Kossan Rubber Industries - Punished by forex contracts

Share price dips on concerns of forex losses, which have already been factored in the consensus forecasts, provide buying opportunity. Strong core earnings in 2010. Maintain BUY and target price of RM4.24

Share price battered after hitting a 52-week high. Kossan hit a 52-week high following a slew of earnings surprises by other glove manufacturers. We believe the surge in net profits of Top Glove and Supermax, +61% yoy and 90% respectively, was mainly due to additional orders from customers which held back purchases in 1Q (prior to the H1N1 viral outbreak) in anticipation of lower latex prices. Buyers are now refilling orders as glove prices are expected to increase. Current latex prices have risen 10% from the low in 2Q09.

Undue selling pressure from concerns on forex losses. The market appeared surprised by last week’s revelations that Kossan had booked an estimated RM12m in hedging-related forex losses in 1Q09 (84% of 1Q net profit), causing the share price to fall by 10%. The forex loss was recognised as ‘other expenses’ and/or as other costs items in Kossan’s accounts during the February reporting season. The 4Q09 accounts also revealed that Kossan had entered into forex contracts, hedging 67% of 4Q08’s receivables (amounting to RM107m) at an average of RM3.37/US$. The differential between 1Q09’s average and hedged exchange rates (i.e. when the US dollar appreciated) triggered the loss.

Diminishing forex losses in subsequent quarters, from balance estimated forex exposure equivalent to RM120m-140m ... Assuming that the company’s currency hedging policy covers 12-14% of 2009 revenues, the outstanding hedging contracts (which we understand is structured to expire in Nov 09 or earlier) amount to around RM120m-140m. Hence, 2Q09’s realised forex loss should be significantly lower qoq at around RM9m, even assuming the same face amount of exposure as in 1Q09, as the greenback has retreated over 2% from 1Q09 average rate.

with potential gains should the Ringgit appreciate. Based on our above assumptions, Kossan would realise a cumulative hedging loss of RM14.5m in 2009 if the Ringgit averages at RM3.55/US$. Should the Ringgit appreciate above the RM3.37/US$ mark before the hedging contracts expire, Kossan will recognise a gain on the outstanding forex exposure.

M&A opportunities and locking in long-term contracts. As the present market dynamics still favour a market consolidation, rubber companies like Kossan could be in the position to acquire smaller privately-held but profitable manufacturers. We also reckon that Kossan is likely to enter into long-term contracts with its buyers, thus raising its earnings visibility.