Highlights/ Comments

• Results review – 2 (Topglove and Karex) out of 4 companies under our coverage were in line. Hartalega and Kossan 3QFY16 and 4QFY15 results were below expectation mainly due to one-off forex-related adjustments. Upcoming quarterly results of the sector are expected to remain flat QoQ as stronger volume would be offset by strengthening MYR as well as mild increase in costs.

• Production costs to inch up marginally. The biannual adjustments in natural gas price; higher electricity; and minimum wage hike (RM1,000 for Peninsula & RM920 for East Malaysia effective Jul 2016) are likely to put pressure on the margin. Impact of the higher levy for foreign workers (RM1,850 from RM1,250) is minimal at circa 1% on earnings.

• Contained raw mat costs. Despite a recent spike in natural rubber and nitrile latex prices, we still expect raw material prices to be capped with downside bias due to supply glut and slower growth in China’s auto industry.

• Diminishing USD catalyst. We note that the strong USD catalyst has diminished as ringgit is poised to maintain its strength given resilient economic fundamental. We al ready trimmed our ringgit assumption to RM3.80/US$ in our FY16- 17 forecasts (vs. RM4.00/US$ previously).

• All-in-all, Neutral call is maintained. Low raw mat prices, still strong USD, beneficiary of TPPA and resilient global demand will continue to contribute favourably to the sector (both glove and condom). However, it will be neutralised by rising energy and labour costs. The industry practice of passing on cost savings may also transpire during the year.

• We like TOP GLOVE (BUY, TP: RM6.46) as (1) it has been the sector’s leader in terms of market share, revenue, and earnings; (2) its resilient capacity expansion ahead; (3) cost reduction via product line automation and SAP ERP system; and (4) its P/E valuation has lagged its peers and it is trading at an average 41.9% discount to Kossan and Hartalega.

Catalysts

• Surge in demand (disease outbreak); more stringent healthcare requi rements; appreciation of USD against MYR and lower rubber prices.

Risks

• Mismatch between demand and supply in rubber glove; potential increase in natural and/or synthetic latex prices; depreciation of USD against MYR.

Rating

NEUTRAL

Positives

• Softening of natural and/or synthetic latex prices, continuous improvement in cost efficiency.

Negatives

• Weakening of USD against MYR.

Valuation

• Given diminishing USD catalyst, we lower our targeted P/E to +0.5SD above 5-year historical average P/E from +1SD.
• Hartalega (HOLD, TP: RM5.09 (previously RM5.32), 27.4x CY17 EPS pegged to +0.5SD above 5-year historical average P/E).
• Kossan (HOLD, TP: RM6.73 (previously RM7.06), 15.9x CY17 EPS pegged to +0.5SD above 5-year historical average P/E).
• Top Glove (BUY, TP: RM6.46 (previously RM7.51), 17.9x CY17 EPS pegged to +0.5SD above 5-year historical average P/E).
• Karex (HOLD, TP: RM4.08 (previously RM4.52), 24.5x CY17 EPS pegged to +0.5SD above 2-year historical average P/E).

Source: Hong Leong Investment Bank Research - 30 Mar 2016