We attended SCGM’s 1Q19 briefing and came away feeling cautious on the Group’s compressed margin of only 1.9% at CNP level (vs. 10.3% in 1Q18) from higher resin, utilities and labour costs. However, top-line growth and expansion plans are on track. All in, we lower FY19-20E CNP margins to 2.4- 3.3% (from 4.8-5.9%), closer to current levels, and lower FY19-20 CNPs by 49-44% to RM5.5-8.5m. Maintain UNDERPERFORM but lower our TP to RM1.15 (from RM1.30).

High cost dragging margins through the mud. To recap, SCGM’s results came in below expectations for the sixth consecutive quarter, with earnings at 10% of our FY19 estimate, at RM1.1m. This was mainly due to weaker-than-expected margins from higher cost (i.e. resin, utilities, and labour). Post meeting with management, we remain cautious on the high-cost environment as costs had continued to escalate mostly from; (i) increasing resin cost (c.+14% YoY), (ii) higher labour cost from Banting factory, (iii) higher utilities, as well as, (iv) weaker product mix due to increased competition for the lunchbox segment which made up c.10% of top-line. This was all on the back of improving top-line (+4% YoY). As a result, CNP margins were at 1.9% vs. 10.3% in 1Q18, but this is a promising improvement from 4Q18 CNL of RM0.7m.

Top-line growth at an all-time high of RM55.8m this quarter, which was attributable to improved sales mostly from extrusion sheets (c. 15% of top-line), while F&B and others segment were flattish to mildly negative at -0.4% and -2.6% YoY due to the competitive climate. The group is focused on expanding its customer base by increasing capacity to new countries such as Cambodia and Myanmar, whilst increasing sales from existing foreign markets (i.e. Indonesia, Australia and New Zealand). The new Kulai factory capacity expansion plans are also well on track for commencement in Dec 2018, with machine transfers currently underway.

Outlook. Post completion, the new factory will boost total group capacity to 67.6k MY/year (+65% from current levels). We are expecting FY19-20 capex of RM50-15m mostly for the Kulai factory. We maintain low effective tax rates of 18-20% for FY19-20 as SCGM is still expected to benefit from reinvestment allowance in coming quarters.

Lower FY19-20E CNP by 49-44% to RM5.5-8.5m. Going forward, we believe that top-line growth will be stable to mildly positive, but margins may take a beating as the Group struggle to manage the escalating cost in the near term. As such, we lower earnings on higher cost sustained from resin, labour and utilities in the near term and marginally lower product margins. All in, we are lowering FY19-20 CNP margins to 2.4-3.3%, closer to current levels (from 4.8% - 5.9%). On the bright side, although the new Kulai factory may incur additional costs in the near term, it is also targeted for increased automation, which should enable economies of scale and help improve margins in the longer run.

Maintain UNDERPERFORM but lower our TP to RM1.15 (from RM1.30). We lower our TP to RM1.15 on a lower PBV valuation multiple of 0.95x (from 1.10x) PBV on FY19E FD BVPS of 1.2x. Our lower PBV multiple is based on the 4-year low PBV valuation (more than -2.0 SD) vs. -2.0SD previously, due to continuous margin compression and earnings volatility in light of missed earnings expectations over six quarters. We believe valuations are stretched warranting an UNDERPERFORM call as we have priced in most positives, including capacity expansions in FY19-20, and we caution downside bias to our valuations due to weakness from margin compressions, while the near- term outlook for earnings stability remains challenging.

Risks to our call include; (i) lower-than-expected resin cost, (ii) higher product demand from overseas markets, and (iii) currency risk from weakening Ringgit.

Source: Kenanga Research - 24 Sep 2018