Better Prospects Priced in

All glove companies within our coverage reported better 2Q17/1H17 results yoy while margins rebounded sequentially as we believe the industry demand-supply dynamics has improved. Moving forward, we believe that automation and cost pass-through will be essential to protect margins while capacity expansion remains the key growth driver. The sector valuation has risen by 12.5% year-to-date. Nevertheless, we believe that the current sector forward P/E valuation of 19.2x has priced in the better prospects ahead and is no longer attractive. As such, we downgrade the sector to NEUTRAL with Top Glove as our sector top pick.

Latest Results Show Improvement From Low Base

For the latest 2QCY17 quarterly results, all the glove companies within our coverage reported better results compared to the same quarter in the preceding year. But, most missed expectations due to various reasons.

Industry Demand-supply Imbalance Has Improved

The industry witnessed stiffer pricing competition in 2016 due to increased supply. However, after a relatively modest increase in industry capacity since 2H16 and robust global glove demand underpinned by more stringent healthcare regulations, increased healthcare spending, growing usage in emerging countries and widening application of gloves in other industries, the industry demand-supply dynamics has improved, as evidenced by rebounding industry profit margins.

Rising costs - automation and cost pass-through likely to protect margins

Moving forward, we expect the glove manufacturers to contend with rising raw material, labour and utility costs. Meanwhile, a stronger Ringgit could reduce the effective sales proceeds received. However, we expect increased industry automation and the ability to pass through the costs to their customers to help mitigate these factors and protect profit margins.

Capacity Expansion the Key Growth Driver

Moving forward, we believe the ability to execute the capacity expansion plans without sacrificing profit margins would be the key differentiating factor among the glove companies within our coverage. We remain lukewarm on certain companies’ diversification plans and do not expect these ventures to be a game-changer.

Better Prospects Priced In; Downgrade Sector to NEUTRAL

We continue to like the glove industry for its unique blend of defensiveness and growth via an inelastic and growing demand for gloves, and expect the glove players to report better profits in line with their capacity expansion and sanguine industry environment. However, we believe these factors have been well-appreciated by investors as year-to-date, the sector market capitalisation had increased by as much as 22% in Jun-17, (+12.5% in Sept-17), outperforming the FBMKLCI Index. The sector valuation has also surged from 16.7x forward P/E in Apr-17 to 21.8x in Jun-17 before prices retraced in recent weeks, possibly due to weaker sentiment on a stronger Ringgit. We believe that the current sector valuation of 19.2x forward P/E is fair and offers limited upside. As such, we downgrade our sector rating to NEUTRAL. For sector exposure, we prefer Top Glove (BUY, Target price: RM6.50) for its strong volume expansion, growing nitrile mix and relatively undemanding valuation.

Key Risks

Key upside risks: better-than-expected demand and/or margins. Key downside risks: stiffer pricing competition, volatility in raw material costs.

Source: Affin Hwang Research - 14 Sept 2017