- Tougher times ahead - Our recent company visits revealed that the rubber glove manufacturers are adopting a more cautious outlook in anticipation of a more hostile operating environment. The glove manufacturers have, on average, been able to enjoy double digit earnings growth and margin expansions of 4ppts-5ppts over the past two years in view of strong demand (2012: +15% and 2013: +9%) and a relatively favourable cost structure. Moving forward, however, we believe that this may no longer be the case.

- Margin compression to drag on earnings - Our less upbeat stance can be attributed to expectations of margin compression in light of:- (1) greater competition (especially in the growing nitrile (NBR) glove segment); and (2) upward cost pressures as headwinds make a comeback. Early signs of this can be seen in the respective companies’ latest quarterly results, whereby EBITDA margins had slipped below their corresponding 5-year averages. The only exception is Kossan, which 4QFY13 EBITDA margin remained a firm 3ppts above its long-term mean.

- Headwinds making a comeback - We understand that the Human Resources Ministry would soon be carrying out a review of the minimum wage (which was implemented last year) and enforce a new directive next year. Besides labour, other input costs, namely electricity and natural gas, have also been rising as tariffs for both were recently increased (by 17% and 19%, respectively). While expectations of a strengthening USD:RM may diffuse some exchange rate pressure, the greater exchange rate volatility and hedging activities by some manufacturers have only increased their currency risk and made them worse off.

- Ease of cost pass-through fading - At present, labour, fuel and electricity collectively make up ~22% of total production costs. This would seem more manageable in relation to raw materials’ 45%-55% and in view of the industry’s practice of passing on any cost increases. However, we argue that ease of cost pass-through (generally 80%-100%) may be fading as restocking activities and scarcity in supply (fewer NBR glove players previously) have made it relatively easier in the past.

- Pricing pressure has been intensifying - The shift in pricing power to buyers is evident in the downtrend of ASPs for both natural rubber (NR) and NBR gloves. We understand that for the latter, the willingness of new segment entrants to accept lower margins in exchange for market share has exacerbated the slide. The lower ASP may be due in part to falling raw material prices (YTD: -16% for NR; -3% for NBR), but with both NR and NBR prices expected to remain range-bound, we do not foresee any significant uptick in margins ahead.

- Robust demand a silver lining - Despite the disapproving cost structure, we do not expect the rubber glove manufacturers’ earnings to experience a sharp YoY fall as the higher costs will be partly cushioned by internal efficiency programs and robust demand (+8%-10% YoY). Current pricing pressures have brought to fore fears of overcapacity, especially in the NBR gloves segment. That said, we are not overly concerned given that:- (1) order lead times are still healthy, with utilisation rates at some NBR glove production facilities remaining high (~90%); (2) potential delays and deferment of new capacity expansions; and (3) Malaysian glove manufacturers’ dominance in the industry (63% of world output).

- Kossan the only BUY... - In view of our less bullish stance and lack of catalysts moving forward, we have cut earnings by 6%-11%. Our only BUY recommendation is Kossan Rubber Industries. Our investment thesis on the stock is largely unchanged. We continue to like the stock for:- (1) its superior FY14F-FY16F earnings CAGR of 21% (double that of its peers’); (2) margin expansion (+2-3ppts) on the back of improving efficiencies and product mix; and (3) bright prospects at its non-core technical rubber products division. Having fine-tuned our numbers by -1% to -2%, we have tweaked lower its fair value to RM5.00/share (from RM5.05/share previously). This is based on an unchanged PE of 17.5x over its FY14F EPS.

- ...with downgrade of Top Glove to HOLD - We are downgrading Top Glove Corp from BUY to HOLD, with a lower fair value of RM5.55/share to reflect our lower FY15F (rolled forward) PE target of 16x in lieu of its deteriorating fundamentals and a downward revision of our FY14F-FY16F estimates. The group appears to be the most affected by the increasingly competitive environment.

- Maintain HOLDs on Hartalega and Supermax - Taking into account a further deceleration of Hartalega Holdings’ near-term growth prospects and greater competition in its core NBR segment, we have reduced the group’s FY14F-FY16F earnings by 8%-18%. Our new fair value of RM5.40/share is pegged to an FY15F PE of 18x. No change to our recently revised earnings forecasts and fair value of RM2.65/share (FY14F PE of 12x) for Supermax Corporation. A key re-rating catalyst for the group would be the smooth execution of its “Supermax Business Park” project. 

Source: AmeSecurities