Aggressive expansion during the pandemic has tipped the rubber glove sector into an oversupply state. We expect the situation to persist throughout 2H22, as it would take some time for the demand-supply imbalance to normalise. ASPs are also expected to stay depressed, and we believe any upward revision in pricing would be marginal, mainly to accommodate the higher operating costs. Margin pressure should also continue to plague the glove makers, given its inability to fully pass on the cost increase amidst stiff competition. We downgrade our rating on Hartalega to SELL, on higher risk to be booted out of the KLCI in the upcoming review, while maintaining our SELL call on Top Glove. Despite facing the same set of challenges, we are keeping our HOLD recommendation on Kossan, as we believe its relatively smaller capacity is a redeeming feature and any potential increase in orders are more likely to fill up Kossan’s capacity sooner. All in, we maintain UNDERWEIGHT on the glove sector.

Not subsiding so soon. Post mass rollout of vaccination globally, the demand for gloves have greatly softened and remained subdued thus far. This was further exacerbated by the aggressive capacity expansion by both incumbents and new entrants, tipping the sector into an oversupply state. We believe the oversupply situation is likely to persist throughout 2H22, as buyers are still unwilling to commit to huge orders. On a side note, we note that some of the new entrants are looking to exit the industry completely, given the challenging operating environment currently. While that should help remove some supplies off the market, we opine that collective effort from all industry players is still the key to curtail excess supply. From what we gather, most of the glove makers are keeping their expansion plans on hold for now. The imbalance demand-supply dynamics should also continue to keep ASPs depressed in 2H22 and we reckon that any possible upward adjustment in glove pricing would be marginal, mainly to accommodate the increase in operating costs.

Juggling with higher costs. Glove players were not spared from the high inflationary environment and have been facing increasing cost pressures arising from higher raw material, wages and natural gas costs. That said, we do expect raw material prices to ease as we move into 2H22, as latex production climbs post wintering season, as well as lower demand for nitrile butadiene rubber (owing to smaller glove players exiting the business and subdued glove demand). Our house view of a ringgit appreciation in 2H22 (USD-MYR average: 4.33; year-end: 4.23), coupled with the relatively lower run rate would also be detrimental to the glove makers. Owing to the soft demand and intense competition, glove makers now have lesser pricing power and have yet to return to the cost-plus basis model. Margin erosions are likely to continue in 2H22 in our view, as the cost hikes were unable to be fully passed on.

On foreign labour. Foreign labour shortage has been an issue besetting the glove makers since pandemic and a recent news article by Reuters has highlighted that the glove industry is currently short of 12k workers. We believe the void is partially due to foreign workers returning to their respective home countries upon the expiry of work visas. Despite having more headcounts than pre-pandemic days, the glove makers are still facing a labour shortage currently as they have commissioned more production lines during the pandemic. MARGMA previously shared that the glove industry submitted applications to collectively bring in 30k foreign workers but the timeline still remains unclear at this juncture. Having said that, we gather that Top Glove has gotten the allocation to bring in 1-2k foreign labour in batches by Oct.

But still sound from financial standpoint. Glove makers’ cash pile have ballooned considerably during the pandemic and part of the cash has been returned to shareholders by way of cash dividend and share buybacks. Based on the latest disclosures, Top Glove/ Hartalega/ Kossan are now sitting on a net cash pile of RM563m/ RM2.14bn/ RM2.35bn, making up of 6.8%/22.3%/71.7% of its market capitalisation (see Figure #1). This should help to provide some buffer to the glove makers financially, as they weather through this price competition.

Mounting risk of exclusion. No constituent changes were made to the KLCI in the most recent FTSE Bursa Malaysia KLCI semi-annual review in June 2022. While both the glove makers, Hartalega and Top Glove, have remained in the index, we caution that they could be at risk of being booted out in the next review (expected in Dec 2022), should share prices continue to deteriorate. Based on the last close on 7 July, Hartalega and Top Glove now ranks at the 35th and 38th respectively. In accordance to the index ground rules, constituents could potentially be removed from the index if it falls below the 35th spot. We caution that a selldown might be triggered should the constituent change materialises.

Maintain UNDERWEIGHT. Operating environment for glove makers are expected to remain tough in 2H22, as we do not foresee the oversupply situation to normalise anytime soon. In view of the intense competition, especially in the nitrile space, we also expect to see further margin contractions in 2H22 as we believe the glove makers are unable to fully pass on the hike in costs to buyers. Maintain UNDERWEIGHT on the glove sector.

• Top Glove. We revise our earnings estimates for Top Glove upwards marginally, by less than 3% for FY22-24f, as we adjust our USD-MYR exchange rate assumption to be in line with our house view. Earnings adjustment for Top Glove was less significant, as we have already lowered our forecasts previously, to account for the margin erosion. Our TP is raised slightly to RM0.83 (from RM0.82 previously), implying a PE of 17.3x on its FY23f EPS of 4.8 sen. Maintain SELL on Top Glove.
• Hartalega. We lower our FY23-24f earnings projections by c.30%, mainly to reflect the anticipated margin erosion, given its inability to pass on the entire cost increase. We also value Hartalega at a lower PE multiple of 16x (from 19.8x previously), to represent the higher risk of its potential exclusion from the KLCI in the next review in Dec 2022. Not to mention Hartalega also has the highest exposure to nitrile gloves (c.96% of FY22 sales volume are made up of nitrile gloves), a segment that is facing the fiercest competition at present. All in, we lower our TP for Hartalega to RM2.37 (from RM4.21) and our recommendation is also subsequently downgraded to SELL.
• Kossan. We lower our earnings forecasts for Kossan by 18-27% as we factor in the expected margin squeeze. Our TP is also subsequently reduced to RM1.44 (from RM1.97 previously), implying a PE multiple of 14.9x on its CY23f EPS of 9.7sen. Despite operating under the same set of tough conditions as the other glove makers, we are maintaining our NEUTRAL recommendation on Kossan, as we believe that its relatively smaller annual output capacity of 33.5bn pcs is a redeeming feature during times of adversity. Any possible increase in orders is more likely to fill up Kossan’s capacity sooner, ultimately leading to better utilisation rate compared to peers. Not to mention that Kossan also has the highest net cash to market capitalisation ratio (71.7%) among the three glove makers under our coverage.

Source: Hong Leong Investment Bank Research - 8 Jul 2022