This article first appeared in The Edge Financial Daily on September 25, 2018

SCGM Bhd
(Sept 24, RM1.35)
Maintain underperform with a lower target price (TP) of RM1.15: SCGM Bhd’s results came in below expectations for the sixth consecutive quarter, with earnings at 10% of our financial year ending April 30, 2019 (FY19) estimate of RM1.1 million mainly due to weaker-than-expected margins from higher costs (such as resin, utilities and labour).

Post a meeting with management, we remain cautious about the high-cost environment as costs had continued to escalate, mostly due to: i) an increasing resin cost of around 14% year-on-year (y-o-y); ii) higher labour cost of the Banting factory; iii) higher utilities; and iv) a weaker product mix due to increased competition for the lunch box segment, which made up around 10% of its top line. This was all on the back of an improving top line (4% y-o-y). As a result, the core net profit (CNP) margin for the first quarter ended July 31, 2018 (1QFY19) was at 1.9% against 10.3% for 1QFY18, but this was a promising improvement from its 4QFY18 core net loss of around RM700,000.

SCGM’s top line grew to an all-time high of RM55.8 million in 1QFY19, which was attributable to improved sales, mostly from extrusion sheets (about 15% of its top line), while the food and beverage and other segments were flattish to mildly negative at -0.4% and -2.6% y-o-y due to a competitive climate. The group is focused on expanding its customer base by increasing capacity to new countries, such as Cambodia and Myanmar, while increasing sales from existing foreign markets, namely Indonesia, Australia and New Zealand.

Its new Kulai factory capacity expansion plan is also well on track for commencement in December 2018, with machine transfers currently under way. Upon completion, the new factory will boost the total group capacity to 67,600 tonnes per year (+65% from the current level).

We have maintained our low effective tax rate assumptions of 18% to 20% for FY19 to FY20 as SCGM is still expected to benefit from the reinvestment allowance in the coming quarters.

Going forward, we believe that its top line growth will be stable to mildly positive, but margins may take a beating as the group struggles to manage escalating costs in the near term. As such, we have lowered our earnings forecasts on higher resin, labour and utilities costs in the near term and marginally lower product margins.

All in, we have lowered our FY19 to FY20 CNP margin assumptions to 2.4% to 3.3%, closer to the current levels (4.8% to 5.9%). On the bright side, although the new Kulai factory may incur additional costs in the near term, it is also targeted for increased automation, which should enable economies of scale and help improve margins in the longer run.

We have lowered our TP to RM1.15 on a lower price-to-book value (PBV) valuation multiple of 0.95 times (from 1.1 times) PBV on FY19 estimated fully diluted book value per share of 1.2 times. Our lower PBV multiple is based on the four-year low PBV valuation (over -2.0 standard deviation [SD]) versus -2.0SD previously, due to continuous margin compression and earnings volatility in light of missed earnings expectations for six quarters.

We believe valuations are stretched, warranting an “underperform” call as we have priced in most positives, including capacity expansions in FY19 to FY20, and we caution that there is bias towards downsides to our valuations due to weakness from margin compression, while the near-term outlook for earnings stability remains challenging.

Risks to our call include: i) lower-than-expected resin cost; ii) higher product demand from overseas markets; and iii) currency risk from a weakening ringgit. — Kenanga Research, Sept 24