KNM Group Bhd - 2011

MARC has downgraded the long-term rating to A+ID from AA-ID of KNM Group Berhad’s (KNM) RM1.1 billion Islamic Medium Term Notes (IMTN) Programme and concurrently affirms the short-term rating at MARC-1ID for KNM’s RM400.0 million Islamic Commercial Paper (ICP) Programme. The outlook of the ratings has been revised to developing from stable. Currently there are no notes issued under the programmes.

The downgrade of the long-term rating reflects KNM’s weak results in recent periods and continued challenging market conditions for the process equipment market. The developing outlook that MARC has attached to the ratings recognises the potential for KNM to stabilise and restore its financial position through rationalisation of its capacity and product portfolio as well as the possibility of negative rating action if the gains from rationalisation are insufficient to stabilise and improve KNM’s credit metrics. The affirmation of the short-term rating is based on its satisfactory liquidity position vis-a-vis ongoing short-term debt obligations.

KNM’s weak results in recent periods reflect increased competition in the lower-to-middle range process equipment segment and reduced demand for process equipment due to economic cyclical factors. In the high-end process equipment segment, KNM also saw modest increase in new contracts secured notwithstanding a general slowdown in capital expenditure by oil and gas majors. Delays in financial close for energy renewal projects which KNM had earlier depended upon to turn around its declining profitability significantly impacted its 2011 results and financial profile. From a geographical viewpoint, the group is exposed to potential macro-economic difficulties in Europe, given the rather high revenue contribution from its European business. The group’s European operations generated 68% of revenue for financial year ended December 31, 2011 (FY2011).

The company has alluded to an expected rebound in 2012, which is expected to be driven by the rationalisation of its plant capacity and product portfolio. In response to the challenges posed by increased competitive intensity in the lower-to-middle range product segment, KNM intends to focus on the high-end segment and diversify into new end markets. On a related note, MARC observes that wholly-owned process equipment manufacturer BORSIG GmbH has defended its niche position well and has significant recurring maintenance and spare parts business. MARC believes that the group’s strategic focus on high-end offerings and cost efficiencies should benefit its consolidated gross margins. At the same time, the agency is mindful of the incremental risks posed by KNM’s decision to market its services as an engineering, procurement, construction and  commissioning (EPCC) contractor and facility operator for renewable energy projects notwithstanding the potential benefits to be gained in terms of margin enhancement and recurring income generation. Apart from the group’s lack of sufficient track record as an EPCC contractor, the execution and sovereign risks exposure inherent in such projects could weigh on its consolidated business risk profile.

Based on unaudited results, the group posted a pre-tax loss of RM147.5 million (FY2010: pre-tax profit of RM46.5 million) on revenues of RM1,982.3 million. The full-year loss was mainly attributable to provisions for foreseeable losses and credit impairment which collectively totalled RM140.0 million for the quarter ended September 30, 2011 (3QFY2011).  MARC’s rating concern is the continuing trend of declining margins compared to the strong historical double-digit margins experienced prior to FY2009. Partially offsetting the pressure on the group’s financial profile is the increase in cash flow from operations (CFO) to RM165.6 million (FY2010: RM53.7 million), presumably due to working capital reductions. Consequently, CFO interest cover increased to 3.3 times (x) (FY2010: 1.1x) while free cash flow reverted to a positive RM90.6 million (FY2010: -RM2.1 million). The group’s liquidity position is strong, backed by cash and bank balances of RM416.4 million (FY2010: RM296.2 million) vis-a-vis the forthcoming notes redemption of RM90.0 million in 2012.

Downward rating pressure would be exerted on the ratings following slower-than-anticipated progress in the group’s financial turnaround and/or a weakening in its business risk profile. While MARC believes that KNM has the potential to restore its financial health to previous levels in the medium term, the meaningful challenges that management will face in achieving this are also acknowledged.

Strengths

Challenges/Risks