We maintain a Neutral rating on the rubber glove sector. The recently concluded 4QCY12 results season was within our expectations, with the four stocks under our coverage reporting results that were generally within ours and the consensus expectations. Sales volume largely grew QoQ across all the companies, led by Kossan Rubber Industries. Moving into 2QCY13, the overall demand for rubber gloves is expected to be resilient as a higher sales volume of nitrile gloves is likely to more than offset the expected flat to lower sales volume of latex gloves. However, re-rating catalysts for the sector are scarce as the stable volume growth and the mildly positive weakening trend of the Ringgit vs. USD are expected to be negated by the minimum wage policy and over the longer term, higher natural gas prices. Our top pick in the sector is Kossan Rubber Industries (“KOSSAN, TP: RM3.64).

4Q12 results were largely within expectations. All four rubber glove stocks that we cover reported results that came in within ours and the market expectations in their 4Q12 results. Sales volume largely grew QoQ across all the companies led by Kossan (+17% QoQ; 40% YoY), Supermax (+13% QoQ; 10% YoY), Hartalega (+7% QoQ; +29% YoY) and Top Glove (+6% QoQ; +23% YoY) due to capacity expansions as well as higher demands fueled by the lower ASPs due to the easing input of raw material prices. The average bulk latex prices declined by 5% QoQ (from an average of RM6.20/kg in 3Q2012 to RM5.88/kg in 4Q2012) while nitrile prices fell by 9.3% QoQ. For the full year 2012, the average input prices of latex and nitrile declined by 20% each.

Potential margin squeezed going forward? Due to the implementation of the minimum wage policy starting 1 Jan 2013 and the low latex production in 1QCY13, rubber glove players could face a margin compression in the 1Q as well as in subsequent quarters. Latex prices have been trading at a stable rate of between RM5.50/kg and RM6.00/kg over the last 6-9 months, which augur well for the rubber glove players. However, in anticipation of a lower latex production between Feb and May, the latex price is expected to move upwards. The lag effect in passing on the higher cost to customers via higher ASPs could crimp profit margins of rubber glove players in the short term. More importantly, starting from 1QCY13, rubber glove players face the prospect of a margin erosion form the minimum wage policy. A case in point is Top Glove’s recently released 2QFYAug13 results, which showed a margin erosion due to the minimum wage policy. Meanwhile, in a bid to mitigate the effects of the minimum wage policy, rubber glove players have adjusted upwards their ASPs by 2%-4%. In addition, most of the players have also invested in automation and computerisation of their manufacturing processes and have gradually reduced their reliance on manual workers to minimise the adverse effect of the minimum wage policy. Some of the automations put in place include the: (i) automated mechanical stripping system (removing gloves off hand moulds) and (iii) glove puller and stacker system. The benefits from automation will take some time to mitigate the effects of the minimum wage policy. Similarly, the increase in ASPs may not be enough to counter the average increase of between 30% and 50% in the wages.

Foreign workers to pay levy instead of employers with immediate effect. Recall that the Cabinet has decided on 30 Jan 2013 that foreign workers should pay the levy instead of employers. The decision is to be enforced with immediate effect on new foreign workers and those who wish to renew their work pass, employment pass or temporary work visit pass. The levy imposed on each foreign worker in the rubber glove industry is expected to be RM1,250 per annum. This cost savings to employers, however, is of little cushion to the additional 30%-50% increase in wages that they have to absorb from the implementation of the minimum wage policy above. Based on our back-of-the-envelope calculation, after taking into account of: 1) the minimum wage policy; 2) cost savings on the foreign workers levy; 3) an average ASP hike of 2%; and 4) savings from automation, the overall impact is expected to hit Top Glove, Kossan Rubber, Hartalega and Supermax’s bottom lines by between 7% and 9%. Note that labour accounts for 9.0% of the overall production cost.

Weakening of Ringgit vs. US dollar is positive to rubber glove players. Generally, a weakening Ringgit is positive for glove makers. Since sales are USD denominated, theoretically, a depreciating ringgit against the dollar will lead to more revenue receipts for glove makers. The ringgit is currently hovering between RM3.08 and RM3.11/USD. Ceteris paribus, a 1% depreciation of RM against USD will lead to an average 1%-2% increase in the net profit of rubber glove players.

Demand for gloves still intact, moving towards nitrile gloves. We believe that the average 8-10% demand p.a. for rubber gloves over the next few years is still intact. On the overall, the demand is expected to continue to be led by natural rubber (NR) gloves but synthetic rubber (SR) gloves have consistently been taking up the former’s market share. According to the Malaysian Rubber Export Promotion Council (MREPC) over the last two years, Malaysia’s exports of rubber gloves, NR and SR have deteriorated. In 2011, NR was still dominant (as a percentage of the overall exports of rubber gloves) in Malaysia, but the trend is moving towards SR. This was evident from the NR:SR sales volume ratio of 69:31 in 2010 compared to 58:42 in 2011. As at 12M2012, the NR:SR sales volume ratio was at 55:45. Amplifying the demand growth for nitrile gloves are its superior quality and lightness (vs. natural rubber gloves) as well as the fact that volatile latex prices have narrowed the ASP gap between latex and nitrilebased gloves, making the latter cheaper during a rising latex price environment.

Source: Kenanga