Capacity onset is converging with supply demand dynamics as players collectively delay capacity installation. The trajectory of the RM is a mixed bag, but expectations are that it could weaken in 2H19 augurs well for the sector. We maintain our NEUTRAL sector rating and Top Glove (BUY RM5.31) as our sector’s top pick.

Capacity managed. Earlier expectations of an oversupply situation driven by robust capacity expansion has been somewhat neutered on the back of better managed and staggered expansion. We understand that the majors have collectively pushed new capacity down by 1-2 quarters to alleviate the pressures on ASP. Overall, we expect total capacity to increase by 9.7% in CY19 vs. our earlier expectation of 14.6% prior to the rationalization exercise by the sector (see figure #1).

MYR daze in 2H19. The trajectory of the USD/MYR is a mixed bag in 2H19, it has picked up to USD/MYR 4.11 on the back of weakening USD due to the market pricing in a rate cut by the Fed in July. However, major catalysts for MYR depreciation in 2H19 including (i) Norway SWF exit from EM bonds and (ii) MGS exclusion from the WGBI, augurs well for the sector in maintaining its cost competitiveness against its regional peers. Our economics team has an average exchange rate projection to USD/MYR4.05-4.15 for the rest of the year 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.

Raw Mats. We expect the price of nitrile and natural rubber to parallel that of global commodities on the back of dampening sentiments driven by trade war tensions. YTD the price of butadiene (a core component in nitrile manufacturing) has declined by -8.5% but has since exhibited an upward trend since May (see figure #3), we expect price NBR to be flattish in 2H19. In June, Top Glove reported weaker than expected results on the back of a sharp incline in NR prices due to (i) wintering season and (ii) support for prices in Thailand due to the general election. We expect the price of natural rubber (NR) to normalize to its seasonal trend in 2H19 (YTD average: RM4.61/kg; 2018 average: RM4.30/kg) assuming no supply disruptions (figure #4).

Gas Tariff Hike. Gas Malaysia recently announced a tariff revision of c. +5.3% for 2H19 (from RM32.92/mmbtu to RM34.46/mmbtu). We understand that this increase will results in an increase of glove prices by less than 1% and should be passed through in 1-2 months. We expect this lag will have an immaterial impact to margins especially to TG given that it has recently raised ASPs (NR: +8.8%; Nitrile: +1.3%) in June. We understand that the more nitrile skewed players have also raised prices within the 2%-3% range to pass thru the increase in nitrile prices recently. This should help to contain the higher operating costs and buffer against further margin compression in the coming quarters.

Valuations. Valuations for the sector is palatable with the sector trading at 25.7x or just above its 3 year historical mean (see figure# 5). We note that further downside would be limited given the sectors YTD mean reversion. However we believe that upside risk remains at a distance given that the sector, in our opinion, is still on the road to recovery and would take at least 1-2 more quarters before ASP, supply and demand favours the producers.

Maintain NEUTRAL. Whilst valuations are cheaper at this juncture, the protracted softer USD would weight on sentiments in the near term. With regard to managed and staggered capacity, we are of the opinion that these measures are still at infancy. Our preferred stock for the sector is Top Glove (TP: RM5.31; BUY).

Source: Hong Leong Investment Bank Research - 16 Jul 2019