Investment Highlights

• 3QCY23 results mostly above expectations. 2 out of 3 glove makers under our coverage came in above expectations (Exhibit 2), while 1 met expectations. Both Hartalega Holdings (Hartalega) and Kossan Rubber Industries (Kossan) beat our and consensus expectations, primarily attributable to better-than-expected revenue, lower raw material prices and cost structure from the decommissioning of less-efficient production lines. Notably, Kossan returned to black in 3QCY23 after registering 3 consecutive quarters of losses. For Top Glove Corporation (Top Glove), the QoQ loss-narrowing results for 2 consecutive quarters were largely in line with our and the street’s expectations.

• Kudos to successful cost-cutting initiatives undertaken by glove makers, bringing QoQ improvement in earnings. To recap, Malaysia’s glove makers in 2023 have unanimously announced the decommissioning of inefficient production lines to reduce the cost of production by transferring orders to more efficient production lines. This is to remain competitive against glove makers in China and Thailand amid an uncertain average selling price (ASP) trajectory in 2023. In early May, Hartalega announced the decommissioning of its Bestari Jaya facility, accounting for 30% of existing 44bil pcs annual capacity. Top Glove decommissioned obsolete production lines with an annual capacity of 5bil pcs (5% of existing 100bil pcs annual capacity). Kossan decommissioned annual capacity of 3bil pcs in FY22 and another 6bil pcs in FY23. After this decommissioning, Kossan’s installed capacity dropped by 27% from 33.5bil in 2021 to 24.5bil pcs/annum in end-2023.
  Based on our core PBT breakeven cost analysis (Exhibit 3), the cost structures of Malaysia’s glove manufacturers experienced meaningful QoQ improvements by 8%-20%, primarily from declining raw material prices while cost-cutting decommissioning initiatives started to bear fruits. This effectively increased the profitability of Hartalega, brought Kossan back to the black and narrowed Top Glove’s losses in 3QCY23. As at 3QCY23, Kossan has the lowest cost structure of US$18.1/1K pcs, followed by Hartalega’s US$19.6/1K pcs and Top Glove’s US$25.5/1K pcs. Nevertheless, we are cautious on Kossan’s sustaining this low cost structure in view of its QoQ profit turnaround (vs. Hartalega’s better profitability) coupled with a lack of management access to confirm that the cost savings came in without any one-off items. Hartalega is still operating 1 factory in Bestari Jaya despite the fact that the factory is designed to accommodate 12 lines to enable 2 production lines to continue running to fulfil certain existing orders. Since this last factory in Bestari Jaya will be shut down by Dec 2023, Hartalega will realise further cost reductions in Jan 2024 onwards.
  Separately, the degree of improvement differs between glove manufacturers; for instance, Hartalega and Kossan achieved greater 12%-20% QoQ cost reductions than Top Glove's 8%. We believe that this was predominantly attributable to Hartalega and Kossan undertaking a more substantial degree of decommissioning than Top Glove.

• Regionally, China remains the cost leader, followed by Thailand. In 3Q2023, Intco Medical Technology (Intco), the largest glove manufacturer in China, maintained its position as the cost leader with a core PBT breakeven cost of US$13.7/1K pcs, followed by Sri Trang Gloves (Sri Trang)’s US$17.1/1K pcs, the largest glove manufacturer in Thailand (Exhibit 3). We believe that regional glove makers’ cost advantage lies on the types of energy use with China using coal while Thailand utilises biomass. YTD, coal costs have dropped by 58% while Malaysia’s natural gas prices declined 15%. This implies that Malaysia’s players may have the least flexibility in a price war for market share.

• Regional ASPs declined QoQ in tandem with lower raw material prices amid weak demand. Based on our QoQ estimates, Intco's ASP decreased by 10%, Sri Trang by 9% and Malaysian glove manufacturers by 4%-7%, predominantly attributed to lower raw material prices in 3QCY23.

• In 4Q2024, Malaysia’s ASP likely to decline QoQ despite rising raw material costs. Profit mark-ups charged by regional competitors in 3QCY23 are considerably lower than domestic counterparts (Exhibit 3). We estimate that Intco and Sri Trang marked up between US$0.18-0.22/1K pcs in contrast to Malaysia’s US$1.59-2.38/1K pcs. Hence, we anticipate that Malaysia's ASP will continue to decline despite increasing raw material costs in 4QCY23 amid weak demand. This is consistent with the guidance provided by local glove makers. Notably, we expect ASPs to improve in early 2024F in tandem with our assumption of inventory replenishment cycle beginning among Malaysia’s glove makers.
  In terms of cost outlook, nitrile price is expected to increase QoQ in 4QCY23, consistent with higher Brent oil prices since late Jun 2023. However, latex prices are expected to decrease QoQ in 4QCY23 due to weak demand. Meanwhile, natural gas is expected to decline further by 5% QoQ in 4QCY23F, before rising in 2024F as Brent oil prices recovered since late Jun 2023.

• Rubber glove demand stabilising with inventory replenishment to begin by 1QCY24F without any ASP compromise. Locally and regionally, the QoQ movement of rubber glove sales volume in 3QCY23 was quite inconsistent. QoQ, rubber glove sales volumes of Intco, Hartalega and Kossan improved but Sri Trang and Top Glove deteriorated. This indicated that distributors have yet to engage in active inventory replenishment in 3QCY23.
  However, rubber glove demand appears to be stabilising. Taking USA (the largest rubber glove buyer globally during the prepandemic period (Exhibit 4)) as a proxy for demand from western countries, demand has stabilised since Mar 2023, subsequent to a persistent downtrend that commenced since mid-2021 (Exhibit 5). Separately, we observe the majority of the overpurchasing occurred between 2Q-3QCY21 (Exhibit 6). Considering the standard 3-year expiration period for medical rubber gloves, inventories in western countries may be depleted between the 2Q-3QCY24; therefore, we anticipate that distributors should begin restocking by 1QCY24, before reaching full depletion of inventories in 2Q-3QCY24.
  China’s major players were running at full plant utilisation (PU) in 2Q-3QCY23. Going forward, we do not anticipate any material capacity expansion from China. This is based on the largest player, Intco, whose percentage of construction in progress relative to the sum of fixed assets and construction in progress in 3QCY23 was comparable to the pre-pandemic period, as opposed to the trend observed during its aggressive expansion between 2020-2021 (Exhibit 7). Therefore, any inventory replenishment beginning in 1QCY24 could flow to Thailand and Malaysia.
  All in, we adhere to our assumption of a meaningful inventory replenishment among Malaysia’s glove makers by 1QCY24. We are more optimistic on Malaysia’s glove makers with higher exposures to nitrile rubber gloves (ie. Hartalega: >90% of revenue and Kossan: 80%), compared to those with greater exposure to latex (ie. Top Glove). This is because Top Glove competes with Sri Trang, which was operating at 60% PU in 3QCY23 with a more favourable cost structure.
  Going forward, we expect gradual QoQ earnings or loss improvements among the 3 glove makers under our coverage, despite lower ASP amid higher raw material prices, as this will be fully mitigated by economies of scales achieved from higher PU in 4QCY24.

• We upgrade the sector to Neutral from Underweight previously, primarily to reflect the recent upgrades of Hartalega from SELL to BUY, as well as Kossan from SELL to HOLD, due mainly to positive surprises stemming from effective cost-cutting initiatives that that enhanced earnings and lowered forward P/E valuations to more attractive/comfortable levels. Moreover, our increased optimism is bolstered by the findings that China’s players will not materially increase capacity in the near term, coupled with a high possibility of demand recovery among Malaysia’s glove makers.
  In this report, we also upgrade Top Glove from SELL to HOLD, with a higher fair value (FV) of RM0.86/share (from RM0.60/share previously). This is based on a CY24F P/BV of 1.5x (0.75 standard deviation (SD) below 10-year average of 3x, from 1 SD previously), to account for improved sentiments as a result of more reassuring loss-narrowing narratives.

Source: AmInvest Research - 12 Dec 2023