Investment Highlights

• We upgrade the sector to Overweight from Neutral previously with Top BUYs being Hartalega Holdings (Hartalega) (FV: RM3.20/share) and Kossan Rubber Industries (Kossan) (FV: RM2.24/share). Our sector upgrade primarily reflects recent findings that USA is restricting an increasing number of Chinese medical rubber glove makers (Exhibit 1) due to quality concerns, whereas Malaysian peers encountered comparatively fewer issues of this nature (Exhibit 2). Considering China's persistent inability to attain comparable quality to Malaysian counterparts since 2010, we deem this quality issue to be a medium-to-longterm problem for Chinese glove makers to resolve. This could imply there will be a gradual trade diversion from the world’s largest medical rubber glove-buying country (USA) to other reputable glove-making countries, especially Malaysia, which is poised to regain market share. We do not discount the possibility that other major glove buyers in the world (eg. European countries) could follow suit in the near future.
  
  We believe this development could ease local investment community’s medium-to-long-term concerns that Chinese glove manufacturers will continue to gradually gain global market share from Malaysian competitors, as they did during the pandemic period (Exhibit 4) by expanding capacities and quoting relatively lower average selling prices (ASP) supported by their lower cost structure. Hence, we deem that these findings could materially re-catalyse local rubber glove share prices.
  
  Furthermore, our positive re-rating is also underpinned by increased near-term optimism highlighted in our Sector Update on 12 Dec 2023 with the findings that a high possibility of demand recovery among Malaysia’s glove makers could start in 1QCY24 as medical glove distributors’ inventories could be depleted amid Chinese major players running at full plant utilisation (PU) in 2Q- 3QCY23 while China’s largest glove maker, Intco Medical (Intco) will not materially increase capacity in the near term (Exhibit 5).

• What is USA Food Drug Administration’s (FDA) import alert? Generally, an import alert against a particular country/manufacturer/shipper informs the FDA's field staff and public that FDA has enough evidence for detention without physical examination (DWPE) of products that appear to be in violation of FDA's laws and regulations. The list of countries/manufacturers/shippers subject to DWPE is known as the “Red List”. If the country/manufacturer/shipper cannot provide sufficient evidence to FDA to overcome the appearance of violation or recondition the products to correct the violation within 10 business days from detention, the detained products will be issued with a refusal of admission. Consequently, the country/manufacturer/shipper can work with USA Customs and Border Protection (CBP) and FDA to either destroy the products or export them from USA within 90 days of refusal.

• World largest glove buyer, USA, is restricting more Chinese glove makers recently. USA is the largest purchaser of medical rubber gloves worldwide during the pre-pandemic period (Exhibit 6). Based on the Red List (for manufacturers) obtained from USA FDA import alert number 80-04 – Surveillance and Detention Without Physical Examination of Surgeon's and Patient Examination Gloves, we derive the following 3 observations (Exhibit 1-3):
  
  (a) In 2010-19, USA FDA issued import alerts for medical rubber glove manufacturers in Malaysia and Thailand at a rate of close
  
  to nil, whereas China experienced a range of 0-21 (or an annual average of 8) within a comparable time period.
  
  (b) Since 2023, USA has become more quality-conscious, with the trend increasing on a QoQ basis (Exhibit 1), following a period
  
  of laxity in quality checks in 2020-22 (ie. there were no newly-added rubber glove manufacturers in 2020-21 and only 2 in 2H2022, compared to a historical annual average of 8 in 2010-19). This was possibly due to Covid-19-related fatalities remaining elevated and volatile in 2020-1H2022 (Exhibit 7).
  
  Based on FDA guidelines, the imposition of an FDA import alert is contingent upon the presence of defects in 1 or more violative samples of medical gloves from a shipment.
  
  (c) Since 2021, the number of import alerts issued for medical rubber glove manufacturers in Thailand has become volatile.
  
  AmResearch’s View:
  
  (1) We deem the medical rubber glove quality issue to be a medium-to-long-term problem for Chinese glove makers to resolve
  
  given China's consistent failure to achieve quality levels comparable to Malaysia and Thailand since 2010.
  
  (2) We believe that the recent increasing quality awareness in USA could trigger medical rubber glove distributors in the region
  
  to diversify away certain portion of their orders from China to prevent future order detentions, given the increasing restrictions
  
  that USA is applying to Chinese glove manufacturers on a QoQ basis.
  
  Furthermore, we do not discount the possibility that other major glove-buyers in the world (eg. Europe, the 2nd largest world glove-buyer) (Exhibit 6)) could follow suit. This is supported by the stabilisation of Covid-19-related fatalities in European countries and a Frost & Sullivan 2022 study which revealed that only 9 (40%) of the 22 glove brands examined passed the testing for (a) freedom from perforation (BS EN455-1 standards), (b) force at break (BS EN455-2), and (c) glove thickness and weight (Exhibit 8). We believe the influx of inferior products into European markets could be due to laxity in quality checks since the pandemic period. 
  
  (3) We anticipate Malaysia could be a preferred location for diversification given that our country exhibited relatively stable quality over the years (pre-pandemic and post-pandemic) compared to China and Thailand.

• Trade diversion could be asymmetrical among Malaysian players. If trade is diverted to Malaysia, we believe USA medical rubber glove distributors will prefer: (a) reputable companies (ie. listed Big 4 namely: Hartalega, Kossan, Top Glove and Supermax), (b) consistent business relationship, and (c) competitive pricing.
  
  Based on our research, we believe that Hartalega and Kossan could have better business relationship with USA customers given their relatively higher exposure to North America compared to Top Glove and Supermax (Exhibit 9). Also, Hartalega and Kossan have not been served with withhold release orders (WRO) by USA authorities. Furthermore, both Hartalega and Kossan have the lowest cost structures among the Big 4 (Exhibit 10), allowing them to have a more competitive pricing. Nevertheless, we believe trade diversion will benefit Malaysian players, albeit biased towards Hartalega and Kossan.
  
  At this juncture, it is difficult to precisely estimate the quantum of trade diversion. However, for the sake of context, the estimated annual capacity of all installed nitrile medical rubber gloves in China for CY24F is 120bil pcs. This is in contrast to 3QCY23 remaining available capacities of Hartalega at 13bil (after fully decommissioning Bestari Jaya facilities) and Kossan at 10bil (after fully decommissioning 6bil pcs/annum). It is important to highlight that the remaining available capacities do not account for inventory replenishment that is anticipated in 1QCY24.

• Recap: Rubber glove demand stabilising with inventory replenishment to begin by 1QCY24F without any ASP compromise. Locally and regionally, 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) as a proxy for western countries, demand has stabilised since Mar 2023, subsequent to a persistent downtrend that commenced since mid-2021 (Exhibit 11). Separately, we observe the majority of over-purchasing occurred between 2Q- 3QCY21 (Exhibit 12). 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 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 5). 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 under our coverage 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.

• Valuation: We maintain BUY on Hartalega with a higher fair value (FV) to RM3.20/share (from RM2.80/share previously), based on a higher CY25F PE of 30x (0.25x standard deviation (SD) above 10-year average of 27x, from parity previously) as a potential beneficiary of trade diversion.
  
  We upgrade Kossan from HOLD to BUY, with a higher fair value (FV) of RM2.26/share (from RM1.34/share previously). This is based on a higher CY25F PE of 22x (0.25x SD above 10-year average of 17x – which was the previous target earnings multiple) to reflect the potential boost from trade diversion and comparable cost structure with Hartalega, as well as increasing FY25F- 26F earnings by 11%/8% to account for lower operational costs after we gathered no one-off items in Kossan’s 3QCY23 impressive results.
  
  For Top Glove Corporation (Top Glove), we retain HOLD with an unchanged FV of RM0.86/share.

Source: AmInvest Research - 2 Jan 2024