This article first appeared in The Edge Financial Daily on June 4, 2018
Karex Bhd
(June 1, 54 sen)
Maintain sell with a reduced target price (TP) of 40 sen from 60 sen: Karex Bhd’s margin improvement was mainly due to a change in sales mix, with a higher sales proportion of 65% in the third quarter ended March 31, 2018 (3QFY18) from the higher-margin original brand manufacturing (OBM) and original equipment manufacturing (OEM) segments, up from 61% in 1QFY18. The tender market continued to be a drag on its margin, as the overcapacity coupled with higher production costs limited its ability to raise prices. As prices had been negotiated earlier, the recent strengthening of the ringgit and increase in production cost have only worsened the situation.
Karex’s management is working on higher-margin products to offset the impact of the higher production costs. Apart from an increase in sales to the OEM and OBM market, management is increasing Karex’s exposure to lubricants and catheters, which carry higher margins. Although the growth potential of these products remains attractive, the current contribution is still relatively insignificant. Nevertheless, we concur with management’s current strategy, although this business will likely take time to grow.
We have lowered our discounted cash flow-based 12-month TP to 40 (rolled forward to 2019), on the back of lower margin assumptions and an updated weighted average cost of capital based on the latest beta, given the cloudy near-term earnings visibility. We reiterate our “sell” call on Karex. Assuming that Karex’s fair valuation is at 20 times price-earnings ratio (long-term average for the glove sector), investors would be paying for earnings three years ahead, hence we believe that the current valuation is lofty.
Upside risks include a better-than-expected recovery in tender orders, as well as cost-effective distribution and marketing. — Affin Hwang Capital, June 1