Looking beyond Karex’s muted financial performance in recent quarters, we anticipate improvements in subsequent quarters on the back of a recovering tender market and sustained traction from its own brand manufacturing (OBM) segment. Alleviating concerns of the continued ascend in natural latex prices in 1QCY17, management alluded that it will renegotiate higher average selling prices (ASPs) for long term contracts if their high prices persist. Nonetheless, we note that natural latex still represents less than 20% of the group’s cost. In view of the compelling upside from the stock’s recent decline since its 1HFY17 results release, we are upgrading our recommendation on the stock to Buy with an unchanged TP of RM2.55/share, pegged to a PE multiple of 30.0x against its CY18 EPS.

Sight of a Recovering Tender Market

To recap, Karex’s muted financial performance in recent quarters was partly due to sluggish demand from the tender market caused by governments and non-governmental organisations (NGOs) holding minimal inventory of condoms in view of the weakened purchasing power of their local currencies alongside the USD’s strengthening, as well as the surge in the refugee crisis which disrupted funding initiatives. A lull tender market is undesirable for the group as it represents an important distribution channel with government and NGOs procuring half of the world’s condoms. Positively for the group, better days are in sight with its tender segment contribution to overall revenue having improved by 8%-points QoQ to 37% in 2QFY17 on the back of the successful capture of tender awards. Going forward, management expects the recovery momentum to persist on expectations of governments and NGOs depleting inventory of condoms. As it is, the group has already started to see new emergency orders with shorter delivery times and we opine that capitalizing on these opportunities would not be an issue with plant utilization rates only at 60% in 2QFY17. Furthermore, it would be positive for achieving greater economies of scale.

Sustained Traction at the OBM Segment

To date, the group’s efforts to bolster its OBM segment is evidently taking shape. While the segment remains the smallest contributor to overall revenue, note that its contributions have almost quadrupled from 4% in FY14 to 14% in 1HFY17, moving the group a step closer towards its target of 20% by 2020. Among others, this was the result of the group’s continuous marketing efforts for its ‘ONE’ brand in existing and newer markets (Malaysia) as well as the consolidation of acquisitions made in 2016. These acquisitions not only expanded the group’s brand portfolio but also presented synergistic opportunities for cross selling via new markets and distribution channels. For instance, with the acquisition of Pasante, it has facilitated the group’s imminent launch of the ‘ONE’ brand into UK via Superdrug, which is UK’s 2nd largest beauty and health retailer and among Pasante’s key customers. Looking ahead, we gathered that management does not discount the possibility of further strategic acquisitions and the group is in a comfortable to do so with its strong financial capacity. As at 2QFY17, the group’s net cash pile stood at RM74.2mn or 7.4sen/share.

Renegotiations for Higher ASPs if High Prices of Natural Latex Persists

Acknowledging the continued ascend in natural latex prices in 1QCY17, management alluded that it will renegotiate higher average selling prices (ASPs) for long term contracts if their high prices persist. Nonetheless, we note that natural latex still represents less than 20% of the group’s cost. Thus far in 1QCY17, natural latex prices have increased by 13.3% QoQ to RM7.31/kg. Based on a conservative assumption of natural latex accounting for 20% of the group’s cost and no revision to ASPs, our sensitivity analysis suggests that net margins will be squeezed by about 1%-point for every 10% increase in natural latex prices. Notwithstanding this, we expect the impact to be cushioned as most of the group’s orders are short term in nature whereby ASPs are revised accordingly from order to order.

Estimates

We make no changes to our earnings estimates.

Valuation & Recommendation

With the recent decline in Karex’s share price by 11.5% to RM2.07/share post release of its 1HFY17 results, we opine that buying opportunity has emerged. Hence, are upgrading our recommendation on the stock to Buy with an unchanged TP of RM2.55/share, pegged to a PE multiple of 30.0x against its CY18 EPS. Above all, we continue to like Karex for its manufacturing capabilities, growing OBM segment and healthy balance sheet.

Source: TA Research - 16 Mar 2017