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. RevenueRevenue 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.
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.
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.
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, the opportunity for value investors lie
here.
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
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
