09 November 2012 Visit Note Kossan Rubber Industries Berhad Higher dividend in the horizon HIGHLIGHTS New plant focusing on surgical gloves production expected to commence operation in December 2012. Product mix to be balanced between NR gloves and NBR gloves. Diversifying into the niche and more stringent segments such as surgical glove, cleanroom glove, face mask, and wipes. Upstream move to diversify income stream. Dividend payout ratio to be increased up to 50% in the next two years. We met with Kossan Rubber Industries Bhd (Kossan) s management recently. Pursuant to the meeting, we remain upbeat on the company s future prospect and outlook. The key takeaways from the visit are: 1. Growth to be sustained through prudent expansion plan. 2. Composition of glove products to be balanced between natural rubber (NR) and nitrile butadiene rubber (NBR) products. 3. Upstream venture intended mainly to diversify income stream. 4. The company is diversifying into niche and more stringent product segments, such as surgical and clean room gloves. 5. Technical rubber products division growth to be stable. 6. The management is looking to increase its dividend payout ratio up to 50% in the next two years. 7. It is establishing its own brand, InTouch, with exclusive distribution rights given to MNCs in more than 37 countries. Future prospect. The operating environment for rubber glove producers have improved substantially over the last few months due the easing of latex prices, which is the main raw material for glove production. We expect the latex price to remain low and stable in the next twelve months, due to the structural slowdown in demand from China and India, the main consumers of this commodity. The exchange rate volatility of USD RM is expected to stay, although the impact is milder compared to latex prices volatility impact. In total, the outlook is highly positive for Kossan over the next 12 months. Reiterate BUY. We maintain our BUY recommendation with an unchanged TP of RM3.71, derived from 10 times price earnings multiple of FY13F EPS, based on its 5-year historical PE ratio average. Based on its track record over the last 30 years, we believe the management will continue to be hands-on and prudent in ensuring the sustainability of the business growth over the long term. At the current price, we are of the opinion that the stock is undervalued, thus offering considerable appreciation potential. Maintain BUY Unchanged Target Price (TP):RM3.71 RETURN STATS Price (8 Nov 12) Target Price Expected Share Price Return RM3.17 RM3.71 17.0% Expected Dividend Yield 2.5% Expected Total Return 19.5% STOCK INFO KLCI 1,641.07 Bursa / Bloomberg Board / Sector Syariah Compliant 7153 / KRI MK Main/ Industrial Products Yes Issued shares (mil) 319.7 Par Value (RM) 0.50 Market cap. (RM m) 1,016.8 Price over NA 1.87x 52-wk price Range RM2.93 RM3.65 Beta (against KLCI) 0.94 3-mth Avg Daily Vol 0.27m 3-mth Avg Daily Value Major Shareholders RM0.83m Kossan Holdings 50.90% KWAP 7.55% EPF 5.02% Asian Small Coys Portfolio 4.93% Invesco Ltd 4.71% KINDLY REFER TO THE LAST PAGE OF THIS PUBLICATION FOR IMPORTANT DISCLOSURES
2 INVESTMENT STATISTICS FYE Dec FY10 FY11 FY12F FY13F Revenue (RM'm) 1,046.9 1,090.0 1,255.4 1,395.8 EBIT (RM'm) 148.6 120.4 145.2 160.9 Pretax Profit (RM'm) 140.7 112.9 136.4 150.7 Net Profit (RM'm) 113.4 89.7 108.1 119.3 EPS (sen) 35.46 28.15 33.77 37.29 EPS growth (%) 70.1-20.6 19.6 10.4 PER(x) 8.8 11.1 9.3 8.4 Net Dividend (sen) 8.0 7.0 8.0 9.0 Net Dividend Yield (%) 2.6 2.2 2.5 2.8 Expansion on schedule. As of September 2012, Kossan has in total 10 glove manufacturing plants, operating 146 lines with a total production capacity of 14.6b pieces per annum. These plants focus mainly on NR and NBR examination gloves. On an interesting note, Kossan is expecting to commence operation at its new plant by Dec 2012, which will focus on surgical gloves production. This new plant will have in total 9 production lines with a projected production capacity of 0.8b pieces per annum, leading to a total of eleven plants with a total of 155 production lines and 15.4b pieces of annual production capacity. More balanced product mix. Currently, NR gloves make up 57% of Kossan s total production capacity, with the remaining capacity being allocated for nitrile gloves. In order to have a more flexible production capability, the company is building more nitrile capacity, with target to have an even production capability between NR and NBR gloves in 2013. We believe this is an encouraging move, as although the current trend points to a switching momentum to nitrile gloves, there is always a possibility that the trend might reverse, especially if there is a significant fall in latex price that will lead to a lower pricing for NR gloves. Penetrating the niche segments. With an eye of diversifying its product mix, Kossan is diversifying into other niche segments, namely surgical gloves, cleanroom gloves, sterilized gloves, special application gloves, face mask, and wipers. We have a positive view on this development, as risk of overcapacity is low in the niche and more stringent product segments due to less competition and products are subject to more stringent requirements by the authorities. Eventually, the company has set a target of the surgical and cleanroom products to contribute at least 5% to its total revenue, and is aiming to be one of the key suppliers for premium surgical glove and cleanroom gloves for E&E industry. Technical rubber products division stable and steady. Currently, Kossan is Malaysia s largest technical rubber products producer, with products range covering the automotive, marine, construction and civil engineering, mining, general industries, and aerospace industries. Although the contribution from the segment, accounting for 12.0% of the total sales in FY11, is minimal compared to the rubber gloves division, the company has its origin in this business, and the business has seen steady growth over the years, as reflected in a 18.7%yoy external sales growth last year. As such, the management intends to grow the business, as there is consistent demand growth forecasted for the technical rubber products, as well as maintain a hedge against glove division earning s volatility. Prudent capacity expansion plan. Over the years, the company s management has been very prudent in expanding its capacity, and this would not change in the future. Driven by the market demand, Kossan is targeting going to maintain a consistent growth in capacity, with a target of adding 80 production lines between 2013 and 2018, and having total production capacity of 24b pieces of gloves by 2018. Consistently exceeding 85%, Kossan s current capacity utilization rate is higher than the industry average of 60%-70%.
3 Healthy balance sheet to be maintained. Over the last five years, Kossan s balance sheet has seen significant improvement, with the debt to equity ratio coming down by more than half from 0.73 times in 2006 to 0.32 times in 2011. Likewise, its liquidity position has been gradually improving, with the current ratio increasing form 1.11 times in 2006 to 1.52 times in 2011. Moving forward, the management has reiterated their commitment of being prudent to keep the gearing at a manageable level in ensuring sustainable long term growth of the company. More attractive dividend payment. From the current level of 25%, the management of Kossan is looking to increase its dividend payout ratio to as high as 50% within the next two years. This is a very encouraging development to the shareholders, as we always believe that the surplus retained earnings after accounting for the future capital expenditure and working capital needs should be returned to the shareholders. Compounded by the fact that earnings growth should be able to be sustained, the shareholders could be looking at a very handsome reward in the long run. Upstream move mainly to diversify income stream. With the main objective to further diversify its business, the management is eyeing to move into the upstream segment of the industry, with a plan to venture into rubber plantation business. The management is looking for land in neighboring countries such as Indonesia, Cambodia, or Myanmar to execute this strategy. This move would also benefit the company in the long run as it would enable the company to hedge its raw material prices to a certain extent from future volatility in latex price. However, on a cautious note, this is a new business outside the core competency of the company, and a greenfield rubber plantation land would take approximately seven years for the trees to mature. This means that the company would need to incur negative cash flow before it can reap the benefit form this venture. Nonetheless, this concern should be minimal due to the company s strong cash flow. Establishing own brand. Diversifying from its strategy of being an original equipment manufacturer to multi-national companies (MNCs), Kossan has established its own brand, InTouch. It has given exclusive distribution rights to MNCs in more than 37 countries to date with a target to reach another additional 20 countries by end of the year. This is highly positive for the company, as we believe having its own strong branding power will help the company to sustain the pricing for its products over the long run. Energy and labor costs increment impact minimal. With the implementation of the minimum wage policy and subsidy rationalization plan, there is a concern that the production costs of the company would rise and affect the profitability of the company. However, we think the impact would be minimal, as labor and energy costs each makes up only 9% of total production costs. Furthermore, the company is embarking onto more advanced stage of automation and computerization to reduce dependency on manual workers, plus any extra energy cost will be transferred to buyers. Latex price volatility the bigger concern. The bigger concern to any rubber glove producer is the latex price volatility, as latex costs make up 50% to 60% of the total production costs. Any increment in latex prices would mean greater impact to the average selling price compared to other costs. However, the impact would be mitigated by the fact that the company is able to pass the increment in material cost to its customers, as it works with the buyers on a monthly basis based on a pricing formula agreed by both parties. With this agreement, the average selling price will be adjusted upward to capture the additional production cost and downward to return any savings to the buyers.
4 Latin America Asia 8% Pacific 12% Europe 30% Market segment USA & Canada 50% Nonmedical 5% Products category Medical 95% Product mix (2012) Product mix (2013) Nitrile 43% Natural rubber 57% Nitrile 50% Natural rubber 50% Packaging 8% Labour 9% Overhea d & Admin 8% Chemicals 9% Costs composition Energy 9% Latex 57%
5 Latex price and USD-RM exchange rate Zulkifli Hamzah Azman Hussin azman@midf.com.my 03-2772 1663
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