Kossan Rubber Industries Bhd
(Aug 16, RM6.63)
Downgrade to hold from add with a lower target price of RM7 from RM7.60 previously. Kossan Rubber Industries Bhd is scheduled to report its second quarter of financial year 2016 (2QFY16) results on Tuesday.

We think its 2QFY16 net profit will be weaker than expected at between RM40 million and RM45 million.

We expect the subpar 2QFY16 earnings performance to be due to loss of production from major revamp works, and industry-wide pricing pressure, leading to average selling price (ASP) decline.

We gather that production decline was due to the complete shutdown of certain lines and inconsistent output from other lines due to ongoing revamp and upgrading works.

However, we expect earnings to pick up in the second half of financial year 2016 (2HFY16), as the period is a seasonally stronger period for the group and we expect 2HFY16 earnings to be boosted by the resumption of full commercial production by upgraded lines in third quarter of 2016 (3Q16).

We also expect the revamp works to result in higher operating efficiencies and increase productivity. Hence, we are confident that the group will achieve our revised earnings per share (EPS) growth forecast of 5.2% for FY16.

Although the group is not adding any new capacity this year, we think Kossan will inevitably be negatively affected by industry-wide pricing competition. While the group’s diversified product mix will provide some reprieve, we estimated the group’s ASPs to decline and which would lead to margin contraction.

However, its strategy of focusing on product innovation and differentiation will be beneficial as it is set to launch its nitrile accelerator gloves on Sept 1.

Kossan plans to continue its expansion projects, adding capacity of 3 billion pieces per annum in 4Q17 and 4.5 billion pieces per annum in the first half of 2018.

Although this intensifies current capacity influx, production will begin on a staggered basis and offer a buffer to the production of existing orders as upgrading works are conducted on existing lines. Furthermore, new capacity will cater to new products as older lines have limitations in terms of efficiency.

Hence, this provides underlying demand for new capacity, alleviating worries of overcapacity.

With ASPs under pressure, the loss of production volume and an underwhelming 2QFY16 in sight, we lower FY16 to FY18 EPS by 6.1% to 7.2%.

Although the company’s strategy and diversified product portfolio are commendable, we believe that these have been priced in. — CIMB Research, Aug 15