Introduction

In an interview by BFM dated 19 January 2015, the radio station hosted the Managing Director of Top Glove Berhad (TOPGLOV), Lee Kim Meow, and CEO of Karex Berhad (KAREX), Goh Miah Kiat, both being the World’s Number 1 Manufacturer in their own field from Malaysia to talk about the manufacturing sector. Undeniably, both companies have historic and natural advantage in their main raw material, ie rubber, which makes up a large portion of Cost of Good Sold (COGS). However, what really pushes the two companies to the World’s No. 1 spot is their continuous improvement and relentless innovation to create value. Without value creation, pricing will be the only strategy, and sooner or later you will be replaced (when there is cheaper option due to technology advancement, or currency fluctuations etc), let alone being the World’s No. 1 manufacturer. However, Research & Development (R&D), Growth Capital Expenditure (growth CAPEX), Earnings Quality etc are always being overlooked by some investors because fundamental analysis has always been watered down to PE checking.

Interestingly, 3 years after the interview, while both of them still being the World’s No 1 Manufacturers in respective industry, one share price has gone up from RM 2.39 to RM 9.39, making close to 300% return, while another has plummeted from RM 1.73 to RM 0.765, down by more than 50% (Both share prices adjusted for Bonus Issue).

In this post, we are going to talk about the one that has plummeted in share price, KAREX.


Condom Industry

I was fortunate enough to meet someone who had worked in the condom industry for a long period and claimed to know Goh Siang personally. In our short conversation, he told me that the technology used in condom industry is different to what being used in gloves industry, for condom has to be made as thin as possible, but not at the expense of its durability. Therefore, it won’t be hard for a condom player to develop the kind of technology to make gloves, but on the other hand for a gloves player to manufacture condom? Well it is not easy. This is why even being a major OEM in FY13, KAREX was still able to command gross profit margin (GPM) of over 30%, while gloves manufacturers’ GPM is normally hovering around 20%. GPM always tells the quality of earnings of a company, and you may refer to this link to see how important is GPM to a company.

Is it really that hard to venture into condom manufacturing, ie. the barrier of entry of the industry? Due to the stringent nature of tender market, and the fact that condom is classified as a medical device, condom manufacturers have to receive certain certifications from and be registered as a pre-qualified manufacturer with respective agencies. In order to be a pre-qualified manufacturer, condom manufacturers must have a proven track record supported by 5 years report to demonstrate its manufacturing capacity and product quality. For OEM manufacturer, it takes 2 years just to get registration done. In that case, KAREX has the necessary licenses, certifications and accreditations to export to more than 110 countries across USA, Europe, Asia, Africa and Middle East. It is also one of the pre-qualified manufacturer for PSI, UNFPA, JSI/USAID and Crown Agents.

Technology wise, it is actually not that hard to manufacture condom (TOPGLOV is doing it, right?). However, the equipment, the technology out there is mostly for the making of plain usual type of condom. KAREX has been designing, developing, re-engineering and customizing the machines, which allow them to cater for different demand from clients, in terms of different shapes, sizes, flavor, without compromising the quality of the condom. The founder of Global Protection Corp Davin Wedel (owner of fourth largest condom brand in USA) once said in an interview that KAREX was the only manufacturer that could cater for their demand to manufacture glow-in-the-dark condom in year 2015. Other than manufacturing different types of condom, and improving the quality of the condom, KAREX also focus in designing their machines and equipment to be more efficient and cost-effective.

We would not classify what KAREX has as a strong moat, but after being in the industry for so many years with relentless innovation, KAREX does have certain competitive advantages over the other condom players or potential condom players.

According to a report by Ariztoin Advisory & Intelligence, the global condom market is expected to cross $11 billion by 2023, growing at unprecedented CAGR of 8.62%. Factors such as an increase in per capita discretionary income of people globally and a rapid growing number of dual-income households in developing as well as developed markets are major growth factors for the global condom market. In the light of the increase in sexually transmitted diseases (STDs) and sexually transmitted infections (STIs), condoms have become essential to prevent sexual ailments and ensure sexual wellness with low cost. Being the largest manufacturer in the world, KAREX is definitely expected to benefit from this growth.


Condom Giant at its IPO (FY13)

Let us rewind to November 2013 when KAREX first listed. At that time, KAREX was already the biggest condom manufacturer in the world with an annual manufacturing capacity of three (3) billion pieces, and manufactured approximately 2.4 billion pieces of condoms, which made up to 10% market share at that time. Here are some financial information of KAREX at FY13, the financial year before it went for IPO:

At the IPO Price of RM 1.85 (which equivalent to RM 0.55 after bonus issues adjustment), KAREX was trading at PE of 17x.

In the prospectus of IPO, KAREX listed out its four key focus as below:

Excerpt from KAREX IPO Prospectus

After listed for one year, at the AGM of FY14, KAREX received approval from shareholders to issue Private Placement with the rationale stated below:

Excerpt from KAREX “Proposal” dated 26 February 2015

To summarize it, both of the fundraising (IPO & Private Placement) have raised a gross proceed of RM 232.87 million, aiming to utilize the fund in 4 areas:

1) Increase Production Capacity

One of the goals for KAREX upon IPO was to increase their production capacity from 2.8 billion units per annum in FY13 to 7 billion units per annum in FY17. We all know that increase in Production Capacity does not translate directly into increase in Revenue, so why did KAREX feel that it was necessary for them to double their production capacity ? In an interview conducted before the IPO took place, CEO of KAREX Goh Miah Kiat revealed that there is no long-term contracts in condom industry, and the orders from tender market normally requires a quick turnaround time of  6-8 weeks, but due to KAREX’s high utilization rate they can only manage to deliver in 4 -5 months. He was in the opinion that the condom market will continue to grow rapidly and increasing the Group’s production capacity at that point of time was urgent and necessary. Besides that, due to the absence of long term contracts, it was hard for the condom manufacturers to hedge effectively against raw material price (especially latex price which makes up of 60-70% of COGS), so a shorter turnaround time would allow them to be less exposed to raw material price fluctuations (we noticed that the GPM of KAREX in FY11 & FY12 was much lower due to the higher latex price).

The investment in production capacity can be traced under CAPEX spending in Prospectus and Annual Reports. The Group initially planned to spend RM 41.7 million from IPO proceeds in CAPEX but ended up spending only 24.2 million in the end, still managed to achieved the 7 billion units production capacity target in 2017. Investors can take this as a positive note that R&D of the Group has been bearing fruits.

2) Invest in OBM (Own Brand Manufacturing)

Goh MK once said that, “the average selling price of one condom manufactured by KAREX is USD 0.03, while the average price of one condom on shelf is USD 1, so where the hell has the rest of USD 0.97 gone?” Even though they were able to command GPM of 30%, KAREX knew exactly where they were  in the value chain. If you don’t know it already, it is worth mentioning that Revenue of KAREX can be classified into 3 market segments:

Original Equipment Manufacturer (OEM): KAREX manufactures and supplies condoms and other sexual wellness products to brand owners which will be marketed under their brand.

Tender: KAREX participates in tender projects by international agencies, NGOs, and government to supply condoms and other sexual wellness products.

Own Brand Manufacturing (OBM): KAREX manufactures and distribute their own brand products under the brand name of Carex and INNO.

At time of IPO, KAREX OEM segment contributed to 60% of Revenue, Tender segment contributed to 36% of revenue, and OBM segment contributed to 4%. If a company is able to achieve GPM of 30% with most of the revenue contributed by OEM segment and Tender segment, imagine when it manage to expand its OBM segment most of the margin lies. You may trace the amount invested in OBM segment in Development & Business Expansion and Working Capital in Prospectus and Annual Reports which was around RM 151 million from both IPO & Private Placement proceeds. (Note: Total amount allocated to working capital was not entirely for marketing, promotion and branding activities for OBM, but also for human capital and increase of short term capital due to increased capacity. However, a big part of it was allocated to brand building).

3) Repayment of Bank Borrowings

RM 10 million (relatively small amount) of the IPO proceed was used for repayment of bank borrowing.

4) Invest in R&D

RM 4 million of the IPO proceed was allocated for R&D. This is only 5.5% of the total gross IPO proceeds. We are in the opinion that at IPO stage, the technology of KAREX is already matured enough heavy investment no longer needed.

The utilization of proceeds were later published in AR FY16

Utilization of IPO & Private Placement Proceeds. Excerpt from KAREX AR FY16

Over the years, Property, Plant and Equipment (PPE) of the Group has expanded from RM 116.98 mil in FY13 to RM 204.01 mil in 2QFY18, and managed to increase its production capacity to 7 billion units by 2017. For its OBM segment, instead of fully building and promoting its existing brand CAREX & INNO, KAREX chose to acquire existing condom brands. Here are some brands acquired by KAREX over the years.

October 2014, acquired 55% of Global Protection Corporation (GPC) at USD 6.6 million by cash, mainly for its “ONE” brand products, fourth largest brand in USA.

October 2015, acquired 100% in Medical-Latex (Dua) Sdn. Bhd. For RM 13 million, mainly for its lucrative and exclusive long term contract to supply Beiersdorf AG existing brands as well as the right of first refusal to acquire its brands in the future.

January 2016, acquired intellectual property assets from Theyfil, LLC for USD 13 million that included trademarks and approvals required to produce custom fit condoms in over 95 sizes with the aim of incorporating such concept into its existing OBM portfolio. You may click this link to understand the concept behind.

July 2016, acquired 100% Pasante Healthcare Limited for GBP 6 mil, mainly for its established brand to complement OBM segment with its experienced sales team.

August 2016, acquired intellectual properties including the trademarks, patents and approvals from Line One Laboratories Inc for USD 8 mil, to market and distribute condoms under the established brands of Trustex, Kameleon and Fantasy.


Comparing Then and Now

Now, let’s compare the Income Statement and Balance Sheet of post IPO KAREX and current KAREX, after going through all the brand building, acquisitions, and capacity expansion.

1. Revenue
Revenue has grown from RM 231 million to RM 374 million, at a Compounded Annual Growth Rate (CAGR) of 8.25%. This is an impressive growth for a manufacturer with a size like KAREX. The Group has achieved record high revenue in Q1 and Q2 of FY18. The management did translate the production capacity to Revenue. Besides that, the geographical diversification and segment diversification of Revenue has also improved. We can see that the Revenue of KAREX in FY17 is almost equally contributed by the 4 regions. The note in ARFY17 also indicated that operations of KAREX is no longer very favourable to US currency. This is a very important part, as we can see the strong Revenue in Q1 and Q2 FY18 was not due to currency fluctuations. For segment diversification, it seems like KAREX is on its track of being a serious OBM player, as the OBM has now contributed to 14% of total revenue in FY17, compared to FY13. However, let’s not forget these are achieved by aggressive acquisition over the years.

Geographical Diversification in Revenue from FY13 to FY17, excerpt from AR 15 and AR 17

Segment Diversification in Revenue from FY13 to FY17, excerpt from AR 15 and AR 17

2. Gross Profit and GPM
Gross Profit grew from RM 59.9 mil to RM 108.15 mil, with a CAGR of 10.34%, and GPM is being maintained at a level of 24% – 33%. While we are impressed by KAREX’s ability to maintain its GPM at the back of high latex price (in late 2016 and early 2017) and less favorable USD, investors should be aware that KAREX was supposed to achieve a higher GPM due to higher contribution from margin fat OBM segment. It was reported that  the Group has reduced its GPM in Tender segment to gain more market share.

3. SGA, SGA/Revenue and Net Profit
Increasing Sales, General and Administration Expenses has been the culprit of lower Net Profit for KAREX over the recent periods, resulting in drastic drop in share price. SGA of KAREX includes Distribution and Administrative Expense, which is generally expenses incurred in promoting, advertising, delivering the products. The increasingly higher SGA/Revenue (from 8.54% in FY13 to 23.47% in 2QFY18) is a result of aggressive effort in pushing its own brand. Investors should bear in mind that even though first brand acquisition occurred in October 2014, the management only started to fully push its own brand in FY17. Therefore, expenses in SGA should be expected to stay high in coming financial quarters. The management guided that the SGA has reached a plateau in FY17. However, we saw higher even SGA in Q1 & Q2 of FY18, which could be the main reason of selling down after 2Q result announcement, market doesn’t like the unexpected.

4. Balance Sheet
Comparing the Balance Sheet (post IPO vs 2QFY18) as a whole, there is a slight increase in Cash & Equivalent (9%), slight decrease in Current Liabilities (15%) and Total Liabilities (13%). Total Borrowings decrease (29%). There are significant improvement in PPE (74%), Current Asset (77%), Total Asset (106%), and Net Cash per Share (107%). The quick ratio and current ratio has also improved significantly. It is a no brainer that current Balance Sheet is much stronger than IPO. However, it is worth noting that the Cash Flow From Operations (CFFO) has turned in the 2QTTMFY18, due to the higher-than-ever SGA. Unverified source stated that CEO MK Goh has hinted in previous AGM that KAREX would consider to increase in Gearing Ratio going forward.


Is KAREX a good deal?

Let’s analyze based on the facts above,

1. World condom demand looks promising, with increasing populations, increasing awareness in birth control and its effectiveness against sexually transmitted disease.

2. Leave your hatred behind, leave your obsession behind, leave the price behind, and don’t think about the future yet, just compare KAREX THEN (Post IPO) and KAREX NOW (2QFY18) as two different companies, which one would be a better company? Looking at Balance Sheet alone, KAREX NOW is definitely stronger. In terms of Production Capacity, KAREX NOW is more than one time larger than KAREX THEN. KAREX NOW also has much higher Revenue, and healthier Revenue in terms of Market Segment and Geographical Segment which would result in better GPM in the future. The lower Net Profit of KAREX NOW is due to high expenses in promoting and advertising its OBM, which can be seen as a short-term pain, long-term gain.

3. Still leaving your hatred and obsession behind, now let’s look at the price. KAREX THEN listed at a price of RM 0.55 (after bonus issue adjustment, which is trading at PE 17x), and KAREX NOW is trading at RM 0.775 (PE 36.93x). Based on comparison at point No. 2 above, how much you would pay for KAREX NOW? Just before you state your general rule of thumb for PE ratio, please be reminded that PE ratio is only meaningful in comparison. KAREX THEN was a major OEM and Tender manufacturer, with only less than half of the capacity of KAREX now, yet it was oversubscribed by 21.76 times at a PE of 17x. And after pouring RM 232.88 mil from IPO and Private Placement to CAPEX, Acquisitions, Brand building, R&D etc, it might be hard (by no mean impossible) for us to see current KAREX to be back to PE of 17x. The closest peer of KAREX, Thai Nippon Rubber, which is a Thailand condom manufacturer with half a size smaller than KAREX NOW, focusing mainly in OEM and Tender, is now trading at PE of 43x.

4. Think about the future now. For KAREX to achieve a Blue Sky Scenario, increasing awareness of using condom as device for contraception and against sexually transmitted disease device is not enough. KAREX heavily invested in R&D to manufacture condom in different sizes, shapes, flavor with the aims of turning condom into a pleasure product. Such perception toward condom must happen in order for KAREX own brands to get a serious world market share. Should that happen, investing in KAREX at this price will make it ridiculously cheap. In an Average Scenario, KAREX will maintain in current OBM market share, stop pushing its own brand aggressively and SGA will normalize. In this case, with its current market share and production capacity, KAREX will still be better than ever in terms of Revenue, Gross Profit, GPM, Net Profit, NPM, Balance Sheet etc. Well in a Worst Case Scenario, KAREX continues to drain its cash to promote OBM but only to give up later. In this case, impairment in goodwill and asset value will be inevitable, and maybe we will see more debts to serve in KAREX. However, the demand for KAREX as a manufacturer is still there, and it is still a way larger manufacturer compared to KAREX THEN.


Summary

Market Efficiency has been a topic in financial market of a long time. Authorities in value investing generally agree that the financial market is efficient most of the time, but undervalued and overvalued opportunities exist when market pendulum swings. However, there is a view that market cannot be perfectly efficient because the investment time frame for each individual differs widely. For example, target price based Discounted Cash Flow (DCF) will not be the same if the time period is different. In other words, you can’t expect a 80-year-old man who doesn’t even buy green banana to invest a company that takes 5 years to turnaround. However, a 20-year-old man can value the same company very differently. The general consensus is that KAREX will eventually turn out to be better, but uncertainty is on its continuity in SGA spending. Paradoxically, if we, the general market, really know how long will it takes for KAREX’s SGA to normalize, KAREX might not be even trading a this price. Maybe, here lies the opportunity for value investors.

 

Sources:

KAREX IPO Prospectus
KAREX Annual Report FY14, FY15, FY16, FY17
KAREX Financial Report 1QFY18, 2QFY18
Condom Market – Global Outlook and Forecast 2018-2023, Arizton Advisory & Intelligence
KAREX, Where value comes from, Ricky Yeo
Latex Price Historical Chart https://www.indexmundi.com/commodities/?commodity=rubber&months=60¤cy=myr
KAREX doubles output size post-IPO, The Breakfast Grille BFM
Talking Heads Episode 2: Lee Kim Meow & Goh Miah Kiat, The Breakfast Grille BFM
Going Global – Global Protection Corp (USA), Enterprise BFM
Expanding An Elastic Business Model, The Breakfast Grille BFM
Up The Ante – Family & Generational Business #2, Enterprise BFM

 

 

 


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