While we believe that Karex’s margins could come under pressure from higher costs (gas tariffs as well as labour costs), we continue to like the stock for its strategic diversification into OBM while maintaining its dominant position in the OEM market. Maintain BUY with a revised TP of MYR4.31 (from MYR4.56, 14% upside). We expect a stronger 2HFY16 (Jun) on the back of its added condom capacity as well as earnings contribution from OBM distribution.

Exciting times ahead. We noted Karex’s sixth successive quarter of gross profit margin improvement on the back of better product mix, favourable raw material movements as well as economies of scale. While 2QFY16’s earnings were punctuated by higher administrative costs (consolidation of Medical Latex Dua SB’s (MLD) accounts), we expect a stronger 2HFY16 on the back of a full earnings impact of an additional 1bn new capacity (+25%), additional 300m in annual capacity at MLD as well as contributions from the own brand manufacturer (OBM) distribution.

Operational challenges. In general, Karex only maintains a latex cost pass-through mechanism with its clients, which is less comprehensive than its rubber glove counterparts. Consequentially, we believe margins could come under pressure from the removal of government subsidies (ie gas tariff increase) and labour cost increase (ie minimum wage as well as foreign labour levy hike). We also expect earnings to be impacted by the recent strength of the MYR. RHB has revised its 2016 USD forex assumption to MYR4.18 (from MYR4.34). Earnings and risks. We lower our FY16F-18F earnings by 5% to 8% after updating our assumptions. The main upside risk to our forecasts would be the re-rating of the sector, driven by liquidity buoyed by market risk aversion. The key downside risk would be higher prices for raw materials, such as latex and nitrile. Karex’s one-for-two bonus issue is expected to be finalised by 2Q16. Ex-bonus issue, our TP would be adjusted to MYR2.87. Maintain BUY. We continue to like Karex for its strategic diversification into OBM while maintaining its dominant position in the original equipment manufacturer (OEM) market. Maintain BUY with a revised DCF-derived TP of MYR4.31 (CoE: 9%, TG: 3%), which implies 32.4x FY16F P/E. Karex is currently trading at 1.0x PEG, which is roughly less than half the valuation of its international peers (Figure 4).

Financial Exhibits

SWOT Analysis

Source: RHB Research - 22 Mar 2016