Karex  plans to increase its production capacity  to 7bn  (from 4bn)  over the next  three  years while growing its OBM business segment to 20% (from 4%)  of total revenue in  five  years. Thus a longer-term analysis is required  to  fully  capture  th  resulting  value  from  this  strategy;  we change  our  valuation  approach  on  Karex  to  DCF  (from   P/E).  Our valuation results in a TP of MYR5.50 (33% upside) and recommend BUY.

Full throttle. Already the world’s largest condom producer with a current manufacturing capacity of 4bn pieces, Karex plans to expand its capacity by 1bn pieces per year and reach  7bn in FY17.  Also  over the next five years  it  plans to grow its  original brand manufacturing (OBM)  businessfrom  4%  to  20%  of  total  revenue,  building  on  the  ONE  condom,  the flagship  brand  of  its  acquired  subsidiary, Global  Protection  Corp  (GP). Through  this acquisition Karex  intends  to  diversify its  markets  and more
importantly,  increase  its  operating  margin  through  cost  synergies between its OEM and OBM operations.

Demand  grows  faster  than  supply.  Based  on  estimates  of  industry experts,  global  demand  of  condoms  is  expected  to  grow  at  a  5-year CAGR of 7.1% (supported by a robust growth in the tender market and a low average per capita use) vs a 5-year CAGR of 4.2% for supply.    

Corporate exercises.  In a recent  private placement  for  40.5m shares,the  company  raised  MYR158m.  Further,  Karex  announced  a  1-for-2 bonus issue with an entitlement date that has yet to be determined.

Forecast and risks.  We upgraded  our earnings forecasts  by  1-10% for FY15-17F.  Key  risks  that  might  affect  our  forecasts  include  d elays  in capacity expansion and a weaker USD vs MYR exchange rate.

Valuation through DCF. To better quantify  the  long-term expansionary strategy  of  Karex  we  switch  our  valuation  analysis  from  a  one  year forward P/E to DCF. We used  conservative  assumptions, specifically for its timing of capacity increases, average selling price (ASP) and costs.

BUY  recommendation  with  a  TP  of  MYR5.50  (33%  upside,  CAPM 8.9%,  terminal  growth  3%).  We  believe  Karex  has  a  compelling  longterm  growth  story  and  expect  earnings  at  a  3-year  CAGR  of  31%  for FY14-17F.  Karex currently trades at a FY16F P/E of 22.3x which implies a PEG of just 0.73  that we consider to be undemanding considering its strong market position and high barriers to entry.

Investment Case
Attractive  earnings  profile.  Condoms  are  used  to  maintain  (sexual)  health  and prevent the spread of sexually-transmitted diseases such as AIDS. Due to the nondiscretionary  nature  of  the  consumption,  condom  manufacturers  such  as  Karex exhibit  resilient  earning  profiles  that  are  non-cyclical  and   defensive.  We  expect Karex’s  earnings  to  grow  by  a  3-year CAGR  of  31%  for  FY14-17F  and  a  5-year CAGR  of  25%  in  FY15-19F,  led  by  capacity  expansion  and  growth  in  its  OBM business segments.

Demand  grows  faster  than  supply.  Based  on  a  historical  analysis  and  future estimates of various industry experts, we believe that demand growth will be stronger than  any upcoming supply expansion  (Figure 1). Global demand is expected to grow at  a  5-year  CAGR  of  7.1%  (supported  by  a  robust  growth  in  tender  market  which makes up to approximately 50% of global market and a low average use per capita of approximately  3.3)  versus  a  5-year  CAGR of  4.2% for  supply.  As such  we  believe that  Karex  would  not  have  difficulty filling  their  upcoming  capacity  expansion  (from 4bn to 7bn in 3 years).  As  the world’s largest condom manufacturer  we believe that Karex will benefit from this trend.

Investment Case
Attractive  earnings  profile.  Condoms  are  used  to  maintain  (sexual)  health  and prevent the spread of sexually-transmitted diseases such as AIDS. Due to the nondiscretionary  nature  of  the  consumption,  condom  manufacturers  such  as  Karex exhibit  resilient  earning  profiles  that  are  non-cyclical  and   defensive.  We  expect Karex’s  earnings  to  grow  by  a  3-year  CAGR  of  31%  for  FY14-17F  and  a  5-year CAGR  of  25%  in  FY15-19F,  led  by  capacity  expansion  and  growth  in  its  OBM business segments.

Demand  grows  faster  than  supply.  Based  on  a  historical  analysis  and  future estimates of various industry experts, we believe that demand growth will be stronger than  any upcoming supply expansion  (Figure 1). Global demand is expected to grow at  a  5-year  CAGR  of  7.1%  (supported  by  a  robust  growth  in  tender  market  which makes up to approximately 50% of global market and a low average use per capita of approximately  3.3)  versus  a  5-year  CAGR of  4.2% for  supply.  As such  we  believe that  Karex  would  not  have  difficulty filling  their  upcoming  capacity  expansion  (from 4bn to 7bn in 3 years).  As  the world’s largest condom manufacturer  we believe that Karex will benefit from this trend.

Valuation and Recommendation
Valuation  through  the  DCFE  method.  Karex  plans  to  expand  its  manufacturing capacity from 4bn  to 7bn  over the next three  years and grow its OBM business from 4% to 20% of its  total revenue in the next  five  years. To best capture this growth, we used  the  Discounted  Cash  Flow to  Equity  (DCFE)  method.  By  discounting  Karex’s free cash flow to equity with a cost of equity  (CAPM) of 8.9% (4% risk-free rate, 5.4% equity risk premium, 0.9x Beta) and applying a 3% terminal growth rate, we derive an intrinsic  value  per  share  of  MYR5.50  for  the  company,  which  represents  a  33% upside from the current market price of MYR4.13. Our target price derived from the DCF implies a FY16F P/E of 28.9x.  Karex currently  trades at a  FY16F P/E of 22.3x.There  are  no  pure-play  publicly  traded  condom  manufacturers  and  to  find  other consumer  companies  with  the  growth  profile  of  Karex  would  prove  difficult  and subjective. Thus we relied entirely on the DCFE method to derive an intrinsic value.

Sensitivity  Analysis.  We  relied  on  our  analysis  on  what  we  considered  to  be reasonable  assumptions  and  conservative  estimations.  In  Figure  3  we  show  a sensitivity analysis by varying  the discount rate  (CAPM)  and  the terminal  growth  to show  the  impact  on  TP.  We  consider  the  3%  terminal  growth  rate  we  used  as conservative.  We highlighted our current assumptions.

Revenue  assumptions  (Figure  5).  Per  below,  there  are  three  main  parts  of  our revenue assumptions:1)  OEM. We incorporate into our assumptions the planned capacity increase of Karex  to  7bn  pieces  by  FY17  from  4bn  pieces  currently.  Although management  has  targeted  commissioning  of  their  5th/6th/7thbn  in  total capacity by April  in FY15/16/17, we have conservatively only budgeted  for the  commencement  of  operations  of  the  upcoming  capacity  in  June  each year, i.e the last month of the respective FYs. Management has guided that capacity  utilization  would  be  around  75%  going  forward,  to  remain  nimble between their tender and commercial market orders. We have also included plans for its  polyisoprene condoms which we priced  at the lower end of five times  the  latex  ASP  (Polyisoprene  condoms  are  typically  priced  between five to seven times latex condoms) with a targeted breakdown of 2% of total condom  manufactured  by  FY19.  As  Karex  is  in  the  process  of  obtaining regulatory  approval,  we  assume  that  production  of  polyisoprene  condoms would  only  start  in  FY16,  albeit  at  a  small  quantum  of  0.5%  of  total mnufacturing  capability.  We  assume  the  ASP  of  both  latex  and polyisoprene  condoms  to  rise  at  a  CAGR  of  0.8%,  while  pricing  in  a weakening  of the USD to 3.16MYR in FY24F  (from our assumed 3.45MYR in FY15F).

2)  OBM.  The  acquisition  of  the  ONE  brand  was  a  strategic  play  for  Karex, diversifying its  target market, expanding the list of distribution countries and allowing  it  to  enter  into  distribution  business.  We  incorporated  into  our assumptions the planned business expansion of Karex’s recently acquired subsidiary, Global Protection  Corp (GP). Karex intends to leverage on  theONE  condom, the flagship brand of GP  and management has targeted to grow  the  OBM  business  from  4%  up  to  20%  of  total  revenue  by  FY19F. While we think that this might be achievable, we assumed a slower growth in the OBM segments in anticipation of any unforeseen delays in distribution such that we forecast the 20% target is met in FY20F instead. Karex intends to expand the ONE condom brand into Asia and Australasia by June 2016.3)  Potential  acquisitions.  Karex  has  recently  raised  MYR158m  from  the placement  of  additional  40.5m  shares.  This  represents  a  significant  ’warchest’, considering that total asset base was MYR289.9m in FY14.  Of  the total amount  raised,  MYR44.5m  will  be  allocated  to  working  capital  needs which  include  the  marketing  of  the  ONE  condom  brand.  The  amount  of MYR3.5m represents the cost for the placement exercise. Per management, the  rmaining  MYR110.0  will  be  used  for  development  and  business expansion.  We  believe  this  ‘war-chest’  is  slated  for  upcoming  M&A  deals due to the size. While it’s  possible  that Karex could acquire another player and  increase  its  OEM  production,  we think  this possibility  is  questionable due to the fact that Karex is already one of the most efficient producers in the industry and the company has openly stated their ambition to move into the OBM space. Nevertheless, we think that Karex  could  still be interested in  an  OEM  player  should  its  target  boost  its  ‘assets’  that  Karex  does  notalready  possess,  such  as  an  expanding  clientele  or licenses/certifications/accreditations.

Having  placed  a  lot  of  focus  on  their  plans  for  ONE  condom  (their  last acquisition),  we think that Karex will unlikely acquire another  flagship brandto  increase  their  OBM  revenues  which  would  potentially  cannibalise  their marketing effort thus far. As such, we postulate our hypothesis that Karex would  look  to  acquire  either  or  both  1)  local  OEM/OBM  players  with  less efficient  production  so  that  they  could  optimize  the  business  2)  overseas OEM/OBM players such that both parties benefit from cost synergies, much like the deal with GP that  could potentially generate  20% savings in COGS from transferring packaging cost to Malaysia or other economies of scale.Management  has  also  hinted  that  there  could  possibly  be  more  than  one M&A  deal.  Corollary,  we  have  assumed  that  the  proceeds  from  the placement would be utilized from Q4FY15 to 1HFY16 in three transactions where  80%  of  the  proceeds  are  utilized  in  FY16.  We  also  assumeconservatively  a  low  margin  (5%)  for the  acquisition  targets  with  an acquisition basis of 0.8x of sales. This is about 20%  more expensive  than the  valuation  that  Karex  executed  for  GP  (0.96x).  We  grew  the  new business conservatively by 10% in the first 4 years and 5% in the remaining 4 years

Cost assumptions  (Figure 6).  Roughly 45% of Karex’s costs  are quoted directly or indirectly in  USD, which primarily includes latex, foil and silicone oil.  Although latex prices are usually quoted in MYR, the commodity  itself  much like other commodities is sensitive to variations in the USD. Using the same USD/MYR assumption we used for  the  revenue  stream  (USD to 3.16MYR in FY24F from our assumed 3.45MYR in FY15F), coupled with an assumed 0.8% CAGR increase in technology efficiency, thecost amount for latex, foil and silicone oil comprise less of a proportion of COGS with time. In line with our assumed growth in the OBM business, the amount of distribution and administrative  costs  would proportionally make up a  higher percentage of total cost  since  a  larger  part  of  revenue  is  derived  from  the OBM  business.  In our cost assumption  we  have  priced in  a recovery  of  latex  prices to  USD1.75/kg  in  FY24F, which is the 10 year latex price average, from the current USD1.24/kg.

We have also worked backwards for our cost assumptions on the  OBM expansion and the potential acquisitions. For the OBM expansion, we have assumed the lower end  of  management  guidance  for  net  margins,  which  would  be  around  6-7%. Management  guided  a  COGS-savings  of  20%  from  merger  synergies  for  GP.  We assumed a conservative 3 years before all 20% savings are fully realized. As  for the potential  acquisitions,  we  have  assumed  a  modest  5%  net  margin  and  moderate improvements from projected cost synergies as those experienced by Karex before the acquisitions.

Income  statement.  With  the  estimated  revenues  and  costs,  we  built  our  income statement  (Figure  7).  We  calculate  depreciation  separately  in  an  investment depreciation schedule (Figure 10). We used a 20% tax rate for local business based
on Karex’s prior experience),  a  34%  rate  for  the US-based businesses and  a  25%rate  for  its  international business, all of which are weighted at the PBT level before arriving  at  total  PAT.  We  assumed  that  Karex  would  execute  and  buy  out  the remaining GP shares that they do not yet own in  two tranches, FY18 (USD3m) and FY21 (USD9m), in accordance with the agreed acquisition proposal between Karex and GP.

Source: RHB