting plastic manufacturers in Malaysia as they are net exporters. This is because there was a strong correlation between resin cost and crude oil at 83% since 2011, and 85% on average for plastic packagers share price vs. the USD to Ringgit forex since 2011. However, we note that the correlation between resin and crude oil is becoming more and more detached at only 64% since 2015 and 47% since 2016, which is likely due to the excess supply of resin in the market. Similarly, plastic packagers’ share prices have also becoming less and less dependent to fluctuations in the USD, with a correlation of 68% since 2015, and 32% since 2016. global supply of ethelyn production. As such, we believe resin prices may be volatile throughout this period in CY17. That being said, we believe there is a possibility that resin prices may trend lower in CY18 in light of increased supply into the market from major resin suppliers such as Reliance and Opal and other producers in Canada, US, India and Iran, as well as US shale-based resin, which is set to enter the market in CY18. Year to date, resin prices have been range-bound between USD1,100 and 1,400/MT currently, with a YTD average of c.USD1,180/MT, while our in-house estimates are slightly more conservative at USD1,200-1,300/MT. We maintain our resin cost estimates for now, between USD1,200-1,300/MT in FY17-18E, while we may look to lower resin cost assumptions in 4Q17 or CY18, pending further clarity of the effects of additional resin supply on prices. We believe this could be a positive rerating catalyst for the sector; assuming a 2% decline in resin prices, this could increase plastic packagers’ earnings under our coverage by 6-8%.

Trimming SLP’s earnings on more conservative margin assumptions. We are trimming our earnings for SLP by 8.8-8.3% in FY17-18E to RM26.3-35.5m as we had initially expected a strong 2H17 from the roll-out of its healthcare products, which command far better margins than kitchen bags and MaxInflax products. However, we believe our margin assumptions were too bullish as the roll-out of these products i pushed to mid 4Q and; thus, the bulk of contributions will be in FY18. We initially expected the healthcare products to contribute 8-10% of revenue in FY17-18 vs. c.3% in FY16, but we have since revised our assumption to 4% in FY17. Additionally, we expect slightly higher expenses for the new factory which is set to come on-stream in FY18. All in, we lower SLP’s CNP margins to 14-15% in FY17-18E (from 15-17%). We make no earnings changes to other plastic packagers under our coverage for now as we have recently accounted for the higher cost during the results season review.

Valuation method recap. We had previously re-based the Plastic sector’s valuations against DAIBOCI (refer to our report dated 8 July 2016 - 3Q16 Sector Strategy Report titled ‘Valuation Re-Rating’) as DAIBOCI’s valuations were stable at 18.0x average Fwd. PER since CY14 on above-average margins and ROE vs. its peers back then despite earnings decline (-13%) in CY14 while other plastic manufacturers soon began to catch-up in terms of ROE, margins and earnings growth. As a result, based on our analysis with DAIBOCI (18.0x Fwd average PER) as a base, we awarded SLP a valuation of 21.5x PER, SCGM at 19.9x PER, TGUAN at 14.6x PER, SCIENTX at 17.6x PER, and TOMYPAK with 19.2x PER which is based on a slight premium to its direct comparable, DAIBOCI, due to better core net margins, earnings growth, slightly better dividend yields, and lower net gearing of 0.06x.

Are DAIBOCI and the plastic sector’s valuations too high? DAIBOCI’s valuations have continued to rise since our initial report, despite consensus trimming its forward earnings per share since CY16, while its share price has remained resilient (18% YTD gains). This resulted in expansion in its Fwd. PER valuations, which are now very steep at 26.4-20.9x FY17-18E PER (based on Bloomberg consensus) against (i) its 5-year historical average 18.2x (ii) well above the plastic sector weighted average of 16.4-14.3x in FY17/18 - 18/19E, and (iii) incredibly close to the rubber gloves sector weighted average of 24.0-21.8x in FY17/18 -18/19E PER. We feel that DAIBOCI’s expanded PER is unjustified at current levels as it pales in comparison to its peers fundamentally. Therefore, benchmarking the plastic sector against DAIBOCI’s valuations at current levels may be overly optimistic.

Rubber gloves a benchmark for toppish valuations. Plastic packagers and glove manufacturers are similar in the sense that; (i) both manufacturers are net exporters, thus benefiting from weaker exchange rates vs. the USD, and (ii) strong product demand due to the nature of the final product which is fairly inelastic of consumer spending power, (ex: rubber gloves - required for the evergreen healthcare sector, and garbage bags, lunch boxes, stretch film and medical devices produced by plastic manufacturers), as these products are necessities to existing consumers. However, we think that the rubber gloves sector is more superior to plastic packagers in terms of demand due to the stringent requirements imposed on glove makers, making barriers of entry into the glove making business tougher, while plastic goods have relatively lower requirements and operate in a more fragmented market. With a larger global reach and an evergreen healthcare sector to back demand, domestic rubber gloves manufacturers are the largest in the world, commanding an estimated 60% of global market share, with a total market cap of RM23.7b for rubber gloves under our coverage (vs. RM7.2b for plastic packagers).

Consumer-based plastic packagers trade closer to rubber gloves valuations vs. industrial packagers. Since 2011, the plastic sector has traded at a 45% discount on average to the rubber gloves sector. Though this may appear steep, note that almost 63% of the plastic sector in terms of market cap comprised of industrial packagers, i.e. SCEINTX and TGUAN, which make up 53% and 10% of the sector, respectively, and this has weighed down the plastic sector’s PER as; (i) both stocks operate in the industrial segment which command lower valuations due to lower product margins vs. consumer packagers, and (ii) SCIENTX’s lower PER is also likely due to exposure to the property segment which carries a lower PER. Consumer plastics packagers (SLP, SCGM, DAIBOCHI and TOMYPAK) tend to trade closer to rubber gloves (i.e. at a thinner discount), between 18% to 1% discount on average since 2011, while industrial packagers trade at 48% to 50% discount to rubber gloves (refer to charts).

Re-evaluating our valuations. We believe our previous valuation method of rebasing the sector against DAIBOCI may no longer be appropriate as DAIBOCI’s valuations is almost on par with the rubber gloves sector, while we believe plastic packagers should be pegged at a discount to rubber gloves due to abovementioned reasons. As such, after evaluating key metrics for the plastic packaging sector such as market cap, capacity growth, margins, earnings growth, balance sheet strength and qualitative factors such as dividend pay-out policy, and exposure to the stable consumer segment, we have re-assigned new PER for plastic packagers under our coverage based on a discounted PER to the rubber gloves sector (refer to chart below).

Downgrade to NEUTRAL (from OVERWEIGHT). We downgrade plastic packagers under our coverage to NEUTRAL from OVERWEIGHT as they have performed well YTD, up by 9-44% (save for TGUAN). This is also on the back of earnings weaknesses in 1H17 on weaker margins from higher cost of production. We believe most plastic packagers under our coverage are fairly valued, save for TGUAN, which appears to be a laggard at current levels. Going forward, we are comfortable with our NEUTRAL call for now as most foreseeable risk as well as upside potentials have been priced in.

TGUAN our Top Pick. Despite its solid earnings and fundamentals YTD, and being the only plastic packagers that met expectations this quarter, TGUAN’s share price performance (-5% YTD) remains a laggard vis-à-vis its peers. We like TGUAN for its stable earnings growth, and expect 12%-6% top-line growth in FY17-18E, premised on modest capacity growth assumptions of 13-15% in FY17-18E and on slightly improving net margin assumptions of 7-8% in FY17-18E (vs. 3-7% over FY14-16A). We believe growth going forward will be driven by its ability to increase sales of its higher margin products, (i.e. Nano-33 stretch film and MaxStretch) and increased sales to Europe, Australia and New Zealand. Furthermore, its healthy balance sheet (strong net cash position of 0.14x), is better than its peers, save for SLP, and we expect this to be maintained going forward. The Group had consistently pays-out c.25-30% of earnings despite having no formal dividend policy. Based on our newly applied PER of 15.1x on FY18E, TGUAN is commanding an attractive 44% total return despite our modest valuations.

Risks; (i) slower-than-expected demand for plastic products, especially from importing countries, (ii) higher-than-expected resin prices, and (iii) a sector de-rating due to weaker valuations from unfavourable macroeconomic situation.

Source: Kenanga Research - 29 Sept 2017