Kossan’s 1Q15 results met expectations, making up 23%/23.4% of our/consensus estimates, while earnings increased 19.8% QoQ on improved operating efficiency and better product mix. We downgrade our recommendation to NEUTRAL (from Buy) with a revised TP of MYR6.35 (from MYR6.06, 2% upside). We switch our valuation to DCF from 1-year forward P/E.

1Q15 results met expectations, making up 23%/23.4% of our/consensus estimates respectively. Earnings rose 19.8% QoQ, while net margin improved to 12.3% (4Q14: 10.5%) on increased production efficiency, higher sales and better product mix. At PBT level, the gloves and clean-room divisions improved 28%/25% respectively.

Stronger gloves division. Kossan Rubber Industries’ (Kossan) gloves division (87% of revenue) booked a 4.5% QoQ rise in sales volume that was mainly attributed to the revamp of two old plants, which brought higher output from more efficient technology. Plants 2 and 3 (4bn pieces capacity in total pa) are expected to run at full capacity in June with ready orders from customers. As such, management expects stronger earnings in 2H15. On the back of strong demand for gloves, Kossan is working on plans to construct another two plants with 4.5bn capacity (total), slated for commissioning in early 2017.

Earnings forecast. Updating our assumptions on the timing of Kossan’s upcoming capacity, we trim our FY15F-17F earnings by 2-10%. The risk to our forecast would be heightened competition within the industry that could lead to lower ASPs.

Valuation basis. We switch our valuation analysis to DCF from a 1-year forward P/E. We believe this basis will better quantify Kossan’s long-term expansionary strategy. In our analysis, we used conservative assumptions, specifically for its timing of capacity increases, ASPs and costs.

Downgrade to NEUTRAL on valuation grounds. We revise our TP to MYR6.35 (from MYR6.06, 2% upside, 8.9% CAPM, 2.0% TG rate). Kossan’s share price has risen 44.2% since Nov 2014. Although its growth prospects remain intact, we downgrade our recommendation as we believe that much of the positive news has been priced in at current prices. The stock already trades at 18.3x FY16F P/E, above its historical 1.5SD trading band of 17.5x.

Investment case Attractive earnings profile. Amidst the uncertain market environment, the rubber glove sector offers investors a safe-haven earnings profile that exhibits resilience due to the association with the healthcare sector, coupled with growth characteristics on the back of aggressive capacity-led earnings expansion. Kossan expects to increase capacity to 31bn pieces by FY17 from 18bn pieces in FY14. We expect the company’s EPS to grow at a CAGR of 18% in FY15-17.

Favourable macroeconomic environment. Latex prices are at multi-year lows, trading at USD1.20/kg from a 5-year average of USD2.03/kg. We expect them to remain subdued in the medium term due to an oversupply of rubber and a weaker global automobile market. Likewise, nitrile prices are trading at multi-year lows at USD0.93/kg from a 5-year average of USD1.37/kg. We expect them to stay subdued due to lower oil prices. The strengthening of the USD benefits Kossan as more than 90% of its revenue is denominated in USD while roughly 26% of its cost is denominated in MYR. The recent fall in energy prices has led to cheaper utilities input cost. Scheduled gas tariff hikes for 2015 were postponed by the Malaysian Government, while electricity hikes were granted temporary relief (annualised 4%) in February.

Improving efficiency. Kossan continues to deliver on operating efficiency improvements. EBIT margins improved to 14.8% in FY14 from 11.7% in FY12. This improvement was all the more notable in FY14, given that other rubber glove manufacturers suffered margins compression due to the competitive landscape during that year.

Landbank. Kossan has approximately 85 acres of industrial land located within the Klang Valley that is ready for development. Accordingly, we forecast that the company will expand 4bn capacity a year from FY18 to FY21, which ought to bring total capacity up to 47bn pieces by FY21. Investment risk Heightened competition. While we believe that the oversupply concerns that hung over the industry for much of 2014 were overplayed, we do anticipate heightened competition among the rubber glove players, which could potentially apply downward pressure on earnings and margins. Our analysis shows that supply would increase faster than demand between FY15-FY17. Nevertheless, we believe that Malaysia will continue to grow her global glove market share at the expense of other glove manufacturing nations due to: i) increasing technology efficiency of new production lines (faster line speeds and more automation), and ii) more competitive advantage from the weaker MYR.

Delays in expansion plans. Unforeseen delays to upcoming capacity would negatively impact Kossan’s potential revenue stream. Weakening of the USD. A weaker USD would negatively impact the company’s earnings and margins. Rise in the price of raw materials. Stronger raw material prices would negatively impact Kossan’s earnings and margins

Valuations and recommendation Valuation through the DCF to equity (DCFE) method. We forecast Kossan to expand its glove manufacturing capacity up to 47bn pieces by FY21 from 18bn pieces in FY14. To best capture this growth, we used the DCFE method. By discounting Kossan’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 2% TG rate, we derive an intrinsic value per share of MYR6.35 for the company. This represents a 2.4% upside from the current market price of MYR6.20. Our target price implies a FY16F P/E of 18.7x.

Sensitivity analysis. We relied on our analysis on what we considered to be reasonable and conservative estimations. In Figure 7, we show a sensitivity analysis by varying the discount rate (CAPM) and the TG to show the impact on TP. We consider the 2.0% terminal growth rate we used as conservative. We highlighted our current assumptions.

Revenue assumptions (Figure 9). There are three main parts of our revenue assumptions: i. Capacity expansion. We forecast for Kossan to expand its rubber glove capacity to 47bn pieces by FY21 from 18bn in FY14. Management has also guided that capacity utilisation would be around 82-85% going forward with a target to achieve 80%/20% production split of nitrile/latex by FY16 from the current 60%/40% respectively. ii. ASPs. In our modelling, we assumed a CAGR increase of -0.3% and 0.3% from FY14-FY24 for nitrile and latex gloves ASPs respectively. As part of the cost-sharing basis between Kossan and its customers, a portion of savings/losses from forex as well as raw material movements are passed back to their customers. Our assumptions are:

The MYR is assumed to recover to MYR3.18 in FY24F from MYR3.65 currently. This represents a CAGR increase of 1.4% over our DCF duration. A recovery in the MYR will increase ASPs as Kossan passes on losses from forex.

Nitrile prices are assumed to recover to their 10-year average of USD1.27/kg. This represents a CAGR increase of 2.5% over our DCF duration. A rise in prices of nitrile feedstock will increase ASPs as Kossan passes on losses from an increase in COGS.

Latex prices are assumed to recover to their 10-year average of USD1.75/kg. This represents a CAGR increase of 3.7% over our DCF duration. A rise in prices of latex feedstock will increase ASPs as Kossan passes on losses from an increase in COGS.

The rise in our nitrile and latex ASPs assumptions are lower than the CAGR rise of the respective forex and raw material prices. This is because we factored in a CAGR decrease of 1.2% in “real” ASPs until FY24 to account for the heightened competition that we expect in the glove manufacturing industry.

iii. Other revenues. We are forecasting for Kossan’s technical rubber products division to grow at a CAGR of 4.5% from FY14-24 while the clean-room division to grow at a CAGR of 14.3% during the same period.

Cost assumptions (Figure 10). Roughly 74% of Kossan’s costs are quoted directly or indirectly in USD. This primarily includes nitrile, latex, chemical and packaging expenses. 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 assumptions we used for the revenue stream: i) USD to MYR3.18 in FY24F from MYR3.65 currently, ii) nitrile prices to USD1.27/kg in FY24F from USD0.93/kg currently, iii) latex prices to USD1.75/kg in FY24F from USD1.20/kg currently, and iv) an assumed CAGR of 1.3% increase in production technology efficiency, we arrive at the cost profile of Kossan. Raw material such as nitrile and latex would constitute a higher proportion of COGS over the years, reflecting the higher raw materials prices in our assumption. In particular, the nitrile cost would increase at a faster rate as the company targets an 80%/20% production split of nitrile/latex gloves by FY16 from the current 60%/40% respectively. We further detailed our assumptions on the depreciation in our depreciation and amortisation table (see Figure 14).

Income statement. With the estimated revenues and costs, we built our income statement (see Figure 11). We have also assumed the effective tax rate to maintain around the 20% level.

Depreciation and amortisation schedule (see Figure 14). Management has guided that Kossan will utilise MYR70m capex for every new factory with a capacity of 2bn pieces. We have also forecasted for a MYR20m maintenance capex while gradually increasing the maintenance capex towards the later stages of our DCFE to reflect our assumption of higher machine maintenance capex.

Balance sheet (Figure 15). Based on the company’s historical ratios, coupled with the forward estimates, we derive the assumptions for the components of the working capital, which we used in building up the balance sheet. We have assumed that Kossan will incur 70 days in account receivables (78.8 days in FY14) and pay its creditors in 55 days (account payables 67 days in FY14).

Debt schedule (see Figure 16). Kossan recently secured a MYR60m term loan and has drawn down MYR20m since. Management expects to fully draw down the remainder of the credit facility in FY15

SWOT Analysis

Company Profile

Kossan Rubber Industries’ (Kossan) principal activities are in the manufacturing of examination rubber gloves and technical rubber products.

Recommendation Chart

Source: RHB Research - 22 May 2015