This article first appeared in The Edge Financial Daily, on May 26, 2016.

Karex Bhd 
(May 25, RM2.35)
Maintain hold, with a lower target price of RM2.45: In the first half of the financial year ending June 30, 2016 (1HFY16), Karex Bhd benefited from growth in sales volume, as well as external tailwinds (weakened ringgit against US dollar and lower latex prices). The group’s 1HFY16 net profit rose 55.7% year-on-year (y-o-y) to RM44.9 million and gross margin increased to 37.3% (+4.5% points y-o-y), although minimal capacity was added. However, we expect the tide to turn as the ringgit strengthened 9.2% against the US dollar quarter-on-quarter (q-o-q) and latex prices increased 33.1% q-o-q in the first quarter of calendar year 2016 (CY16). Note that latex costs constituted 28% of Karex’s total cost in FY15.

Given the unfavourable conditions, we expect the group to report weaker third financial quarter ended March 31, 2016 (3QFY16) results tomorrow. We expect a 3QFY16 net profit of RM10 million to RM15 million, with earnings before interest, taxes, depreciation and amortisation margin of 18% to 20%. We believe that the strengthening of the ringgit against the US dollar and the uptrend in raw material prices caught many players in the rubber sector by surprise. Karex is unlikely to have aligned prices immediately due to time-lag effects.

We would deem 3QFY16 earnings underperformance a blip. We expect better 4QFY16 results due to ramp-up in the group’s newly added capacity (+one billon pieces per year in December 2015) and price adjustment after a two-month lag. We still believe that Karex’s earnings outlook is bright, driven by its budding original brand manufacturing (OBM) segment and its expansion plans (expecting 40% rise in production capacity to 7.2 billion pieces per year by end-2017), which would solidify its position as an original equipment manufacturer. — CIMB Research, May 24