Despite the weak 9M19 results, we are upgrading the sector to Overweight from Neutral, as we believe that the worst is over and earnings growth would resume in 2020. Higher production costs and labour issues were the 2 common factors that led to the earnings disappointment. We believe that the companies are already addressing the issues, and we are expecting better performance starting 1Q20. We make some changes to our preferred picks, as Top Glove and Kossan are now our top BUYs for the sector.

No Winners in 3Q19

Sector earnings for 9M19, down by 12% yoy, came in below both the consensus and our estimates, delivering around 66% of the respective forecasts. Apart from the increase in production cost (higher utilities cost) arising from the natural gas price hike in July, the sector was also faced with labour shortage since the hard cap on overtime limited the total allowable overtime in a month to 104 hours only. As both were industrywide issues, almost all the glove makers recorded declines in profit yoy for the 9M19. Due to the weak performance, we had cut our earnings forecasts for 2019-22E by 5%-6%.

Labour Issue Impacting the Sector

We had underestimated the impact of the report relating to forced labour issues in the rubber glove sector, which we believe caused a 15-25% shortage in manpower, post the hard cap on the allowable overtime for employees. The government’s decision to freeze the recruitment of Bangladeshi workers, due to concern over bonds related to debt, had worsened the problem. Some companies have started recruiting from other countries or received approval to recruit directly to address the problem. We are also expecting the government to re-open the recruitment soon, after rooting out the problematic recruitment agencies.

Higher Utilities Cost Will be Passed on

The industry was also negatively impacted by the 5.3% hike in natural gas tariff in July, which we believe reduced GP margins by 0.5%-0.8% in 3Q19. It was challenging for the manufacturers to raise prices with such short notice (3 days), as the lead time for orders was around 45 days. Given that the impact of the gas price hike was across the board, we believe that the manufacturers have already started passing on the higher cost to customers. Hence, we are expecting margins to recover in 4Q19. Longer term, unless the government is willing to provide a 1-2 weeks’ notice prior to a price hike, the problem would likely persist.

A Better 2020

We believe that 2020 would be a better year for the gloves makers, as they would likely benefit from stronger demand from the US after its imposition of a 15% tariff on Chinese imported gloves. As the concern in 3Q is being resolved, the rubber glove manufacturers are poised for a better 2020. The improving prospects and likely stronger earnings growth will help with a re-rating of the sector; hence we upgrade our sector rating from Neutral to Outperform. Top Glove and Kossan are our top BUY picks for the sector.

Domestic Issues Hurt Profit in 3Q19

We have cut the earnings forecasts for all the glove manufacturers after their recent results announcements, to incorporate the weaker earnings in 3Q19. The common themes of the 3Q19 earnings were labour issues and higher production costs. Post the cuts, we now forecast earnings growth of 0% for 2019 and 12% for 2020, compared to 5% and 13% previously.

Positioning for a Better 2020

With the problems faced in 3Q19 gradually being resolved, coupled with higher demand from the US, we believe that the sector is poised for a better 2020. Given the better prospects, we think that sector valuations could re-rate as the earnings start to kick in. The sector is currently trading at around its historical average, which we believe is undemanding given the improving prospects. In our view, the larger cap names are likely to move ahead of the smaller cap names, despite having slower earnings growth.

Risk to Our Ratings

Downside risks: 1) a sharp spike in the volatility of the USD/MYR, 2) higher-than-expected production cost, and 3) a prolonged labour shortage issue. Upside risks: 1) glove supply cut in China, and 2) change in regulation to mandate usage of gloves.

Source: Affin Hwang Research - 6 Dec 2019