- Upgrade to Overweight . We are raising our call on the rubber gloves sector from NEUTRAL to OVERWEIGHT following our view of a USD bull market in 2015, of which the sector would be a prime beneficiary. Additionally, we expect the downward earnings revision cycle to soon bottom out given the improving operating environment. Buying interests will also be spurred by the sector’s YTD share price retracements of 10% and decent dividend yields of ~3%.

- Favourable USD:RM exchange rate in 2015. YTD, the USD had advanced by 6% against the RM. Given that the US Federal Reserve is expected to normalise rates in 3Q2015, the USD should continue to appreciate in the coming year. A strengthening greenback bodes well for the glove manufacturers given that it is an export-oriented industry, with sales quoted in USD/’000 pieces. Additionally, a sharper appreciation of the USD against the RM relative to currencies of the other glove manufacturing countries (i.e. THB and IDR) would ensure the competitiveness of Malaysian glove exports and underline its position as the industry’s global leader (~63% of world supply).

- Short-term earnings distorted by hedging activities… We understand that all the rubber glove companies under our coverage save Supermax Corp hedge their currency risk (net exposure of 30%-40%) using forward contracts. While this method is meant to protect their receivables, variations in lock-in rates and marking-to-market may result in fluctuating quarterly earnings (unrealised profit/loss).

- …but earnings to trend up in the longer run. That said, an upward trajectory of the USD:RM rate could result in margin expansions due to the pricing mechanism adopted by glove manufacturers. A higher ASP would help alleviate the current downward pressure on ASP (mainly from declining raw material prices), and stem the ongoing quarterly contractions in margins. As it is, the 9M2014 EBITDA margins for most of the glove manufacturers (except for Kossan) had contracted by ~2ppts YoY following various cost inflations. These included hikes in both electricity (+15% in Jan) and natural gas tariffs (+19% in May and +2% in Nov).

- Sensitivity analysis. Our back-of-envelope calculations show that should the USD rally against the RM to RM3.60/USD in 2015 (+11% YoY from 2014’s average of RM3.25/USD), sector earnings could jump by an average of 30% YoY, ceteris paribus.

- Earnings to be capacity-driven. Against the backdrop of healthy global glove demand (+8% to +10% p.a.), we continue to expect earnings to be capacity-driven. We thus prefer companies with an accelerating capex cycle, namely Hartalega Holdings and Kossan Rubber Industries. Despite the challenging conditions in the past year, both these companies had managed to register above-average margins. We also believe that premium valuations (vs. average sector forward PE of 17x) for the stocks are justified given their superior financial and operating performance.

- Hartalega raised to BUY. We are upgrading Hartalega Holdings from HOLD to BUY with a higher fair value of RM7.90/share. Our fair value is based on a higher target PE of 23x over its fully-diluted FY16F earnings. We believe a re-rating of Hartalega at this juncture is appropriate given that its earnings are at an inflection point following the commissioning of the first lines at its game-changing NGC project (average capacity growth of 15% over next 5 years to 43bil pcs). The coming on-stream of the new capacity, which management assured has ready buyers, is also timely given our view of a strengthening USD next year. Coupled with potential cost savings, its earnings are expected to gradually pick up in 2HFY15 before accelerating by ~19% YoY p.a. from FY16F.

- Kossan still a top pick. On a similar note, we are maintaining our BUY call on Kossan Rubber Industries but have revised its fair value to RM5.65/share. This is based on an FY15F fair PE of 18x (20% discount to industry leader Hartalega’s). The group’s FY15F earnings are expected to step up by 25% as it will be registering the full contributions from its three new plants (17 new lines with total new capacity of 5-6bil pcs). Also, operating leverage is high given its enlarged revenue base.

- HOLDs on Top Glove... Our HOLD recommendation on Top Glove Corp remains. Unlike its peers, Top Glove is the only one holding back its capacity expansion plans (FY15F-FY17F three-year installed capacity CAGR of 5.3% vs. 10% historically). Having recognised that its volume strategy is no longer effective, the group is now working on improving its operational efficiencies to raise margins. Despite its weak fundamentals, we suppose that the stock will benefit from the improved sentiment towards the sector and have thus tactically pegged its FY15F earnings to a higher target PE of 17x (+1SD above its mean) to arrive at a fair value of RM5.15/share.

- ...and Supermax. We also reiterate our HOLD recommendation on Supermax Corp with an unchanged fair value of RM2.40/share. Our PE target of 12x its FY15F EPS is on the higher-end of its 5-year PE band. Although the stock should also gain from the sector’s overall re-rating, we choose to be conservative given that its earnings moving forward remain clouded amidst the uncertainties in its expansion plans. 

Source: AmeSecurities