This article first appeared in The Edge Financial Daily on April 16, 2020

Kossan Rubber Industries Bhd
(April 15, RM5.51)
Maintain outperform with a higher target price (TP) of RM6.30: The stage is now set for a solid financial year 2020 (FY20) after three quarters of anaemic quarterly earnings growth. Looking ahead, forward earnings growth will be amplified by a ramp-up of restocking activities due to the current Covid-19 pandemic and further boosted by better margins from higher average selling prices (ASPs).

Longer delivery lead times are indicating that demand will outstrip supply at least over the medium term. The Malaysian Rubber Glove Manufacturers’ Association has forecast a 20% demand growth to 230 billion pieces in 2020.

We believe Kossan Rubber Industries Bhd will benefit from the robust demand which has led to industry longer delivery lead times (the moment order was placed to delivery) which has risen to an average of between 80 and 100 days compared with 40 to 50 days normally.

Signs of demand outstripping supply could potentially lead to higher ASPs. Looking at the stable raw material prices, ceteris paribus, hikes in ASPs are expected to lead to expansion of margins. We understand that Kossan has raised prices by 3%-5% in anticipation of higher demand and we also noted the industry’s current high utilisation rate of more than 90% for nitrile-centric players sets a stark contrast compared to the lacklustre demand in 2019.

We expect its first quarter of FY20 (1QFY20) profit after tax and minority interests (Patami), due to be released by end-May, to be higher quarter-on-quarter (q-o-q) and year-on-year (y-o-y) due to its new capacity expansion from Plants 18 and 19 and better margins due to higher operating efficiencies from the new plants.

For illustration purposes, with the full-quarter commencement of Plant 18, and partial commencement of Plant 19, net margin of 10%, and ASP of 9.5 sen/piece; 1QFY20 Patami could come in at RM66 million to RM68 million (+8% to +11% q-o-q; +12% to +16% y-o-y), fitting within our/consensus full-year forecasts at 25%/24% respectively.

Anecdotal evidence could potentially suggest a potential price-earnings ratio rerating as Kossan is embarking on an aggressive capacity expansion as opposed to its past historical conservative expansion stance. Recall, beyond Plant 19, land clearing is underway in the Bidor plant, and the first plant is expected to start commercial operation sometime in 2021, earlier than the previously targeted 2022.

We understand that Plant 18 (2.5 billion pieces) was fully commissioned in November 2019. Plant 19 (three billion pieces) currently has two to three lines commissioned and another two are expected to be commissioned soon and on track for full operations by the first half of 2020. Upon completion, these three new plants will bring the group’s total installed capacity to 32 billion (+28%) pieces of gloves per annum.

We roll forward our valuation from the estimated FY20E to FY21E. Our TP is raised from RM5.90 to RM6.30 based on 28.5 times FY21E earnings per share (at +1.5 standard deviation above a five-year historical forward mean). We expect the valuation gap to narrow considering that Kossan’s net profit growth is 17% versus industry average of 13%. We reiterate an “outperform” call. — Kenanga Research, April 15