We came away from SCGM’s 3Q18 results’ briefing feeling concerned of near-term margin compression from higher cost, while resin cost is increasing in 4Q18. However, cost pass-through should help cushion FY19E margins, while longer term plans are intact with completion of the new factory by 2H19, increasing capacity (+65%) to 67.6k MT/year. All in, we lower FY18-19E by 13-9%. Maintain MARKET PERFORM but lower TP to RM1.75 (from RM2.00).

Margin compression on higher raw materials and expansion cost. To recap, recent 9M18 results disappointed for the fourth quarter in a row, primarily on margin compression from higher resin cost, as well as increased overhead from ongoing expansions, and higher financing cost from additional borrowings to fund the expansion. We have trimmed our earnings post results (refer to report dated 14th March 2018, ‘9M18 Below Expectations’) to account for weaker margins, but we caution that there may be more downside risk to 4Q18 margins.

Cost pass-through may not benefit 4Q18, but should cushion FY19E margin compression. Management guided that resin cost for polypropylene (PP) has increased in March 18 (c.5% YoY), while they may look to pass on the higher cost on certain products gradually in coming quarters in light of the higher cost environment in FY18. As such, we believe the benefits of the cost pass-through will mostly accrete from FY19 onwards.

Expansion well on track. We expect improved contributions in coming quarters from SCGM’s rented Klang Valley factory. As at Jan 2018, the factory has four thermoform and two extrusion machines, adding 5k MT of capacity per year. The construction of the second factory in Kulai, Johor is completed (as at 3Q18), pending the issue of the CCC and expected to come online in Dec 2018 (2H19), as scheduled. Post completion, the new factory will bring the group’s total capacity to 67.6k MT/year (+65% from current level).

Outlook. We are expecting FY18-19E capex of RM60-54m, with FY18E capex to be utilised for; (i) the 2nd factory construction in Kulai, and (ii) the new Klang Valley rented factory, while FY19 capex of RM54m will be utilised for constructing its Kulai factory. We expect low effective tax rates of 13-18% for FY18-19E as SCGM will benefit from reinvestment allowance.

We lower FY18-19E CNP by 13-9% to RM19.3-21.1m (from RM22.0- 23.3m) upon lowering our FY18-19E EBIT margins to 10.4-10.9% (from 11.8-12.0%), accounting for; (i) higher resin cost in 4Q18 onwards, and (ii) gradual increase in average selling prices (+1% to FY19 revenue) from FY19 onwards. We are assuming conservative margin assumptions going forward in light of constant margins compressions in FY18, but we may look to upgrade our earnings should we see margin improvements.

Maintain MARKET PERFORM but lower our FD ex-all TP to RM1.75 (from RM2.00). Our FD ex-all TP is based on a lower FD CY18E EPS of 9.6 sen (from 10.8 sen after accounting for the bonus issue and full conversion of warrants), and a lower Fwd. PER of 18.0x (from 18.5x) post trimming our margins and earnings. Our applied PER is lower than SLP’s Fwd. PER of 18.7x due to SCGM’s weaker margins and earnings growth, but above TOMYPAK’s PER of 17.5x. We are comfortable with our MARKET PERFORM call in light of recent share price weakness (- 30% YTD), in tandem with the FBMSC (-7% YTD), and we believe that we have accounted for most foreseeable earnings risk going forward.

Source: Kenanga Research - 15 Mar 2018