An imbalance in supply demand is expected to manifest in 2019 with the glove players expected to increase supply by c.14% (annual global demand growth of 8%-10%). The RM is expected to be weaker in 2H18 which augurs well for the sector whilst the reversal to the SST regime will yield a neutral effect. We expect the glove players will apply for and receive an exemption for SST. We maintain our NEUTRAL sector rating. We downgrade Karex to a Sell given the recent share price run.

Capacity. We estimate that the top 4 in the glove industry will have increased capacity by c.11% in CY18. At this juncture we believe that the supply demand dynamics remains balanced as the excess supply has been mopped up as evidenced by the higher utilization rates experienced by the sector in general. However we do note that an imbalance is expected to manifest in 2019 with the glove players expected to increase supply by c.14% (see figure #1) which outstrips the expected annual demand growth of 8%-10%. However, in view of the oligopolistic industry structure, we do not rule out the possibility of glove players’ eventually expanding capacity in a more gradual manner to avoid price competition.

A weaker RM. The RM is expected to be weaker in 2H18 which augurs well for the sector in maintaining its cost competitiveness against its regional peers (despite the RM being the better performer against a basket of EM currencies). Our economics team revised its exchange rate projection to USD/MYR3.90-4.10 for the rest of the year (previous: USD/MYR3.85-4.00) which is within our forecasted range. Within our coverage, Top Glove is the main beneficiary of a weaker RM (stronger USD) as it has the highest exposure to NR latex gloves.

Migration to SST. The reversal to the SST regime will yield a neutral effect to the glove sector as it is mainly export driven. It has been guided that as per the previous SST regime, the glove players will apply for and is expected to receive an exemption. Thus the migration from GST to SST is neutral to the sector. Furthermore, based on the recently released proposed SST exemption list, many (if not all) of the core input costs used in the manufacturing of rubber gloves are exempted.

Minimum wage. The PH government mentioned in its GE14 manifesto to increase minimum wage RM1500 (from RM1000). At this juncture the government is expected to announce their decision on the minimum wage by Aug. We understand that the increment is staggered and that there will be a government subsidy component. As always, the increase in costs will be passed thru to the customers. However we can expect a temporary negative impact to margins as the glove players take time to renegotiate prices. We estimate that the impact to net profit ranges between 1.5% - 2% for every RM100 increment in minimum wage.

Raw materials. We expect the price of nitrile to increase moving forward on the back of renewed strengthening of the price of oil and stronger demand from China. As such, nitrile heavy players such as Hartalega and Kossan would be negatively impacted. YTD the price of butadiene (a core component in nitrile manufacturing) has increased by 48.8% YTD (see figure #3) outpacing the price of crude oil (+9.4%). We expect the price of natural rubber (NR) to remain low for the remainder of FY18, averaging RM4.00-4.50/kg, (YTD average: RM4.57/kg; 2017 average: RM5.92/kg) assuming no supply disruption (see figure #4). This is primarily to the benefit of glove players with a skewed product mix toward natural rubber (TG and Supermax).

Downgrades. We are downgrading Karex (TP: RM0.86) to a SELL from a HOLD given the recent run in share price. Although management will have instituted margin improvement measures and ASP’s are on the rise, we note that earnings outlook remains soft on the back of a higher overall cost structure as the group builds its OBM segment and make inroads overseas. We also take this opportunity to downgrade Kossan (TP: 3.84) to a SELL from a HOLD due to valuations.

Valuations. Valuations remain lofty with the sector trading at 35x or 2SD above 3 year historical mean (see figure# 6). We note that further upside could be capped due to a more flattish outlook on earnings in 2H18. However downside risk to the sector could be limited in 2H18 due to the “export play” factor and capacity expansion led earnings growth.

Maintain NEUTRAL. Maintain Neutral on the sector as we believe that share prices will be supported by inclusion into key indexes (MSCI and KLCI) for Top Glove and Hartalega amidst the backdrop of a weakening RM which augurs well for the export players in general. Nonetheless, with valuations remaining lofty and expected downward pressure to margins arising from wages and raw materials (Nitrile) will in our opinion, cap further upside. Our preferred stock for within the sector is Top Glove (TP: RM9.92; HOLD).

Source: Hong Leong Investment Bank Research - 24 Jul 2018