This article first appeared in The Edge Financial Daily on June 5, 2017 - June 11, 2017

KUALA LUMPUR: After posting a less-than-impressive 28.3% decline in its net profit for the third quarter ended March 31, 2017 (3QFY17), Karex Bhd saw its share price take a beating to a two-year low of RM1.67 as investors took out their disappointment on the stock.

Last Friday, shares in the world’s largest condom manufacturer by volume regained nearly 3% or five sen to RM1.72 as bargain hunting emerged.

The share price is likely to continue seeing volatility as investors reassess the stock’s valuation, which now sits at a historical price-earnings ratio of about 45.7 times.

“People might not be willing to pay such a high price after the disappointing earnings in 3QFY17,” said an analyst who declined to be named.

However, the group’s chief executive officer Goh Miah Kiat remained unfazed by the selldown last week, reiterating his commitment to growing Karex’s own brand manufacturing (OBM) segment, which weighed net profit down to RM6.9 million as a result of higher distribution and marketing costs in 3QFY17.

“The branded segment has been a bit of a drag, but it needs to reach a certain scale before profits [can be seen],” Goh told The Edge Financial Daily in an interview last Friday.

Listing fees at retail outlets, repackaging for new markets, streamlining operations and promotional pricing in collaboration with local councils are just among the expenses the group has absorbed under “distribution expenses”, he explained.

Karex has been intensifying its marketing push of its ONE brand of sexual wellness products in North American and British markets, in addition to 3,500 points of sale in Malaysia.

The company’s next target markets for the brand are Singapore and Thailand, for which marketing expenditure has been accounted for, although the group has yet to see profits, said Karex chief strategy officer Wong Your Can.

Goh noted that Karex sees great potential for its ONE brand in Asian markets because of its young demographic and growing brand consciousness through social media.

“These are all the things that we see future potential in, but we have to spend today to reap the benefits tomorrow,” Goh said.

The OBM segment contributed a higher percentage of 15% to revenue in 3QFY17 compared with 7% a year ago, boosting quarterly revenue 4.53% to RM92.22 million. Goh highlighted that the group’s gross profit margin of above 30% outpaced an average 18% margin of other pure condom original equipment manufacturing (OEM) players.

How quickly this will translate into an improved bottom line remains to be seen.

Of the eight analysts covering the counter, seven have cut their target prices and two downgraded their calls on the stock, which also saw a 39.43% cut in Bloomberg’s consensus earnings forecast for the group’s financial year ending June 30, 2017 (FY17).

CIMB Research, which has set the lowest target price of RM1.70 for Karex and downgraded it from “hold” to “reduce”, commented that current valuations are expensive and advised investors to reconsider the stock only on further share price weakness.

Credit Suisse, which had also downgraded the stock from “outperform” to “neutral”, said that the group “had now shown several quarters of earnings disappointment”. However, it remains hopeful that recovery in the group’s tender segment could mask the gestation period of its OBM venture, which is a long-term positive.

Karex remains focused on its core segments of OBM, OEM or commercial and its tender segment, Goh said, adding that despite variance in yearly profits, the group is committed to long-term sustainability.

“In our two main segments [of OEM and tender], we think more people will start coming to us instead of us looking for customers,” said Wong.

Rising competition in the tender segment also contributed to the group’s unexpectedly weak quarterly earnings, said analysts. The segment, which relies on contractual orders from governments, non-governmental organisations and the World Health Organization, made up a larger share of Karex’s revenue at over 30% in 3QFY17 compared with the two preceding quarters.

However, Goh foresaw orders coming back in a big way with a surge in “emergency orders” after fierce price competition and healthcare budget cuts, particularly in Europe, depressed earnings across the industry.

Although Goh believes the condom manufacturing industry is ripe as it squeezes out smaller, underperforming players, he maintains that Karex is no longer considering any acquisitions after its buying spree last year that saw it spend some RM60 million between 2015 and 2016.

He insists that building the group’s own brand has been the aim since the group’s listing on the Main Market of Bursa Malaysia in November 2013 with an opening price of 82 sen.

“Value is not in making a product [cheaply] but in where the brand is,” he said, adding that Karex aimed to market ONE as a premium sexual wellness brand.

The past two years were something of a “perfect storm” for the group as a sharp depreciation of the ringgit boosted Karex’s net profit by as much as 72% year-on-year in FY15 from FY14, Goh said. Its share price more than doubled from the start of 2015 to an all-time high of RM3.09 in the second week of 2016.

However, high latex costs and a weak pound, which had increased costs at recently acquired subsidiary Pasante Healthcare Ltd, crimped margins in the second half of last year, subduing profit growth despite a significant depreciation of the ringgit.