• The coronavirus outbreak has well catalysed sentiment on the glove sector. However, taking into account previous epidemic outbreaks and our base assumptions, valuations appear to have fairly priced in the incremental demand impact on sector earnings.
• We lift our 2020-21 sector net profit forecasts by 16% and 11% to factor in our higher volume growth assumptions. We raise our valuations to reflect the enhanced earnings growth going forward.
• Maintain MARKET WEIGHT. Top pick: Kossan.

What’s New

Outbreak spreads but WHO stops short of an international emergency classification.

• Coronaviruses are a group of viruses that cause diseases in mammals. The virus has sickened more than 2,700 people in China, with more than 80 reported deaths. The new coronavirus was temporarily named “2019-nCoV” and has already spread to more than 10 countries, across 4 continents. Recently, the World Health Organisation (WHO) met on 25 January but stopped short of declaring the 2019-nCoV virus a public health emergency of international concern, a declaration used for the gravest of epidemics.
• The absence of evidence of human-to-human transmission outside of China and unprecedented measures to rein in the spread of the virus in China has held back WHO officials from assigning 2019- nCoV the highest possible threat classification. WHO officials are due to reconvene this week. The previous pandemics, severe acute respiratory syndrome (SARS) and H1N1 were eventually declared as global emergencies but on varying timelines.

TIMELINE OF PREVIOUS PANDEMICS - SARS & H1N1

SARSH1N1

* Mid-range of estimated impact from Apr 09 to Apr 10

Using preceding H1N1 outbreak to measure 2019-nCoV’s impact.

• We look at the previous outbreaks to determine the possible impact 2019-nCoV could have on the glove sector. That said, back in 2003, the SARS outbreak and the glove industry were still under-developed.
• Fast forward to 2009, H1N1’s outbreak had a pronounced impact on the sector. Sector volume grew in excess of > 20% against higher economies of scale and better demand-supply imbalance; profit margins improved to 14.5% from 10.5% in the four quarters after and before the H1N1 outbreak. Incremental demand for hospital care and by proxy, medical grade gloves appear to be dependent on the extent of the epidemic outbreak, infection rate and time taken to discover a vaccine.

Sector earnings enjoyed three quarters of enhanced growth after vaccine discovery.

• Based on H1N1’s first suspected infection, it took two quarters for incremental demand to significantly impact glove sector earnings. Following which, there were three quarters of extraordinary q-o-q profit growth between 3Q09 and 2Q10. This is in spite of a vaccine discovery on 15 Sep 09. Only after 2Q10 did top-line see q-o-q growth and profit margins started moderating.

Valuations tracked sector earnings, not vaccine discovery.

• In terms of valuations, it peaked to 17.8x one-year forward PE (or > +1 SD of 16.3x) in Jul 10. Peak valuations coincided with peak sector earnings in 2Q10. However, we note that valuations continued to rally well past the approval of the drug vaccine as there was a gestation period for containing the H1N1 outbreak. This had a delayed impact to earnings.
• However, it is apparent that valuations traced sector earnings and not the vaccine discovery. Subsequent to the containment, valuations tumbled as the glove industry had a surplus of gloves.

Essentials

• It has been close to a month since China alerted the WHO of several unique cases of pneumonia. As of 28 January, there were close to 4,000 people infected with the coronavirus. To adjudge the impact on glove players, our base assumptions for the 2019- nCoV factors in the timeline midpoint between SARS and H1N1, assuming a timeline of 12 months before WHO declares a containment.

Timeline.

• Based on the H1N1’s time lag effect on earnings, exhaustion of inventory and existing delivery lead times of between 45 to 50 days (potentially up to 60-70 days), we imagine incremental demand driven by the new coronavirus could be reflected in 2Q20. The time span of “supernormal profit” depends on vaccine discovery and extent of the pandemic. However, our base case assumes two quarters of “supernormal profit”.

Glove volume growth and earnings assumptions.

• Based on the assumptions above, we raise our industry volume growth assumption from 10% and 9% in 2020 and 2021 to 15% and 12% respectively. Broadly, we upgrade sector earnings forecasts by 16% and 11% for 2020 and 2021 respectively.

Action

Maintain MARKET WEIGHT.

• The recent coronavirus outbreak has certainly rerated valuations. Based on our base case, we expect incremental demand for medical grade gloves to significantly impact earnings by 2Q20 and enhanced earnings could be sustained for three quarters should the H1N1 outbreak be a comparable measure.
• Apart from raising sector earnings, we raise our PE valuations to +1SD from the mean PE peg that we previously applied to glove producers to capture the surge in earnings based on our base assumptions. Sector valuations are elevated, trading at 29.4x PE, slightly above +1SD to the PE mean of 28.8x. This is backed by an expected surge in two-year earnings CAGR of 18.5% over 2019-21.
• The exciting growth appears fairly priced in by elevated valuations. Top pick for the sector is Kossan.

Vaccine discovery may be too premature for profit-taking.

• Depending on the severity of the outbreak, profit-taking upon discovery of vaccine may be too premature. During H1N1, valuations continued to climb 9 months after vaccine discovery, in tandem with q-o-q profit growth.
• We believe a more reflective measure is potential shortening of delivery lead times and decline of infected cases as potential red flags to waning demand. Apart from that, potential peak valuations that we have highlighted may be indicative of a sell trigger as it factors in +2SD valuations against aggressive incremental demand.

Kossan Rubber Industries (BUY / Target Price: RM6.22).

• Maintain BUY but with a higher target price of RM6.22 (from RM4.70) as we raise our 2020-21 earnings forecasts by 17% and 10%. We also lift our PE peg to 26x 2020F PE (from 23x) to factor in the attractive earnings growth (2-year earnings CAGR of 20% over 2019-21).
• Over time, the outpaced earnings growth relative to its peers, coupled with consistent execution, should reinvigorate Kossan’s valuations. The potential re-rating should narrow its discount to Top Glove and Hartalega which we think should be trading at 28.5x and 32.5x PE respectively.

TOP GLOVE CORPORATION (HOLD / Target Price: RM6.05).

• Our target price is lifted to RM6.05 from RM4.50 as we raise FY20-21 earnings forecasts by 18% and 14% based on a higher 28.5x 2020F PE (from 25x). (Using the latest FX rate of 1RM to 0.3329SGD, we derived target price of 2.01 in SGD term.) We factor in the incremental demand ripple to earnings. Aside from that, the company could be in the best position to benefit, given its excess capacity on latex glove production.
• We believe Top Glove’s premium of 28.5x or +1SD to the sector PE mean is fair given it is a component in the FBMKLCI Index and therefore deserving of a slight premium to the sector. Entry price is RM5.50.

Hartalega Holdings (SELL / Target Price: RM5.32).

• Our new target price is based on a higher 32.5x 2020F PE (from 29x) and enhanced earnings forecasts of +13% and +8% for FY21-22 respectively. The premium can be justified by its strong operating efficiency and innovation ahead of peers. Nevertheless, our bearish call is premised on Hartalega’s lofty valuation (39x 2020F PE) which limits potential price upside.

Source: UOB Kay Hian Research - 29 Jan 2020