Macro fundamentals stable, priced into earnings. We expect demand for plastic packagers to remain resilient backed by stable revenue growth in the recent results season (2-12%), from local and export demand, while growth going forward will be driven by penetration into new markets (i.e. China, United States, Canada and Africa) with niche client-specific products, a stable clientele base (MNCs and loyal Japanese clients) and state wide polystyrene bans. We maintain our Ringgit to USD assumptions at RM4.25 in FY17-18, which is slightly lower vs. the YTD average of RM 4.36, while increments in resin cost in 1HCY17 have been priced into our forward assumptions. CY17 resin prices have been range-bound between USD1,100/MT and 1,400/MT, (USD1,180/MT YTD average), while our in-house estimates are slightly more conservative at between USD1,200-1,300/MT in FY17-18. Alternatively, we believe there is a possibility of lower resin prices in FY18 on increasing resin supply in coming quarters which would be a re-rating catalyst for the sector if it materialises.

Correlation with macro factors have become more detached post 2015. We note that the correlation between resin and crude oil is becoming more detached from a correlation of 83% since 2011, to 64-47% in CY15-16, which is likely due to the excess supply of resin in the market. Similarly, plastic packagers’ share prices are also becoming less dependent on fluctuations in the USD, from a correlation of 85% since 2011, to 68-32% in CY15-16. As such, we believe plastic packagers’ earnings and share prices will be less influenced by macro factors, and will be determined more by microeconomic growth.

Valuations. In our recent sector update (refer to our report dated 29th September 2017, ‘Taking A Breather, Selective on TGUAN’), we rebased our valuation method at a discount to Rubber Gloves sector. Our previous valuation method of benchmarking to DAIBOCI was no longer justifiable due to its high PER of 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 16.5-14.3x in FY17/18 - 18/19E, and (iii) close to the rubber gloves sector weighted average of 24.0-21.8x in FY17/18 -18/19E PER.

Due to the rubber gloves sector’s similarities to plastic packagers (i.e. net exporter, beneficiary of weaker Ringgit vs. the USD and strong product demand as final product is fairly inelastic), we are attaching a discount on plastic packagers compared to the rubber gloves sector PER based on respective quantitative and qualitative factors.

Post our analysis, we awarded SCGM 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 earnings.

Maintain NEUTRAL. We maintain NEUTRAL (as we recently downgraded the sector from OVERWEIGHT in our report dated 29th September 2017, ‘Taking A Breather, Selective on TGUAN’). We believe the sector warrants a NEUTRAL call as most share prices have performed well YTD (up 4-44%), save for TGUAN (-5%), despite earnings weaknesses in 1H17 on weaker margins from higher cost of production. As such, 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 potential 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 FY17-18 (vs. 3-7% over FY14-16). 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 paid out c.25-30% of earnings despite having no formal dividend policy. Based on our newly applied PER of 15.3x on FY18E, TGUAN is commanding an attractive 43% 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 - 6 Oct 2017