Karrie International (1050.HK) - Recommend BUY

Karrie International (1050.HK) - Recommend BUY



Target price is $1.2, +130% from $0.52 now



· Karrie's profit margin is poised to recover, because a) many competing OEM/ODMs have folded during the economic downturn, b) very few new entrants in the past 24 months due to low industry profitability and lack of bank credit, c) gross margin outlook for Karrie's customers is stable (alleviating pressure for, say, Epson to beat up their OEM/ODM, e.g. Karrie), d) raw material prices (e.g. steel, plastic) have come down, e) labor inflation in China has alleviated, and f) Karrie has cut back staffing and adopted other measures to reduce costs in the past 12-18 months. Given all the above, profit margin is very likely going to recover in the short- to medium-term. In fact, one can see that profit margin has already started to recover since September 2008.



· Karrie managed to do $2.5-3.5b in Sales and 5-6% Net Margin in normal, good times. While I think the industry's margin is structurally lower, it's conceivable that Karrie will be able to go back to $2.5b in Sales (not to mention that Karrie spent $400m in capex for the past few years, which in theory, should boost its capacity, i.e. Karrie can handle probably $5-6b in Sales if there are orders), and 4% Net Margin. As such, "normal" Net Income would be $100m, which is almost 5x the current Net Income level (because current Net Margin is only 1%). Industrial OEM/ODMs normally trade at 7-9x P/E, so "normal" equity valuation for Karrie should be $700-900m, translating to "normal" share price of $1.1-$1.5.



· While a company's stock price should in theory driven by the future cash flows discounted by a rate of return, book value is a good (albeit not perfect) metric to gauge what value one can get out of the company, if one were to buy it, repay the debts and sell all assets. Karrie's book value per share stands at $1.2.



· Karrie will hold an AGM in late-August 2009 to approve a share buy-back program for up to 10% of issued shares. Purpose of the program is to put the Company's cash ($640m) to best use, e.g. boost EPS/BVPS. If this happens, and given the trading liquidity of the shares (which is reasonable but not high), it would be provide a lot of upward momentum for Karrie's share price.



· Karrie's balance sheet is very healthy and the Company is in a net cash position (i.e. cash of $640m and debt of $605m so net cash of $35m). Karrie's operating cash flow is very strong as well, and capex will be much less in the next 2-3 years (i.e. the Company has already expanded enough for possible demand in the next 6-8 years).



· Karrie has recently formed a JV with a listed Taiwanese OEM/ODM manufacturer called Teco. Teco managed to maintain gross margin of 25-30% in the past few years. If that is any indication to the gross margin level of the JV, this would be very positive to Karrie, though any meaningful contribution will take 2-3 years to materialize.



· Overall, this one is a medium risk / high return play, and the theme could take 18-24 months to fully play out, so I would advise against buying if one's investment horizon is only a few weeks or months. But for those that can be patient, and even though share price has already doubled from the $0.265 bottom reached in November 2008 (market picking up signals that Karrie's business is improving), there is still significant room for share price to run up (the extent of the possible recovery is not yet fully priced in). The stock has only minimal correlation with the broader Hang Seng Index, so even if you expect a correction of the latter, you can still buy the stock right now. But again, you should always do your own homework before making any investment decision.