KNM Group - 1HFY12 rebound may not be sustainable

-  We downgrade our call on KNM Group to SELL from HOLD as the share price has risen above our unchanged fair value of RM0.55/share based on a 10% discount to our diluted book value estimate of RM0.61/share. Notwithstanding the strong set of results, we maintain our price/book valuation vs. earnings-based methodologies given KNM’s past erratic earnings record over the past three years. 

-  KNM’s 1HFY12 net profit of RM69mil (+2.3x YoY) came in above expectations, accounting for 91% of our FY12F net profit of RM76mil and 90% of street estimate’s RM77mil. Excluding RM28mil write-back of provisions for foreseeable losses, the results accounted for 54% of our FY12F net profit. We maintain our FY12F-FY14F net profits for now, as we remain uncertain about the group’s current earnings trend against the backdrop of the disconnect between KNM’s revenue and declining net order book (excluding the Peterborough and Sri Lankan waste-to-energy projects) (see Chart 3). 

-  Despite a flat QoQ revenue growth, KNM’s 2QFY12 pre-tax profit rose 36% QoQ to RM36mil mainly due to an estimated write-back of provisions for foreseeable losses of RM19mil vs. RM10mil in 1QFY12. Excluding the Peterborough and Sri Lankan projects, KNM’s current order book has fallen by 8% QoQ to RM2.3bil. While the group is tendering for up to RM16bil potential orders, we remain cautious about the success rate, given the tightening credit markets in Europe.

-  KNM has so far invested RM10mil as deposit for the Sri Lankan project in the joint-venture with Octagon Consolidated, which is currently undergoing a debt restructuring exercise. The group has also invested around RM26mil as initial deposit and option to purchase a 55-acre Peterborough land. 

-  Although the Peterborough project’s 35MW Phase 1 may involve a lower cost of GBP233mil vs. GBP600mil for the entire project, an 80% equity stake could still cause KNM’s net gearing to surge from 0.5x to 1.2x. If these two projects were eventually aborted due to an inability to secure financing, we expect an all-in write-off of RM36mil – representing half of FY13F net profit.

-  While we had already expressed doubts about KNM’s capability to proceed with the highly capital-intensive projects in the UK and Sri Lanka since last year, we are now even more concerned that the group is going ahead with a highly dilutive rights issue for working capital and repayment of bank borrowings. Assuming the first call rights price and warrant exercise price are set at RM0.40/share, we estimate that the group’s diluted FY13F EPS will fall by 36% to 4.4 sen. 

-  KNM currently trades at an unjustified 28% premium above our adjusted book value of RM0.61/share vs. a discount of over 10% in the past year.

Source: AmeSecurities