Prolexus's key customer earning's update - Nike Inc. Profit Beat Analysts' Estimate

Yesterday (28 Feb 2015), Nike Inc. (Nike) reported an overachieving quarterly report ended on 28 as more higher margin shoes and apparel were sold. Share price up 4.5% to $102.75 in heavy after-hours trading.

This update mainly focus on Nike's performance that facilitate projection of Prolexus's future performance and Q2FY2015's performance, due to announced tentatively on today (20 Mar). Keynotes as below:

-  Nike's Worldwide Apparel sales growth 9% yoy excluding currency changes (ex-forex) or 3% if inclusive of currency changes
- Future orders of Nike Brand growth 11% ex-forex or 2%
- Future orders growth would have been even higher if not compared to strong growth last year due to the soccer World Cup
- Inventories up 12% due to higher inventories in wholesale business and growth in Direct to Customer
- Wholesale inventories increase 17% in units, but offset 5% by changes in average product cost and Forex change.

Positive implication of Prolexus's earning:
- Higher growth in current sales and future orders indicate strong apparel orders to Nike's worldwide suppliers. Prolexus should be one of Nike's supplier that receive strong order, hence boosting potential sales growth
- Nike's reporting of market-beating earning result shows, one again, Nike's continuous ability in growing its business worldwide, even amid challenging macroeconomic condition. This indicate Nike need to rely on its supplier in the long-run to achieve sustainable success.

Risks:
- Strong demand from Nike may not be met by Prolexus due to capacity constraint or any delay in production expansion. Hence, risking losing order or damping relationship with Nike.

Opportunity:
- Given the opportunity to ride on Nike's high sales growth, Prolexus should expand aggressively to (i) fulfill Nike's higher demand (ii) expand its market share of Nike's order (iii) but most importantly, to achieve a better economic of scale to stay competitive among this competitive industry. Apparel industey is very competitive. In order to stay relevant and competitive in the long-term, Prolexus has to gain a competitive edge in production cost through better economic of scale. Although aggressive expansion to cater Nike's need increase its risk due to higher fixed cost and higher reliance on single-customer, this is a necessary step to strengthen its relationship with Nike. Besides that, Prolexus's strong balance sheet and OCF allow them to take the necessary risks of expansion.

View on Investment:
Prolexus's share price has appreciated significantly (+63% YTD) and now have a valuation of TTM PE at 9.35x, which is relatively high compare to its PE in the past 2 years. Market is giving a high valuation due to expectation of impressive Q2 earning result (to be announced tentatively today). Q2 have been one of the best quarter of Prolexus in term of revenue achieved. The strong expected revenue is further boosted by strengthening of USD (around + 8% QOQ).

At this valuation, I would give Prolexus a HOLD rating pending on the earning announcement later of today due to:
i) concern on its ability to make timely production expansion to meet the higher demand
ii) relatively high valuation - which has exceeded my previous DCF/SOP-based TP of RM1.89
iii) although its key customer's demand is growing rapidly, but the positive macro-situation is offset by its production capacity constraint and the risks due to (i) intense competition (ii) high customer concentration risk

LTKM - The Omitted Egg

Poultry and layers farms have been the current theme-play due to higher selling price of eggs and chicken as well as falling feed price. With some of the industry players' stock (e.g. QL, TeoSeng, CAB & PW) have been under coverage by sell-side analysts, I tried to research on company that is currently not under coverage. I have looked into LTKM, a long-time layers farm company listed in Bursa Malaysia since 2000. It is the 5th largest egg producer in Malaysia with daily production capacity at 1.8mil eggs.

1.0 Summary

LTKM is a pure-play on the egg production story with 98% of its sales comes from layers business. LTKM recently reported a strong financial report with 9MFY15's operating profit margin at 23%, which is unprecedented in the past 10 years due to (i)higher selling price of eggs to Singapore (LTKM exports over 40% of the egg production to Singapore and Hong Kong) (ii) declining feed price in the past 2 years.

Looking forward, I expect LTKM to sustain the current profitability in FY2016 as (i) feed price is expected to stay low and stable and  (ii) eggs' ASP is expected to remain high in CY2015.

After FY2016, Revenue and PBT are expected to decline slowly due to (i) gradual recovery of feed price and (ii) normalized of eggs' ASP (iii) lack of capacity expansion plan.

Overall, I still see upside potential of the stock with SOP TP at at RM7.55 (14% upside) as (i) Feed price increase will be gradual and stable in the next 5 years, which do not hurt LTKM's margin significantly (ii) ASP, though fluctuating, is generally rising in the long-term. (iii) Recent market's focus on poultry-theme play due to the former 2 factors as well as investors shift to recession-proof consumer-sector amid concern over GST and slower economic growth will dampen consumer spending. 

However, as poultry business is cyclical in natural, I do not advice long-term investment in the stock but rather give a Hold or Short-Term Buy rating to the call. Disclaimer: This is just an advice, not a investment recommendation. 

2.0 Background

LTKM listed in Bursa Malaysia in year 2000 and is tightly-held by its director, Datuk Tan Kok with direct and indirect shareholding of 65% of the company. (Hence, free-float available to the market is not much, that is also why it is not covered by any sell-side.) LTKM's egg production capacity is at 1.4mil eggs per day since 2011, up only 40% from 1.0mil egg in 2000. LTKM is the 5th largest egg producer by egg production capacity.

Layers farm is a cyclical business, LTKM has seen its Net Margin swinging in the range of 5.9%-18.2% in the past 8 years. The 2 major factors determined the ups and downs of the company's profitability are (i) Average Selling Price (ASP) of the eggs, which depend largely on the supply condition of the market as demand is stable and predictable as well as inelastic to price change (ii) and feed price. Cost of layers' feeding take up 55-65% of the total cost of layer farms. The main component of the feed are soybean meal and corn, the price of which, like other commodities, have been fluctuating in the last decades and the price of the commodities determined largely the profitability of the business. I have done a regression analysis on the effect of change in feed price to LTKM's Gross Margin. It shows that the later is 90% explained by the former in the past 8 years, which make layer farm business behave like like a commodity business, just the opposite way.

Since 2008, LTKM has ventured into other non-related business and now, besides the core poultry business, they are also in the business of sand mining and extraction as well as property development. In 2009, they have ventured into glass-processing business but have in 2013 discountinued the business with a net loss of RM12.9mil registered in FY2013. Besides that, they also currently own RM40.5m of investment properties and RM33.4mil of investment securities, which are cumulatively 35% of the 3Q2015's total asset.

Sand mining business contributed insignificantly to the group Revenue and PBT. Although property development contributed 16-26% of PBT in the past 2 years, it is not expected to have significant contribution in FY15 as there are no development in progress currently.

LTKM is a company where the key shareholders/directors have most of the say on the company direction. Dividend payout have been meanly low at average of 28% of the Net Profit. This may probably due to cyclical natural of the business and Cash Flow, hence, and the management prefer to hoard cash for raining day. Non-core asset and net cash position now contributed 45% and 54% of the total asset and total equity respectively.

3.0 Key Industry Development

LTKM's Poultry business GPM have been rising in the past 8 quarters from 15% in Q4FY13 to 29% in Q3FY15 mainly due to:

i) Rising average selling price (ASP) of eggs in Singapore

In 2014, ASP of eggs have gone up over 10% in the second half of the year after 3 farms in Malaysia were suspended from selling eggs to Singapore by Agri-Food and Veterinary Authority (AVA), Singapore. The suspension was due to eggs from the farms were found to contain Salmonella enteritidis, a bacterium that causes food poisoning. The 3 farms accounting for less than 8% of Singapore total supply. Currently, 20 Malaysian farms are approved to export eggs to Singapore by AVA, down from 23 previously. LTKM exports over 40% of their eggs to Singapore and Hong Kong. With the higher average selling price (ASP), LTKM's Poultry GPM rise from 23% in 4QFY14 to 29%, which is around the period of the incident.  Beside higher ASP in SGD, Gross Margin is also partially benefited from the strengthening of SGD of about 5% in the past 6 months.

(Link to approved list: http://www.ava.gov.sg/docs/default-source/tools-and-resources/resources-for-businesses/my_layerfarmy150126.pdf) 

Undersupply of egg in Singapore do not expected to last forever as the invisible hand will work for itself with new source of supply will eventually enter the market to take a share of the economic benefit. Hence, egg price will eventually normalized in Singapore. Teo Seng have already planned to increase their daily capacity by 400k eggs annually in the next 5 years. Will the new capacity get approved from AVA to export to Singapore? Though one of their farms just get suspended last year.

Side story - From game theory point of view, it would be best if all producers do not increase their supply to Singapore market to keep the eggs' price and their margin high. It is called the Socially Optimal Situation(SOS) where all players get to earn more by selling the same amount of eggs. But this SOS will not achieved as players will start to increase supply in concern of others will do it beforehand. Game theorist will predict supply will eventually rise to equilibrium.

Even though ASP in Singapore may normalized eventually, generally ASP of egg in Peninsular have been rising at 5.6% CAGR in 2007-2013, much faster that the inflation rate of 1-3%.

Output have been rising at CAGR of 4.4% in the past 10 years, or average of 370,000 daily eggs output per annual. 


ii) Lower feed price

Beginning in 2013, the price of feed have been declining due to significant increase of supply and stock of soybean and corn internationally.  The surge in the commodities' stocks are due to increased planting, higher yield as well as overestimation of China's demand.

With the bless of cheap feed, LTKM's Cost of Inventories(COI), which is part of the the cost of goods sold, fall from the high of 68% of the sales in FY2013 to 58% in FY2014, which is a 10% cost saving. COI is expected to be lower in FY2015 at projected 53% of the sales. Nevertheless, the benefit of fall in feed price is partially offset by the weakening RM. LTKM's payable in USD is insignificant, its purchase of feed should be done with local suppliers. Although hike in feed price due to currency exchange rate will still be mostly bared by LTKM, but it will be more manageable and less uncertain. 

Source: World Bank; Annual Average Feed Mixture Price represented by 72% Corn/28% Soybean Meal price in RM per Metric Ton.

 COGS (as a % of Sales) move in parallel with the feed price. With the fall in feed price in the past 2 years, COGS is near record low. Hence the Gross Margin is at record high.

Source: World Bank

4.0 Industry Outlook

Due to record high of plantings and yield in US as well as over-planting in China caused by over optimistic projection of China's economic growth, supply surge faster than demand caused stocks-to-use ratio to rise significantly in the past 2 years. This cause the slump of feed price in the past 2 years. In the next 5 years until 2020, stocks-to-use ratio of corn(maize) and soybean are expected to declined steadily, yet still generally higher that the figure 2 years ago. Hence, price of corn and soybean is expected to remain low stable and low in the next few years, which is a very good news for poultry farms. Although feed price is expected to bias upward in the near future as planters start to reduce planting and stocks is declining, the rise is expected to be mild and stable with the still-high stocks-to-use ratio. The recent decline in crude oil price and slow global economic growth should also help to keep feed price lower in the coming years.

LTKM currently has about 10% of the market share by production capacity and no production expansion plan. The production volume is expected to be flat in the future and topline is mainly depends on the ASP of eggs. LTKM's competitor, Teo Seng (Malaysia third largest producer) is planning to expand its production capacity by 400,000 eggs per day annually for the next 5 years. Capacity is planned to grow to 5.1mil eggs from the current 3.1mil in 5 years time and increasing its market share. With Teo Seng's daily production expansion at 400,000 eggs annually, which approximate the average annual rise of output in the past decades, LTKM and other players have no much room for expansion (in egg production) as doing so may risk oversupply. I do not foresee high capex in the coming years of LTKM and production should remain flat. 

5.0 Financial 

Other ratio not available in the common size analysis above

6.0 Current Market Valuation

7.0 Projection & Valuation

My TP is based on SOP/DCF approach. However, market/PE approach is shown here for comparison. Poultry business valued at 8x FY16 Earning which is lower than 13X given by AmResarch to TeoSeng and 9x given to CAB by Kenanga as LTKM do not have expansion plan compared to these 2 competitors. However, 8x PE is reasonable as LTKM's ROE and PAT Margin ranked second among the others players. The discounted value of Investment Properties/Securities is as shown in SOP valuation above. PE-based TP of RM7.43 coincide with my TP (1.6% variance). 

8.0 Risk & Mitigation

i. Any outbreak of birdflu or other type of virus will cause lost of sales, inventories and biological asset impairment loss and reputation damage to LTKM

ii. Suspension by AVA from export eggs into Singapore due to detection of Salmonella enteritidis bacteria will cause lost in revenue and drop in profit margin

iii. Significant rise in feed price due to supply disruption (due to unexpected weather pattern or lower than expected planting) or higher-than-expected demand growth will erode LTKM's Gross Margin. 

LTKM have bio-security system for the farm in addition to control measures put in place by relevant authorities to minimize the risk of contamination. With the current high stock and supply condition for feed commodities as well as sluggish global growth, supply and demand is expected to remain stable except for factors due to weather, which is getting more volatile in the recent years.

9.0 Conclusion

The stock will still have room for appreciation given recent market's attention on poultry play. Among the competitors, LTKM is one of the cheapest and most profitable players. However, the upside is capped by its limited growth potential. My TP is based on SOP/DCF and at RM7.55 suggesting a 14% upside potential. However, investors/traders should be caution as the stock have appreciated significantly in the past 1 years, any shift in stock market sentiment will give reason to  the existing shareholders to take profit. The stock also have high liquidity risk due to the low free float. My advice is to keep holding this stock if you have already entered earlier. If not, you can look at CAB and Teo Seng for better growth prospect. Besides the ASP rise and lower feed price, poultry stocks are recently in favor as investors look at recession-proof consumer-setor amid concern on GST and slower economy growth. Investors' sentiment on consumer stocks have been dampen due to these due to expected lower consumer spending caused by these 2 factors, but poultry stocks offer a defensive play as eggs and poultry consumption have been resilient in the past, regardless of the economic condition.

10.0 Appendices

Update: Prolexus Bhd - Ramping Up Production Capacity To Fill Higher Demand

Prolexus Bhd. (Prlexus) was recently featured in "Trade Wise" section of TheEDGE weekly (the 9-Feb-2015 issue). Some of the keynotes as below:

- Prlexus is currently operating in near maximum capacity.
- Prlexus's customers are expecting rapid growth ahead and requests Prlexus "to be ready"
- They are planning to ramp-up the production capacity of both Malaysia and China plants in this year to fill up the expected increase in sales orders from its major customers and international brands.
- Malaysia's plant: to increase number of sewing operators to 1,400 from 1,000, which will potentially increase the production capacity to 1 million pieces of garment/month or additional sales of RM80mil
- China's plant: to double the operation capacity. Target capex is at RM8mil this year.
- Expect China's operation to contribute over 50% of group sales in 5 years time.
- They are actively looking to set up production factories in Asean region, which will start this year

Optimistic growth expectation from the existing customers and Prlexus's expansion plan shows that the group will sustain its growth moving forward. Prlexus's operation efficiency and margins has peaked since its operation is nearly fully utilized. Future profit growth is expected to be driven by increase in sales order provided production expansion can be done as expected.

With the management guideline, I have re-performed the valuation using Sum-of-part (SOP) methods and set my updated target price at RM1.82 (20% upside) and is optimistic on the group long-term perspective based on (1) indicated higher demands from its existing customers and (2) proven growth track record in the past 5 years

Key Risks:
1. Loss of customers due to unable to meet rising order demand
2. Loss of major customer - 2 major customers contributed to over 85% of the group sales
3. Slow or delayed in capacity expansion. Expansion may be challenged by difficulties in recruiting sawing operators.
4. Fall in operation efficiency and margin caused by new operations

Required return was obtained with CAPM method. (refer to my previous post)

The required return on equity, R

Required return on equity, or R, is an important building blocks for stock’s valuation. It is used in various valuation model i.e. DCF and other relative value method (i.e. P/E and P/B method).

Due to its importance, I have been searching for methods that produces a reliable result and is practical in term of availability of input data and simplicity of the model. After review of the CFA curriculum and online materials, I came across works done by Aswath Damodaran, a Professor of Finance at the Stern School of Business at New York who is teaching valuation and corporate finance in MBA programs. He was named by Business Week, in 2011 as the most popular business school professor in US. In his “Equity Risk Premiums(ERP): Determinants, Estimation and Implication (2013)”, he presented a number of methods to compute the ERP, which is one of the inputs for Capital Asset Pricing Model (CAPM), a popular model to determine the R. Besides his work on ERP, his website also provided an extensive range of data to facilitate the computation of ERP.  

Before detailing my selected method, I will give a list of general choices in determining R as below.

           A.   CAPM

Required return on stock i, R_i = Risk-free return, R_f + β_I (ERP)

               B.   Fama-French Model (Multifactor Models)

                              R_i = R_f + β^market RMRF + β^size SMB + β^valueHML

RMRF: R_m - R_f (Return on market (i.e. FBMKLCI) – Risk-free return)

SMB: Small minus Big (Return of SmallCap Portfolio – LargeCap)

HML: High minus Low (High Book/Price – Low)

           C.   Build-up Method

 R_i = R_f + ERP ± Risk Premia₁ ± Risk Premia_{2 ±} ……. ± Risk Premia_n

I will use the CAPM to compute R because

(i)                  it requires fewer inputs compare to the method B and C

(ii)                input data is more available (compare to, say, B that require return on SmallCap portfolio like FBMSmallCap, return data on FBMKLCI is more easily available)

(iii)               Damodaran’s site provide updated data for the computation of ERP, which is less work for me

Hence,

R_i = R_f + β_I x ERP

where:

R_i = Required rate of return of stock i

R_f  - Risk-free rate of return. Represented by Malaysia 5-Years or 10-Year Govt Bonds Yield depending my selected time-horizon

ERP =Equity Risk Premium for investing in the market(FBMKLCI), relative to the risk-free rate

Β_i – Beta of stock i against market. To obtain via regression analysis of FBMKLCI and stock’s return data

Method for the inputs are described above but ERP’s is following.

In his work, Damodaran explained that ERP for a country’s market can be obtained by, first, calculate the ERP of a matured market like US as the base. Then, a Country Risk Premium (RP) is added to the base for the additional risk.

ERP = Base ERP for mature market + Country RP

Based ERP is obtained by a method called Implied ERP. On a brief note, the Implied ERP is obtained by solving the R(required return) for the latest S&P500 year-end closing given an estimated future dividends growth. I will use the data provided by his site as I believe his work is reliable and the computation (if I choose to compute myself) is too data-intensive for me.

(Other that the Implied ERP, one can also use the historical ERP. It is can be obtained by subtracting Average Return of S&P500 with Average Return of T.Bond over a certain period of time. However, this method is backward-looking. A forward-looking method like the Implied ERP is more relevant)

For the Country RP, I will use the Melded CDS approach (describe in his work).

Country RP = Malaysia CDS Spread x Relative Standard Deviation (Equity Market/Bond Market)

The first term of the formula is the 5 years Credit Default Swap(CDS) rate of Malaysia (or 10-years, depending on my selection). It is the required rate of return for investors to provide insurance against the risk of sovereign debt default and the latest rate can be obtained from the Deutsche Bank Research website. The higher the CDS, the higher the probability debt default by Malaysia’s government. As the CDS only represent the risk of sovereign’s bond default, we need to covert the bond’s risk premium to equity risk premium. Hence the second-term is used, which is the relative standard deviation (or risk) of the equity market(FBMKLCI) vs bond market. In this case, I will used the data provided by Damodaran, which are based on 2 years weekly data.

(Alternatively, the CDS can be replaced by Moody’s Rating-based default spread according to Malaysia’s sovereign rating. It is more stable and do not change frequently compared to CDS, which is determined by the market and is fluctuating daily. As CDS is usually higher than default spread and it imply all the market’s expectation, I choose CDS as a conservative approach and most relevant to the current situation. )

In conclusion,

R_i = R_f + β_I x [Implied ERP_US  + (CDS Spread_Malaysia x Relative S.D.)]

  

ERP of US Market (1-Jan-15)	5.75%
Malaysia 5-years CDS (22-Jan-15)	1.3115%
Relative σ (2 years weekly data)	1.27
ERP	7.416% (5.75% + 1.27 x 1.3115%)
Malaysia 5Y Bond Yield (22-Jan-15)	3.811%

Hence, R_i = 3.811% + β_I x 7.416%

For example, the R of FBMKLCI (β = 1.0) is 11.227%.

The application of the R, for example, is as below. We can extract market expectation on the current FBMKLCI level, based on Gordon growth model

                P₀ – 1803.08 (23-Jan-15)

                E₀ – 106.37 (estimate)

                D₀ – 59.354

                R – 0.11227

Solving the formula, I get g = 0.0768 (7.68%). The market is expecting FBMKLCI to have a constant growth rate of 7.68% (if based on Gordon Growth Model).

Reference: http://pages.stern.nyu.edu/~adamodar/

Prolexus Bhd - an undervalued gem with solid track record

1.0 Summary
Prolexus is a long-time apparel manufacturer with customer from international brands like Nike. Prolexus's has a healthy balance sheet with net cash position of RM0.20 per share. Sales and profit growth has been solid and consistent in the past 4 years. The stock has been trading with low valuation ranging 3.5-8.0x P/E in the past 1 year despite 4 years PBT's CAGR of 45%. My target price to this stock is RM2.28 (Kindly refer to Section 7.0 Projection and Valuation for the basis of valuation). I expect Prolexus FY15's PAT to growth 58% (on my optimistic scenario) due to (i) better economy growth and consumption prospect of US (ii) Weaker RM to boost competitiveness and provide forex gain (iii) higher operating margin after a surge in production wages due to minimum wage implementation in 2014.

2.0 Business Background

Core Business: Apparel Manufacturer

Established since 1976 and listed on Bursa Malaysia’s Main Market since 1993, Prolexus is mainly a garments manufacturer or Original Equipment Manufacturer (OEM) for internationally brands. In FY13, 2 major customers contributed to 87% of Prolexus total revenue. Nike Inc(Nike), is believed, to be the largest customer of Prolexus although the exact contribution is not known.

Porlexus has 3 factories in:

	Location	Build-Up Area (Acres)	Plant Revenue (FY13)
i)	Batu Pahat, Johor	1.8	RM172m (Malaysia)
ii)	Seberang Perai, Penang	0.6
iii)	Jiangsu, China	3.0	RM57m

63% of the sales is from US customers, Prolexus enjoys forex gain advantage from the raising USD as seen from the previous financial results. (63% could be a good proxy to Nike’s contribution to Prolexus’s sales)

Other Business: Outdoor Advertising

Prolexus also provide outdoor LED screen advertising services under the brand name “PowerScreen” which contributed to 3% and 10% of the group’s revenue and PAT.

Source: Company Website

Besides the companies shown above, under the Group is also Novel Realty SB, which is an investment holding company that hold Prolexus's non-core investment real estates (i.g. bungalow house and vacant land). The company has over RM14m of asset currently (24% of the Group's PPE)

2.1 Management

• Ahmad Mustapha Ghazali, Executive Chairman - aged 66, appointed since 1993 and become chairman in 2002. Member of a few overseas and local accountant associations and institute including Chartered Association of Certified Accountants (UK) and others. Have directorship in Tambin Indah Land Bhd, Malaysia Packaging Industry Bhd amd Global Maritime Ventures Bhd.
• Lau Mong Ying, MD – aged 65, is the MD since 1993 (21 years ago). Graudated with Bachelor of Commerce in Economics (Nanyang University of Sg)

Non-executive directors

• Lau Mong Ying, MD – aged 65, is the MD since 1993 (21 years ago). Graudated with Bachelor of Commerce in Economics (Nanyang University of Sg)
• Khadmudin bin Mohd Rafik -  aged 61, appointed in 2003. Used to be a Senior Police Officer and Assistant Superintendent of Police.
• Lin Cheng-Lang – Taiwaneses aged 75, appointed in 1998. Used to be MD with various textile companies in Taiwan
• Chin Chew Mun – aged 43, appointed in 2012. A Chartered Accountant.
• Boo Chin Liong – aged 53, appointed in 2013. An advocate and solicitor.

3.0 Macro Outlook

US – Overall improvement in consumer spending

A series of optimistic economic data showing US economics is growing fairly well and consumer spending is generally on the rise with lower unemployment rate, rising retail sales and better Consumer Confidence.  Overall, US economic is growing and the consumer is spending more.

On a forward looking note, US consumers are expected to be spending even more due to (1) higher disposable income thanks to lower fuel and energy cost (2) strengthening USD boost consumer spending power on import goods (3) expected continuous improvement in US economy

Hence, Prolexus’s sales to US’s consumers is expected to growth at a higher rate in the next FY.

Euro – Slow growth ahead

With Unemployment rate still high above 10%, Euro economy is moving like a snail. Industrial production rose slowly, even the powerhouse of Eurozone, Germany see its Manufacturing PMI only slightly above 50.0 level (51.2 in Dec 2014). IMF expect a moderate Real GDP growth rate of 1.8% in 2015.

 

Weakening RM a boost to Prolexus’s sales and earning

Against USD, RM is the biggest losers compared to some of other apparel exporters’ currencies. The RM depreciation will not only improve the attractiveness of Prolexus's products, strengthening USD will give Prolexus forex gain due to its exposure to USD-based asset and export.

Rising China Manufacturing Cost

Cost of manufacturing in China has been rising in the recent years and eroding the profitability and attractiveness of China manufacturers. Minimum wages of China are rising at a double-digit rate. Base monthly wage of a factory worker in China is over $400, compared to $130 in Cambodia. Many factories has moved their operation to Vietnam and Cambodia, where operating cost is much lower. 

Improving Nike’s Apparel Sales

As the largest customer of Prolexus, Nike’s apparel sales performance have a significant relationship to Prolexus’s sales. Nike apparel sales has been improving in the past few years. In Nike’s 2Q Quarterly report ended 30 Nov 2014, Nike’s worldwide futures orders (for Nike Brand footware and apparel) scheduled for delivery from Dec 2014 to Apr 2015 were 7% higher (11% if excluding currency changes). Accelerating Nike’s orders indicate a good prospect to Prolexus.

4.0 Financial Analysis

4.1 Past 5 Years Performance

Revenue growing every year in the past 4 years with CAGR at 24%. PBT’s growth was remarkable in FY2012 and FY2013 due to significant efficiency improvement, cost rationalization programmes as well as improvement in China’s plant profit. PBT’s growth normalized to 25% in 2014 (from 84% in 2013) as operating margin reach a plateau.

4.2 Financial Analysis

i) Income Statement

Sales continues to grow at a steady rate of 25% in FY14 (FY13 : 24%) contributed by sales growth across all 3 main customers regions (US, Euro Area and Others).

PAT growth decelerate to 21% in FY14 (FY13: 58%). PAT growth is contributed by Revenue growth and Gross Margin improvement but dragged by higher operating cost rise and higher effective tax rate.

In contrast with 21% PAT growth in FY14, Apparel business actually recorded a 1.8% lower PAT despite sales and EBIT grow at 25% and 7.1% for the business segment. EBIT Margin is lower due to higher production wage cost while PAT is lower due to higher effective tax rate. Prolexus's effective tax rate is lower than Malaysian statutory rate at 25% as they have Unabsorbed tax losses (at RM18.5m in FY14), capital allowances and reinvestment allowance. Realization of tax benefit is lower compared to last year, hence the higher effective tax rate.

 In fact, the Group's FY14 higher PAT (+RM3.6m yoy) is over-contributed by higher PAT from the Investment Holding segment (+RM3.8m). In 2014 Annual Report of the Group, the chairman attributed the higher PAT, among others, to better margin achieved through production efficiency. However, the number  is telling a different story where the EBITM in FY14 is actually lower (to 7.1% from 8.3%).

FY14 saw a staggering rise in staff cost to RM58m from RM44m in previous year, which is a 32% rise. Expressed at a percentage of Revenue, staff cost rised to 19.7% of FY14's revenue from 18.6% previously. The rise in staff cost is mainly due to implementation of minimum wage. There was no significant addition of Plant and Machinery in FY14 which indicate that the Group are not heading to automation aggressively to address the issue of rising wage. 

ii) Balance Sheet

FY14 saw an increase of Fixed Asset at RM17m to RM58m mainly due to purchase of a vacant land in Tanjung Kupang, JB (Land) with carrying amount at RM8.7m and a vacant factory in Pontian (RM5.6m). Both purchases are for investment purpose targeting capital appreciation. 

Prolexus is very cash-rich with RM35m of total cash and deposit and 80% of it is in USD. Net cash at RM24m.Though the cash hoard, Prolexus do not provide high dividend payout nor cash distribution. Instead, they are constantly looking for investment opportunity. 

iii) Cash Flow Statement

Good Operating CF at RM26m compared to PBT of RM24m. FY14 saw a high capex at RM21m funded by CF from Operation and drawdown of new Term Loan. RM5m of net cash is generated in FY14, boosting the cash hoard to RM34m.

FY14 saw a better Gross Margin at 17.5% (from 16.8%) but EBIT margin unchanged at 8.3% due to rising operating cost. This lead to flat PBT margin YOY. Together with higher effective tax rate, Net Margin fall 0.2% to 7.1%.

iv) Ratios

ROE and ROA is remarkable at 20.6% and 13.9% respectively. Prolexus has good liquidity with Current Asset and Cash cover Current Liabilities at 2.1x and 0.8x. Cash-to-cash cycle improved to 29 days (from 33days)

4.3 Recent 8 Quarters Performance Review

Revenue increased YOY in all of the past 4 quarters at 14 to 32%.

PAT rised 32 to 62% YOY in the past 4 quarters except a 12% YOY drop in 3QFY14 due to an Unrealized Forex Loss of RM1.7m from weakening USD at that period. 

5.0 Future Prospect

i) Continuous growth in revenue

Prolexus has a good track record of sales growth in the past 4 years with CAGR at 21% and the increase is across customers from all regions. Moving forward, I am comfortable with the Group’s ability to secure more orders from existing customers. Besides that, with better prospect of US economy and consumption, orders from the US customer will have a brighter prospect.

ii) Weak RM against USD a gift to competitiveness and earning

RM has been weaken for over 10% against USD and generally against other currencies since FYE 31-Jul-2014. This will translate to higher sales value and Gross Profit in RM for orders to US and oversea counties in the coming quarters. In the longer term, oversea customers will request Prolexus for a lower selling price in their home countries to take a share of the benefit. Eventually, weak RM will boost competitiveness of Prolexus’s production in Malaysia and increase their sales. In 2014 Annual Report, the Group has net exposure to USD asset of RM29m and with every 10% strengthening of USD will increase Prolexus’s 2014 PBT by RM2.9m. Though this is just a one-time effect and may reverse itself if RM recover, but Prolexus 2QFY15 PAT is expected to be boosted by the forex gain. Prolexus’s China operation is generally not beneficial to the weak RM.

iii) Oversea operation expansion
With a stronghold of cash, good OCF and net cash position, Prolexus is financially capable of taking up big investment like setting up new plants in other counties like Vietnam and Cambodia where they can exploit the cost advantage. Should this happen, operation cost and depreciation charge will be higher in the near term before any earning contribution come in. However, it will facilitate the Group's long-term expansion.

6.0 Risks

i) Customer concentration risk

Sales of 2 major customer contributed to over 80% of the Group sales. Loss or significant reduction of order from one of these 2 customers will have a serious impact to Prolexus’s financial. This is a low-risk-high-impact event.

ii) Competition risk

Apparel manufacturing is a globalized business. Just like manufacturing, competition is always happening among the major manufacturing counties like China, Vietnam, Cambodia, North America and other counties. Any sudden or systematic rise in competitiveness for their competitors from other counties may cause the Group loss in market share. The weaken RM is an example of the change in competition environment, though it is in favor of Prolexus. 

iii) Rising production wage cost

A continuous rising wage cost in China manufacturing will erode Prolexus's China profitability and competitiveness. Besides that, the Group has constantly facing difficulties in recruiting production operators, which may cause higher wage cost in order for the operation to recruit enough operators.

iv) Investment risk from non-core asset

As noted earlier, the Group's investment holding has RM14m worth of investment real estate in the form of vacant bungalow and several vacant lands. It is 9% of the total asset. Prolexus has low dividend payout rate (14% in FY14) but choose to invest the cash generated from operation in non-core real estate. The investment is not expected to generate much shareholders'value in the medium-term as it is not cash-flow generating (due to its vacant condition). Shareholder can only see value if there are sales of the asset or revaluation done in the future. Should the management distribute the cash to shareholders and let them decide what investment is more proper to them? Besides that, lower asset base also give financial reporting benefit and support better valuation.

7.0 Projection and Valuation

7.1 Current Market Valuation 

Based on closing price on 16-Jan-2014

As on 16-Jan-2014, the market give Prolexus a 7.5x P/E valuation, way lower than FBMSmallCap P/E of 14.77 despite good track record of growth in the past and bring prospect ahead. EV/EBITDA at 5.2x shows the acquisition cost of the Group can be recouped with 5.2 years of FY14's EBITDA. That seems to be cheap considering the Group's ability in generating cash and stability of EBITDA in the past.

Optimistic Scenario is based on:

i) Higher sales value in RM due to depreciating RM. 

ii) Stronger sales order from customer due to stronger demand from US customers and lower price of Malaysia goods (due to weak RM)

iii) After implementation of minimum wage in 2014, wage cost rise normalized. EBIT Margin improved to 7.8% (before considering forex gain)

iv) Forex gain of RM2.9m

Conservative Scenario is based on:

i) Lower sales growth despite weaker RM

ii) Higher EBIT Margin due to continuous rise in wage cost. 

iii) New capex that cause higher operating cost, depreciation charge, higher interest cost (new borrowing) and lower interest income (from cash drawdown). 

iv) Lower forex gain of RM2.0m

v) Higher effective tax rate.

My target price is set at RM2.28 (61% upside from 16-Jan-2014 closing). I think the optimistic scenario is 75% possible as (i) Weak RM situation will sustain longer to benefit Prolexus (ii) Operating cost growth should normalize in FY2015 after a big jump in FY2014 (iii) No significant action or plan in capex yet. 

Factors for revaluation:

My TP will be revised if:

i) There are announcement of significant capex

ii) Stronger than expected RM recovery

iii) Actual result deviate significantly from my estimate as review quarter by quarters

Disclaimer: This  research is not a recommendation to buy or sell the securities, but only for informative purpose to help reader to understand the company better. Despite my target price is higher than current market price, the stock price may not reach the target price due to various factors, including significant deviation of my estimate with the actual figures. Readers are advised to perform due diligence before making any investment and after reading my research as my estimation and projection can be highly fallible.