We  maintain  our  BUY  recommendation  on  Karex, with  a  slightly-raised TP of MYR3.43 (20x CY15 P/E, 19.5% upside). The company’s expansion plans remain intact and it is operating in a  favourable environment. Its capacity expansion  could drive organic growth, while its acquisition of Global  Protection  may  elevate  group  earnings  via  the  own  brand manufacturing (OBM) segment.   
 
Organic growth remains intact. Karex’s organic growth remains intact, spurred by its capacity expansion. It has achieved an annual production capacity  of  4bn  pieces  in  FY14  (Jun)  and  its  expansion  is  on  track  to meet  its  5bn  and  6bn  pieces  per  annum  target  by  FY15  and  FY16 respectively.  In  view  of  the  strong  demand  in  the  condom  industry,  we are confident that its additional capacity will be taken up.

Global  demand  still  strong.  Market  experts  believe  that  demand  for condoms may hit 30.4bn pieces per annum in 2016 (from 22.8bn pieces per  annum  in  2012-2013)  and  forecast  that  by  2018,  condom  demand could grow to 38.2bn pieces per annum. Apart from being used for family planning,  condoms  are  in  high  demand  in  countries  with  high  HIV prevalence  rates  (particularly  African  countries),  which  are  still  facing shortages of condoms.

Favourable  operating  environment.  The  price  of  natural  rubber  latex has eased to MYR3.80 per kg (vs a MYR5.63 per kg average in 2013), which is favourable for Karex. As its products’ ASPs do not fluctuate with raw material prices, Karex should be able to keep its earnings margin.

Opening a new chapter in OBM. Early this month, Karex completed the first  tranche  of  its  acquisition  of  Global  Protection  (GP),  which  entails  a 55% stake in the latter with a cash consideration of USD6.6m. We deem the  acquisition  attractive  as  the  valuation  is  relatively  fair,  while  GP should  open a  new  chapter  for  Karex  to  expand  its  OBM  division.  ONE brand from GP is a top-four condom brand in the US and Karex believes the potential market in Asia is huge. We did a  simple illustration on how Karex  can  improve  its  earnings  through  expansion  in  its  OBM  segment (see Figure 7).  

Maintain  BUY,  with  a  new  MYR3.43  TP.  We  make  minimal  revisions (less than 1%) to our earnings forecasts after incorporating Karex’s FY14 audited  numbers.  We  tweak  our  TP  slightly  higher  to  MYR3.43  (from MYR3.41), pegged to a 20x CY15 P/E and implying a 19.5% upside. Our target P/E of 20x is at a slight discount to Hartalega’s (HART MK, BUY, TP:  MYR7.70)  target  P/E  of  21x,  which  we  deem  justifiable  for  its  high expected growth rate. Maintain BUY.

Company Update

Organic  growth  remains  intact.  Karex  reported  a  strong  FY14  net  profit  of MYR45m (+56%% YoY), which beat street estimates. The strong growth was mainly driven by its expanded capacity and prudent cost management,  coupled with strong demand  for  its  products.  Management  guided  that  all  its  expansion  plans  are  on track. Karex has achieved an installed capacity of 4bn pieces per annum in FY14 and aims to achieve 5bn and 6bn pieces respectively by FY15 and FY16.

Global  demand  remains  intact.  Industry  experts  believe  that  the  demand  for condoms  may  grow  to  30.4bn  pieces  per  annum  in  2016  (from  22.8bn  pieces  per annum  in  2012-13)  and  forecast  that  by  2018,  demand  may  grow  to  38.2bn  pieces per annum. Apart from being used for family planning, condoms are in high demand in countries with high HIV prevalence rates (particularly African countries), which are still  facing  condom  shortages.  In  Nov  2013,  the  United  Nations  Population  Fund (UNFPA)  and  Population  Service  International  (PSI)  conducted  joint  studies  on  the total  market  for  male  condoms  in  six  selected  African  countries,  namely  Mali, Botswana,  South  Africa,  Lesotho,  Swaziland  and  Uganda.  The  results  show  that there  was  a  shortage  of  445m  condoms  in  these  six  African  countries,  which  made up only 10% of total population in Africa. Thus, it is estimated that 11bn condoms are needed  in  the  whole  African  region  alone.  We  understand  that  the  United  Nations’ target is to supply 20bn pieces of condoms per annum to the African region in 2020.   

Stable  average  selling  prices  (ASPs).  We  believe  one  of  the  key  competitive advantages of Karex is that its ASPs have been relatively stable and do not fluctuate with the changes in latex prices. Based on the historical trend, its ASP per piece has been maintained at USD0.03-0.04 per piece. We believe this was mainly attributed to its  customer  base  which  is  not  price-sensitive,  eg  government  agencies  and  non-governmental  organisations  (NGOs).  In  addition,  condoms  may  comprise  only  a small portion of its  commercial  buyers’ total costs, for  which  logistics  and marketing are  the  major  components.  Around  54%  of  Karex’s  products  are  sold  to  the commercial market, 42% to the tender market (NGOs and government agencies) and the remaining 4% to its OBM market.

Favourable  raw  material  cost.  Karex’s  main  direct  raw  material  is  natural  rubber latex.  Its  price  has  been  trending  down  since  2011  and  is  currently  at  the  historical low  range of  MYR3.80-4.00  per  kg.  This  is  favourable  for  Karex’s  operating margin. Due  to  an  oversupply,  we  do  not  foresee  the  price  of  natural  rubber  latex  spiking drastically in the near term.

Winning  back  customers.  We  learnt  that  Karex  previously  faced  a  capacity bottleneck  (3bn  annual  production  capacity)  and  needed  to  give  up  some  of  its orders,  even  when  it  was  running  at  above  a  80%  utilisation  rate.  With  its  new installed capacity and utilisation rate kept at 70-75%, we believe the company would be  able  to  plan  its  production  more  efficiently  and  win  back  more  orders  from  its customers. Going forward, the group’s organic growth via capacity expansion should remain intact.

A New Chapter Begins

Acquisition of Global Protection. Karex acquired a 55% stake in Global Protection (GP) in early October, with a cash consideration of USD6.6m. Karex will increase its stake in GP progressively based on the proposed schedule below:

Briefly on GP. GP is a leading condom and lubricant distributor in key markets such as  the  US  and  Canada  and  owns  the  ONE®  brand  (one  of  the  top  four  brands  in North  America).  GP  distributes  over  100  stock  keeping  units  and  has  access  to around  30,000  stores  in  the  US  and  Canada.  Upon  acquisition,  Karex  targets  to increase  its  accessibility  to  40,000  stores  by  2015.  GP  has  significant  relationships with  over  1,000  customers,  including  several  major  clients  such  as  Walgreens, Shoppers and CVS, among others.  

Investment  rationale.  The  acquisition  is  expected  to  complement  Karex’s OBM products  –  Carex  and  INNO.  This  should  mark  the start of Karex’s OBM expansion plan,  which is in line with the company’s growth  strategy.  Karex  will  be  granted  the exclusive  rights  as  the  sole  distributor  of  ONE®  brand  as  well  as  other  condom brands in some Asian countries (including China), North Africa and some countries in the  Middle  East.  With  GP  on  board,  Karex  can  leverage  on  its  marketing  and distribution expertise to venture into the distribution business. Potential  synergies  from  acquisition.  Management  expects  to  see  several potential positive synergies from the acquisition:

a)  Karex  would  help  GP  improve  its  earnings  margin  through cost savings  as GP is now able to transfer part of its cost of sales (such as packaging and raw  material  costs)  to Karex. Management guided for GP’s  net  margin  to improve by roughly 0.6ppt to 10.6% (it guided that GP’s current net margin is around 10%). 
b)  GP can now leverage on Karex’s market accessibility in more than 110 countries  across  the  major  regions  of  Africa,  Asia,  Europe  and  the  US, where Karex has obtained the licenses/permits to increase its sales volume. The group’s aggressive marketing of ONE® brand condoms to increase its footprint in key markets would help expand its revenue. 
c)  Karex will eventually become the sole supplier of lubricants for GP. Karex’s management  is  positive  on  the  future  growth  of  the  lubricants  market  and sees strong earnings prospects in the segment.

Attractive  acquisition  for  a  strong  brand.  We  deem  the  acquisition  of  GP attractive,  as  we  compared  it  with  Anglo-Dutch  consumer  goods  company  Reckitt Benckiser’s  GBP2.54bn  acquisition  of  UK-based  Durex  condom  maker,  SSL International. We  understand that  the  valuations  at that  time  were  P/E  of  35.0x  and price/sales  (P/S)  of  3.1x.  Reckitt  Benckiser  was  willing  to  pay  a  premium  of  45% above SSL International’s 6-month average share price back then. This shows that a strong brand name, especially a world-renowned brand, is worth the extra premium. Hence,  we  believe  Karex’s acquisition  of  GP,  which  owns  ONE®  –  one  of  North America’s top four and fast-growing condom brands – is very attractively priced and we believe GP would be a good fit for Karex’s future growth plans.  

Potential growth in OBM. We believe the acquisition of GP could propel  growth in Karex’s  OBM  segment,  given  the  significant  incremental  profit  margin  as  the  retail price of condom per piece is well above the manufacturing price per piece. We did a simple  illustration in  Figure  7,  based on  the  following  assumptions:  i)  1% of Karex’s production volume goes to its OBM segment, and ii) Malaysia is the company’s sales location.  Under  normal  manufacturing  prices,  Karex  sells  condoms  at  MYR0.10  per piece. However, through branding (possibly GP’s ONE® brand), Karex could charge MYR0.30 per piece (which is still below the average retail price of MYR2.00 per piece in  Malaysia).  For  the  same  volume,  if  Karex  sells  through  its  OBM  segment,  we estimate  at  least  a  100%  increase  in  earnings,  even  with  very  conservative assumptions.  For  this  reason,  Karex  is  eyeing  the  OBM  market  as  its  next exponential growth segment.

Investment Merits

Strong  performance  since  IPO.  Karex’s  market  value  has  grown  tremendously  in the  past  12  months.  Its  market  cap  hit  MYR500m  during  its  IPO  in  Nov  2013,  and surged to MYR1.2bn as at 28 Oct 2014, based on its last closing price of MYR2.87. Karex’s  production  capacity  has  also  expanded  by  33%  since  its  IPO,  driving  its FY14 (Jun) earnings to MYR45m (+56% YoY), which beat consensus estimates.  Favourable  operating  environment.  Although  natural  rubber  prices  have rebounded  slightly  of  late,  we  believe  the  oversupply  issue  is  still  plaguing  the segment.  Hence,  we  do  not  foresee  any  drastic  surge  in  raw  material  prices  in  the near  term.  Also,  Karex  is  continuously  enhancing its  automation  production  process to  improve  its  profit  margin.  Moreover,  its  investment  in  the  automation  process would enable it to enjoy government incentives – ie an automation capital allowance of 200% will be provided for the first MYR4m expenditure incurred within the period from 2015-2017, as stated in Budget 2015.

Experienced  and  prudent  key  management.  Karex  has  been  in  the  market  for decades  and  is  currently  run  by  the  third  generation  of  the  Goh  family.  It  is  well-known  in  the  industry  and  has  obtained  approvals  in  more  than  110  countries  to supply  condoms  –  which  provides  assurance  on  the  quality  and  reliability  of  its products.  We  are  also  comfortable  with  its  prudent  management  skills,  which  are important in protecting shareholders’ value.  Strong growth potential with a strong brand name. There is still a lot of room for Karex to grow: i) organically by expanding its production capacity and sales volume, as the strong demand for condoms should be able to absorb its capacity increase, ii) inorganically through the acquisition of GP, which is in line with Karex’s plan to grow 
aggressively in the OBM market.  

Maintain BUY, with a new MYR3.43. We make minimal revisions (less than 1%) to our  earnings  forecasts  after incorporating Karex’s FY14 audited numbers.  We  also tweak our TP slightly higher to MYR3.43 (from MYR3.41), pegged to a 20x CY15 P/E and offering a 20% upside. Our target P/E of 20x is at a slight discount to Hartalega’s target  P/E  of  21x,  which  we  deem  justifiable  for  its  high  expected  growth  rate. Maintain BUY on Karex

Financial Exhibits

Financial Exhibits

SWOT Analysis

Company Profile

Karex is the word's largest condom manufacturer, with a global market share of 11%.

Recommendation Chart

Source: RHB