Although the rubber products sector was one of the best performing sectors in Malaysia for 2018, share prices have corrected by -11.5% since the start of the year and underperforming the FBMKLCI's return of +0.2%, due to renewed concerns over potential supply overcapacity and the recent strengthening of the RM. While we still maintain our Overweight call on the sector, there could be downside risk to our thesis, depending on the outcome of China’s environmental policy.

The Switch From Vinyl Might Slow

As economic activities slowed in China due to the on-going trade tensions, the government has set a less ambitious environment goal target for 2019. Manufacturers have been given a longer grace period to convert their coalbased burners to the more environmentally friendly gas-based burners. The change has helped eased the shortage in vinyl gloves and reduced the overall selling prices for vinyl gloves. Nevertheless, as we still believe that the China government is still keen on improving the country’s air quality, the conversion will resume, in or view. We still expect prices for vinyl gloves to rise, expediting the switch from vinyl gloves to latex/nitrile gloves.

Malaysia Glove Maker Market Share Could Improve

The negative impact might be reduced, as medical gloves exported from China to US is currently exempted from additional tariff, and if the trade tensions do escalate and a 25% tariff is imposed on all items imported from China, manufacturers from other countries like Malaysia are potential beneficiaries. China’s medical glove export market share to US is around 30%, and 70% of those gloves are vinyl based. US is the world largest medical glove consumer, consuming 30-35% of global production.

Strengthening of RM Is Not a Concern

We are not too concerned over the strengthening of RM against USD, as we have assumed an exchange rate of RM3.9/USD by end of 2019. Moreover we believe that manufacturers are able to pass on the rising production cost to customers, within a reasonable period (2-4weeks). However, the spike in volatility of the RM recently might put pressure on margins, as manufacturers might not able to revise their pricing significantly in over a short period of time. Nevertheless, we believe the problem is short-term in nature.

Competition Will Always be There

We expect Malaysian manufacturers to raise their capacity by around 15- 18% for 2019. While the capacity growth may outpace the demand growth of 8-10%, we do not think that this will create an overcapacity issue as older production lines will be phased out to cater for speciality gloves. Manufactures are also venturing into the non-medical sector, which provide additional avenue for growth.

Valuation and Recommendation, Key Stock Ideas

Kossan (BUY, TP: RM5.15) and Supermax (BUY, TP: RM2.30) are Top Buy ideas for Malaysia and our preferred picks for the sector. We believe that both offer a cheaper alternative to its peers, Top Glove (HOLD, TP: RM6.00) and Hartalega (HOLD, TP: RM6.30), as we believe that the valuation gap will eventually narrow.

Source: Affin Hwang Research - 11 Feb 2019