• We reiterate our NEUTRAL stance on the glove sector. We expect 2H2022 to continue being affected by persistent downwards pressure on average selling price (ASP), worsened by higher operating costs (opex), particularly, energy and labour costs. Moreover, the continued de-rating of the healthcare premium has dampened valuations, especially for Hartalega Holdings and Top Glove Corporation, which could be removed from the FBM KLCI.

• Earnings were generally below expectation. Out of the 3 glove companies under coverage, 2 missed expectations while the other met expectation (Exhibit 2). The results of Top Glove and Hartalega missed expectations due to a faster-thanexpected drop in ASP amid rising operating costs. However, Kossan Rubber Industries’ core net profit performance was in line with our 1HFY22 earnings, accounting for 66% of our full-year forecast, but below consensus, making up only 46%.

• Huge inventories must be cleared. From the demand perspective, end buyers are still holding a significant level of inventories for the time being, potentially leading to waning purchase orders over the coming months. We expect glove demand to shrink by 16–18% in 2022 (Exhibit 3), annualising global glove demand in 5M2022, in line with the combined 1H2022 sales for the 3 companies under our coverage which slid 16% YoY. In comparison, MARGMA is guiding for a growth of 10–12%, which we think is too optimistic. As a result of weak demand, the industry's utilisation rate is running at 50–60% (versus an optimal rate of 80–85%). This may result in higher operating expenses due to a lower economies of scale. On a positive note, Hartalega guided that customers may start restocking by the end of this year in its 9 August results briefing.

• Declining ASP amid rising costs, eroding industry margin. Continued intense competition among regional glove makers stemming from overcapacity has led to a downward ASP spiral from its peak in 2Q2021. Furthermore, rising operating costs (energy and labour costs) has slashed the EBITDA margins of the Malaysian Big 4 glove makers, where most of them registered lower margins than in CY2019 (Exhibit 4). Notably, Top Glove and Supermax have already recorded the lowest margin since their listing, whereas Kossan is currently at the lowest level since 2009. Furthermore, smaller players like Careplus Group has been loss-making since 4Q2021 and Comfort Gloves in 1Q2022. This caused the share prices of glove makers to plunge to below the pre-pandemic era.

• Scaling back capacity expansions. Glove makers have unanimously announced a scale-back of capacity expansions over the coming months. Hartalega guided that the 1st line of NCG 1.5, with total annual capacity of 19bil pieces, will be delayed from the commissioning date in Oct this year. Also, Hartalega is working to decommission some inefficient lines to cut costs. Meanwhile, Top Glove revised downwards its original ambitious expansion plan of achieving total annual capacity of 204bil pieces to 156bil pieces in Dec 2025. Kossan guided that it has deferred near-term capacity expansion plans in adapting to market conditions and curtail excess supply. We believe this combined scale-backs could relieve some supply-side pressure in the glove industry.

• Impact of US tariffs against Chinese gloves. To recap, the US temporarily lifted import tariffs against Chinese medical gloves from 7.5% (under the Phase 1 trade deal in Jan 2020) to 0% since mid-2020 given the severe glove shortages. However, these import tariffs were reinforced in Nov 2021 at 7.5%. The Biden administration is considering to remove some tariffs as a way to counter inflationary pressures in May 2022. However, the administration announced that the tariff will be kept in place while continuing a statutory review on the duties, according to latest media reports. We view this easing of competition in the US market as a near-term positive to the sector. After several conversations with glove makers, we found that most end buyers prioritise pricing over premium quality, so we believe the 7.5% difference does make a meaningful impact on US demand for Malaysian gloves. Based on channel checks, Chinese players are currently selling medical gloves at below US$20/1K pcs as compared to US$25–27/1K pcs in Malaysia.

• No longer enjoying the healthcare premium. During the pre-pandemic period, PE valuations for glove makers under our coverage have been on uptrend since early 2014, from an average of 16–20x to 24–50x in early 2020 (before the pandemic boom). We believe this is mainly attributed to the healthcare premium’s better revenue visibility, consistent with the high 50x level of IHH since 2014, rather than strong margin prospects (Exhibit 5). With the price war plaguing the industry, we believe this premium will continue to dissipate.

• High possibility of exclusion from the FBM KLCI. As at last Friday, Top Glove’s market cap was RM6.4bil (45th place) while Hartalega’s was RM5.5bil (56th place). With no near-term positive outlook in sight, we believe these 2 glove makers may be removed from the FBM KLCI at the next semi-annual review date on 21 Nov 2022. Based on guidelines, constituents could potentially be removed from the index if they fall below the 35th spot. We see this as a further de-rating factor, which could reduce the glove sector’s trading liquidity and investment profile.

Source: AmInvest Research - 12 Sept 2022