Pecca Group Berhad TP: RM1.69 (+15.0%) In Expansion Mode Post IPO

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1 A Member of the TA Group MENARA TA ONE, 22 JALAN P. RAMLEE, KUALA LUMPUR, MALAYSIA TEL: / FAX: INITIATION Thursday, September 07, 2017 FBM KLCI: 1, Sector: Automotive Pecca Group Berhad TP: RM1.69 (+15.0%) In Expansion Mode Post IPO THIS REPORT IS STRICTLY FOR INTERNAL CIRCULATION ONLY* Last Traded: RM1.47 Abel Goon Tel: ext:1641 abelgoon@ta.com.my BUY We initiate coverage on Pecca Group Bhd (Pecca) with a BUY recommendation and TP of RM1.69, based on 14.5x CY17 PER. We like the Group due to its market leadership and exciting growth prospects in the retail market and airplane leather upholstery industry. We have factored in earnings growth from the Group s capacity expansion, which is expected to be completed in CY17. The increased capacity will underpin earnings growth of 41.7% in FY18. Note that we have yet to factor in growth from the airplane leather upholstery, which is expected to drive Pecca s next growth phase. Hence, there is potential upside to our earnings forecast. Meanwhile, our estimates translate to decent dividend yield of 3.7%-4.7% in F18-FY20 on the back of a 50% payout assumption. Core Business Pecca is the largest automotive leather seat cover manufacturer in Malaysia with 47.6% market share. It supplies to three main market segments (Figure 1) in the auto parts industry. Recently, Pecca secured approval from the Department of Civil Aviation (DCA) to include leather upholstery in their part refurbishment activities for aircrafts. Meanwhile, it plans to establish retail outlets in Malaysia to market its patented product, Smart Fit, to the public. Investment Thesis 1. Market leader in leather seat upholstery industry 2. High barriers of entry 3. Patented products 4. Expected growth and diversification 5. Decent dividend yield and strong balance sheet 6. Benefits from a slowing automotive industry Key Risks 1. Heavily reliant on few large clients 2. Dependent on foreign workers 3. Fluctuation of forex and raw material prices Valuation There are no listed competitors directly comparable to Pecca in Malaysia. The closest comparison is Interhides PCL (IHL), a leading player in Thailand for leather upholstery. We fairly value Pecca at RM1.69 /share based on 14.5x CY18 PER. Note that, this is a 20% discount to IHL s current forward CY18 PER of 16.8x. We believe the discount is justified due to IHL s 1) larger market cap and 2) integrated business strategy. Pecca s FCFF yield exceeds dividend yield, which implies a growing cashpile to cushion its share price. Share Information Bloomberg Code PECCA MK Stock Code 5271 Listing Main Market Share Cap (mn) Market Cap (RMmn) Par Value wk Hi/Lo (RM) 2.07/ mth Avg Daily Vol ('000 shrs) 302 Estimated Free Float (%) 86.2 Beta n.a. Major Shareholders (%) MRZ RHB Asset Datuk Teoh Forecast Revision FY18 FY19 Forecast Revision (%) Net profit (RMm) Consensus TA's / Consensus (%) Previous Rating Non-rated Financial Indicators FY18 FY19 Net Debt / Equity (x) Net cash Net cash CFPS (sen) Price / CFPS (x) ROA (%) NTA/Share (RM) Price/NTA (x) Share Performance (%) Price Change PECCA FBM KLCI 1 mth (3.3) (0.3) 3 mth (2.0) (0.8) 6 mth (9.8) mth (21.4) 4.9 (12-Mth) Share Price relative to the FBM KLCI Source: Bloomberg Page 1 of 11

2 Earnings Summary FYE June (RM mn) E 2019F 2020F Revenue EBITDA EBITDA margin (%) Pretax Profit Reported Net Profit Core Net Profit Core EPS (sen) Core EPS Growth (%) (7.6) (11.8) Core PER (x) DPS (sen) Dividend yield (%) BUSINESS OVERVIEW Pecca is principally involved in the styling, manufacturing, distribution and installation of leather upholstery for car seat covers. The group manufactures 3 main products in 3 main market segments for the auto parts industry (Figure 1). The company has also ventured into the aviation industry and retailing of leather seat covers under their subsidiaries PAviation and EEmpire (Figure 2). Figure 1. Description of Products Market Product Segment Original Equipment Manufacturer (OEM) Pre-Delivery Inspection (PDI) Replacement Equipment Manufacturer (REM) OE Fit Product Description Based on the car manufacturer s specification and very stringent quality control Leather seat covers embedded for selected variants. Pecca jointly develops car seat covers with Tier 1 car seat manufacturers who will then install the car seat covers onto bare car seats. Patented leather car seat covers separated into 2 pieces. Smart Fit Installed at vehicle distribution centres Designed to be fitted onto a car seat without having to dismantle the car seat from the car. Airbag deployment compliance. Smart Fit, Quick Fit Aftermarket accessories at the retail level. Quick Fit patented one piece car seat cover Full PVC Designed for the mass market. Designed to be fitted onto a car seat without having to dismantle the car seat from the car. Page 2 of 11

3 Figure 2. Company Subsidiaries Pecca Leather (PLeather) Pecca Leather Aviation Services (PAviation) (60% owned) Everest Empire (EEmpire) Pecca Leather (Thailand) Ltd (49% owned) Main company involved in carrying out Pecca s principal activities. Manufacturing, repair, refurbishment, distribution and installation of aircraft leather upholstery. Received approval from DCA on part refurbishment and leather upholstery scope. Intended principal activity is operation of retail outlets to sell Smart Fit and Quick Fit. Expects to open fifty outlets in the next two years To support domestic operation of seat cover business in Thailand INVESTMENT THESIS Market Leader in Leather Seat Upholstery As of 2016, Pecca commands 47.6% market share in the OEM/PDI passenger vehicle segment. Their closest competitor is DK Leather (24.5%), which we understand intends to shift its focus to the property segment. Thus, Pecca is the frontrunner for most of the contracts in the local industry. Note that Pecca is the sole external supplier for Toyota, Nissan, Perodua and Mitsubishi. Additionally, the high sales volume allows Pecca to lock-in cheaper prices for its raw materials versus smaller players whom do not have economies of scale. Therefore, this allows Pecca to price its products competitively. No real competitors in the local OEM/PDI market Figure 3. Market Share (CY16) Figure 4. Number of Seat Covers Manufactured Pecca DK Leather Gosford Others ('000) Pecca Others 25 13% % 24% 48% High Barriers of Entry The manufacturing of leather upholstery for cars requires some technical skill as well as industry experience. Each leather hide is unique - hence, selection of leather to make seat covers requires extensive knowledge. Besides that, low volumes of leather hides are difficult and expensive to procure - driving up costs for smaller players. Lastly, a good working relationship with clients is essential to secure contracts for the OEM market. All these factors allow the market leader, Pecca, to strengthen its market share. Small players are disadvantaged as economies of scale required Page 3 of 11

4 Patented Products Pecca has two patented products (i.e. SmartFit and QuickFit) (Figure 5) which will underpin its retail business. These products are competitively priced due to their innovative installation method. Given that car seats do not need to be dismantled prior to installation, the process of installing both products are much faster and convenient versus conventional seat covers. Management revealed that installation merely takes about 1.5 hours versus other products, which may take up to a week. Furthermore, the seat cover is customized to the car model, hence ensuring a good fit. Additionally, installation will not void the car s warranty as the car seats need not be dismantled. On top of that, SmartFit is also airbag compliant. Lastly, the products meet stringent OEM/PDI requirements as Pecca s main revenue contributors are from the OEM segment. Unique patented products with easy installation method to underpin retail business. Figure 5. Pecca s Products Source: Company, Expected Growth and Diversification During its IPO, Pecca guided that it will 1) increase capacity of its factory, 2) open retail outlets, 3) start leather upholstery for airplanes and 4) solidify its base in Thailand. Since then, Pecca has taken several steps in the right direction to follow through on its guidance. The group has purchased new machinery for expansion of its factory, and expects construction of additional floor to be completed in 3QCY17. Meanwhile, for its retail outlets, sales began in 2QCY17 after training of dealers were completed. The group has contacted selected high-end car tinting shops to piggyback on their network of stores. Growth from capacity expansion. Diversification from airplanes, retail and Thailand. Pecca also recently received DCA approval for the leather upholstery scope, and have begun pursuing various contracts. It recently entered into a JV agreement with AirGo to jointly develop an aircraft seat cover for the Langkawi International Maritime and Aerospace Exhibition Lastly, the Group incorporated a new subsidiary in Thailand to support its business there. We note that Pecca has secured contracts to supply SmartFit to Honda in Thailand. Given the recent developments, Pecca has the potential to recognise three new revenue streams in CY17. Furthermore, its existing revenue stream is expected to grow significantly as capacity increases to 170k units in 2HCY17 from 120k units currently. Page 4 of 11

5 Figure 6. New revenue streams CY16 CY17 Leather seat covers to OEM manufacturers Leather seat covers to OEM manufacturers Leather refurbishment for aircrafts* Retail sale of leather seat covers* Thailand operations* *new revenue streams Source: Company, Figure 7. Timeline Post-IPO 15 Apr Sep Oct QCY17 3QCY17 Initial Public offering Receive approval from DCA for leather upholstery scope Incorporate new subsidy in Thailand Retail and Thailand sales begin Completion of additional storey in factory Source: Company, Decent dividend yield and strong balance sheet Pecca has pledged an annual dividend payout of 40%. This translates to decent dividend yield of 3.7%-4.7% in FY18-FY20, according to our estimates. We believe Pecca is able to easily meet this payout as the Group is currently in net cash position of RM90mn. This translates to 48 sen/share (25% of our TP). Furthermore, it has robust operating cash flow of circa RM2.5mn every quarter and zero borrowings. Additionally, near-to-medium term capex is subdued as the Group is merely adding an additional level to its current factory where foundation works have been completed. Meanwhile, Pecca will piggyback on selected highend car tinting shops as opposed to new investments in brick-and-mortar stores. Decent dividend yield supported by strong balance sheet. Figure 8. Dividend per share (sen) Figure 9. Cash and cash equivalents (RM mn) 8.0 Cash & cash equivalents Dividend yield FCFF yield E 2019F 2020F % % % 4% 5% 5% 4% 4% 3% 3% E 2019F 2020F 8% 7% 6% 5% 4% 3% 2% 1% 0% Benefiting from Automotive Slowdown We believe that Pecca may benefit from the slowdown in the automotive industry. This is because auto makers frequently offer restyling options and discounts to clear inventories and entice buyers. Note that, a simple restyle is adding leather upholstery to the car. Hence, there will be an increase in demand for Pecca s products. Recent examples include: 1) Nissan s RM1 leather upholstery promotion, and 2) the Honda City X, which was touted as a premium, limited availability model. Simple restyle via addition of leather upholstery. Page 5 of 11

6 KEY RISKS Heavily Reliant on Few Large Clients Pecca s earnings are mainly derived from the OEM market. Hence, Pecca is reliant on a few major clients to ensure optimal plant utilisation. Therefore, the group is pressured to price its products competitively. However, as Pecca practices strict quality control, and has a loyal customer base, it is unlikely that they will lose contracts from major clients. We understand that Pecca is the sole external supplier for Perodua, Toyota, Mitsubishi and Nissan car seat covers. Furthermore, as it diversifies its business, Pecca will be less reliant on the aforementioned car manufacturers. Heavily Dependent on Skilled and Foreign Labour The production of leather seat covers is a labour-intensive industry, which relies on foreign labour. Pecca currently employs about 323 foreign workers. Any shortage in the supply of foreign labour will affect Pecca s operations substantially. Pecca partially mitigates this by continuously recruiting new employees and providing them with in-house training. Furthermore, any increase in foreign worker levy may reduce earnings. That said, labour costs only constitute 15% of total cost of sales and will not impact the Group s bottom-line significantly. Fluctuation of Forex and Raw Material Prices Circa 80% of Pecca s costs of sales comprise of material costs denoted in USD. However, its revenue is denoted in MYR. Meanwhile, leather hides constitute 60% of material costs. Hence, any fluctuation in forex or leather hide prices will impact Pecca s earnings. According to our sensitivity analysis, we estimate that a +5%/-5% change in leather price and USD/MYR rate will impact FY18 s core net profit by -5.5%/+5.5% and -8.7%/+8.7% respectively. That being said, Pecca has secured contracts with its suppliers to lock-in prices for leather hides. Also, similar to other auto parts manufacturers, Pecca negotiates deals with its clients to cushion the impact of forex fluctuations. This deal allows Pecca to set the exchange rate for the next month/quarter/half-year based on the average rate in the previous period. This effectively allows Pecca to partially pass through increased costs to its customers, i.e. auto makers. Sensitivity Analysis - Core Net Profit +5.0% -5.0% Leather hide price -5.5% 5.5% USD/MYR rate -8.7% 8.7% Figure 10. USD/MYR rate Figure 11. Leather Hide Price Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Jan-17 Mar-17 May-17 Jul-17 USct/lb Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Source: Bloomberg, TA Research Source: Indexmundi, TA Research Page 6 of 11

7 SWOT ANALYSIS Strengths - Industry has high barriers of entry - One-of-a-kind product in SmartFit and QuickFit - Market leader with loyal customer base and large volume - Decent dividend yield and strong balance sheet Opportunities - Expected growth into Thailand - Diversifying into aviation sector - Revamping interior design of vehicles to clear old inventories - Retail business underpinned by patented products Weaknesses - Reliant on a few large clients - Reliant on foreign workers Threats - Fluctuation of forex and raw materials going forward - Weak automotive sector FINANCIALS & VALUATION Historical In FY14, Pecca registered substantial revenue growth of 50.6% and earnings expansion of 37.4%. This was largely driven by the OEM market as Pecca secured contracts for the Perodua Alza and Toyota Vios TRD Sportivo models. Hence, OEM is the biggest market for Pecca. To recap, Pecca increased its production capacity to 120k units from 90k units in FY14. Whereas in FY15, Pecca recorded revenue growth of approximately 30.1% and earnings growth of 23.4%. Again, this was mainly due to an increase in OEM contracts, namely from Perodua Axia, Proton Iriz and Toyota Hilux models. In FY16, Pecca s earnings dropped by 19.1% whilst revenue slipped by 2.5%. This was mainly due to the weak automotive sector which reduced demand for its products, coupled with one-off listing expenses of RM2.1mn. In FY17 core net profit fell 11.8% as Pecca s major customers, Toyota and Nissan registered weak automotive sales. Figure 12. Breakdown of Product Sales (unit) Figure 13. Breakdown of Revenue by Products (RM mn) OEFit SmartFit OEFit SmartFit Others Expected net profit growth We are expecting a 41.7% increase in net profit in FY18 followed by an 11.9% increase in FY19 due to the capacity expansion and greater interest income. Furthermore, we expect demand for leather seat covers to grow as the automotive sector recovers slightly. Note that in FY14, revenue and net profit grew by 50.6% and 37.4% respectively after Pecca increased its capacity from 90k units to 120k units. Our earnings forecast is based on the following assumptions: 1) leather seat cover sales volume of 102k/106k/111k, 2) USD/MYR rate of 4.15 from FY18-20 and 4) leather hide price of US ct/lb of 65 for FY Page 7 of 11

8 Upside potential from new revenue streams To recap, Pecca recently obtained the DCA approval for leather upholstery scope. The Group is currently targeting airlines including AirAsia and Malindo for contracts. Furthermore, the Group is expected to establish fifty new retail outlets in the next two years where the majority will piggyback on selected highend car tinting shops. We note that ASPs and margins for the retail market will likely be superior versus the OEM market. Lastly, Pecca has established an entity in Thailand to expand and solidify its businesses there. Given the multiple new revenue streams, we believe there is additional upside to our earnings forecasts. It is important to note that currently, we have not taken into consideration any of the new revenue streams pending further guidance. Figure 14. Historical and Forecasted Financials Revenue Core PATMI Net Margin % 16% % 12% 10% 8 8% 6 6% % 2% E 2019F 2020F 0% Source: Company, Valuation There are no other listed competitors that are directly comparable to Pecca in Malaysia. The closest comparison is IHL, a leading player in Thailand for leather upholstery. Hence, we fairly value Pecca at RM1.69/share based on 14.5x CY18 PER. Note that, this implies a circa 20% discount to IHL s current forward CY18 PER of 16.8x. We believe the discount is justified due to IHL s 1) larger market cap and 2) integrated business strategy. Pecca s FCFF yield exceeds dividend yield, which implies a growing cashpile to cushion its share price. Page 8 of 11

9 Earnings Summary Page 9 of 11

10 APPENDIX Figure 15. Overview of Manufacturing Process Source: Company Page 10 of 11

11 Figure 16. Example of In-house Design and Styling Source: Company Stock Recommendation Guideline BUY : Total return within the next 12 months exceeds required rate of return by 5%-point. HOLD : Total return within the next 12 months exceeds required rate of return by between 0-5%-point. SELL : Total return is lower than the required rate of return. Not Rated: The company is not under coverage. The report is for information only. Total Return is defined as expected share price appreciation plus gross dividend over the next 12 months. Gross dividend is excluded from total return if dividend discount model valuation is used to avoid double counting. Required Rate of Return of 7% is defined as the yield for one-year Malaysian government treasury plus assumed equity risk premium. Disclaimer The information in this report has been obtained from sources believed to be reliable. Its accuracy or completeness is not guaranteed and opinions are subject to change without notice. This report is for information only and not to be construed as a solicitation for contracts. We accept no liability for any direct or indirect loss arising from the use of this document. We, our associates, directors, employees may have an interest in the securities and/or companies mentioned herein. for TA SECURITIES HOLDINGS BERHAD(14948-M) (A Participating Organisation of Bursa Malaysia Securities Berhad) Kaladher Govindan Head of Research Page 11 of 11