• There were no major surprises from the briefing yesterday. However, we note that Top Glove stands a high chance of being admitted into the FBMKLCI. Based on recent trends, we acknowledge that an inclusion may help to book alpha. That said, we caution this is not a fundamentally driven price movement.
• Regardless, our new valuation has pencilled in a partial re-rating to capture this event but downside risks still prevail.
• Maintain SELL with a revised target price of RM10.00 (from RM8.20).

What’s New

Post-briefing key takeaways.

Top Glove held a results briefing yesterday, and similar to the past, it was well attended by various stakeholders. 

There were no major surprises from the briefing as discussions revolved mainly around FY18 operational review and re-iterating its outlook. Key takeaways include:

1. emerging markets continued to spur overall volume growth,
2. unveiling its expansion plans over the next 1-2 years, and
3. an explanation on why there was no goodwill impairment charged on Aspion.

Potential inclusion into the FBMKLCI.

Recall that there are two key criteria to be met before a stock can be admitted into the FBMKLCI:

1. market cap ranking, and
2. share turnover in issue of at least 0.05% for more than 9x in the 12 months preceding the semi-annual review (SAR).

Assuming last Friday’s data was unchanged till appraisal time, we find that Top Glove has a strong chance for inclusion, replacing Telekom Malaysia by virtue of the latter falling to the 36th spot, and scoring a perfect 12/12 for the liquidity test.

Three important dates to take note of are:

1. 26 November for data assessment,
2. 6 December for results announcement, and
3. 24 December for effective inclusion/exclusion from the index

Stock Impact

Emerging markets driving volume growth.

We understand that a large proportion (72%) of the robust demand (26% volume growth) seen in FY18 came from emerging markets: Asia ex-Japan (volume: +58% y-o-y), Eastern Europe (+40% y-o-y), and Middle East (+39% y-o-y). Product appetite in these regions was skewed towards those made from natural rubber (powder free +24% y-o-y, powdered +23% y-o-y), fuelled by rising healthcare awareness and spillover effect from the shortage of global vinyl gloves; the segment makes up 47% of total volume growth. 

However, developed areas such as North America (2% y-o-y) saw much slower volume growth due to the market maturity combined with a more competitive operating environment, but Western Europe saw good sales fraction (+36% y-o-y).

Unveiling its new expansion plans.

With the acquisition of Aspion completed in early-April along with the completion of Factory 31 in July, Top Glove is now capable of producing up to 60.5b gloves p.a.. Also, management unveiled its new expansion plans (Factory 33, 5A and 8A) to the investment community on top of the outstanding expansion timeline for Factory 32 (by end-19). When all are fully operational by 2020, Top Glove’s enlarged manufacturing capacity will balloon to 70.3b gloves p.a. (+16%).

The new lines are for nitrile gloves, which should raise capacity mix in this space to about 40% from 35% currently. Management intends to achieve a 50:50 nitrile-to-latex glove production split over the longer term.

Explanation for no impairment charge.

Although the RM1.2b goodwill on its book is created from the purchase of Aspion, management explained there is an underlying difference between its impairment test vs the RM640m overvaluation amount they are seeking from the vendors.

Essentially, the impairment test is based on conservative discounted cash flow (DCF) method with a zero terminal growth rate as compared with the original acquisition price tag, which was based on PE multiplier model.

The argument is that the financial projections used in the impairment test accounted for the enhancement to Aspion’s glove production process. Hence, this requires input and effort from Top Glove. Only then can it match the sort of profit estimates initially guided by the vendors of Aspion in 4-7 years’ time.

Lesser impairment risk moving forward.

With the conservative DCF parameters used for the recent impairment testing, this reduces the risk of a negative charge in the near term as long as Top Glove is able to meet its own financial forecasts.

We gathered that management is looking at FY19-23 net profit range of RM40m-65m, which is below the earlier profit guarantee of RM80m.

Similarly, we have built in comparable earnings contribution from Aspion of RM40m-RM50m over the next three years in our financial model. Besides, the outcome of the on-going litigation should not be affected as it is a separate matter altogether.

Earnings Revision / Risk

No change to our forecasts. 

Key upside risks include:

1. recovering the RM640m from Adventa Capital,
2. market share gains,
3. more bona fide sizeable value-accretive M&As, and
4. US dollar appreciating markedly vs the ringgit.

Valuation / Recommendation

Maintain SELL but with a revised target price of RM10.00 (from RM8.20) as we peg the stock to a higher 2019F PE multiple of 22x (from 18x). This is +1SD above its 5-year forward mean PE of 16x but below the sector’s 27x.

The premium is fair as:

1. Top Glove has been making steady headway into the generally faster-growing nitrile glove space, and
2. despite the negative development at Aspion, the group is still touted as the no.1 surgical glove player globally.

That said, the discount to the glove sector is warranted, considering its relatively stretched balance sheet (net gearing of 0.9x vs peers' average of 0.1x).

The primary reason for the valuation bump-up is to capture a partial re-rating from the potential inclusion into FBMKLCI. We note that after Nestle and Press Metal were included into FBMKLCI, both stocks generated commendable returns of 12-32% over a short three months.

While we acknowledge post-index inclusion may help to create alpha, we caution that this is not a fundamentally driven price movement. Further, there were no major structural business developments and valuations remained rich. Hence, should Top Glove become a FBMKLCI component in December, we advise investors to sell on strength.

Post-bonus issue, our target price would be RM5.00, excluding the potential dilution from full guaranteed exchangeable bonds conversion into new Top Glove shares pending more details of the exercise.

Source: UOB Kay Hian Research - 18 Oct 2018