We are maintaining our OVERWEIGHT rating on the rubber gloves sector. Although rubber glove stocks under our coverage have performed admirably YTD 2013 rising by an average 53% led by Kossan (+106%), Hartalega (+57%) and Supermax (+37%), in line with our OUTERFORM calls, we believe the sector to remain resilient and be further re-rated moving into 4QCY13 underpinned by: (i) the overall resilient demand for rubber gloves, led by latex gloves, although nitrile gloves, which have consistently been taking up the former’s market share, will continue to show better growth prospects, (ii) the weakening of the Ringgit against the US dollar, which is positive to rubber glove players, and (iii) the sustained low raw material prices. In our view, we believe the ramp-up of production capacity mainly for nitrile gloves amongst local players is expected to be well absorbed and hence unlikely to cause an oversupply situation till end CY2014. We expect any introduction of Goods and Services Tax (GST) and hike in natural gas price to have a neutral impact on rubber glove makers. Our TOP PICK is Kossan with an OUTPERFORM call and a higher TP of RM7.86 (RM6.88 previously) based on 16x FY14 EPS (14x previously). We think the narrower valuation gap between Kossan compared to both Top Glove and Hartalega is warranted due to: (i) its superior net profit growth of 18% and 27% in FY13 and FY14, respectively, compared to an average of 13% each for Top Glove and Hartalega in FY13 and FY14, (ii) unprecedented earnings growth underpins by capacity expansion over the next two years, (iii) potential margin expansion from the new plant; and (iv) Kossan’s improving dividend payouts. We have OUTPERFORM calls for Hartalega (TP: RM8.13 raised from RM7.32) and Supermax (TP: RM2.82) but MARKET PERFORM on Top Glove (TP: RM6.36).

Solid sales volume and results in 2QCY13. All four rubber glove stocks under our coverage reported 2QCY13 results that came in within our and the market expectations. Sales volume grew strongly YoY across the board led by Kossan (21% YoY, +1% QoQ), Hartalega (+23% YoY, +5% QoQ), Supermax (+11% YoY, +5% QoQ) and Top Glove (+17% YoY, +7% QoQ) due to capacity expansions as well as stronger demand fuelled by lower ASPs in tandem with easing raw material prices.

No major worries on the potential higher energy cost going forward. Looking ahead, we believe that rubber glove players may face higher production costs following the recent increase in fuel pump prices, which is in line with the Government subsidy rationalisation programme. Effective Jun 2011, the government raised the gas price by 7% to RM16.07 per mmbtu from RM15 per mmbtu. There will be a subsequent 8-19% price increase every 6 months until 2015. However, the dateline for the last review in December 2011 has passed without being effected while in 2011, the electricity tariff rate was raised by 8-10%. The hike in energy prices was expected, in line with the Government’s subsidy rationalisation programme. We are not overly concerned on any potential hike in gas price since energy cost makes up only 8-9% of the production cost.

Rubber glove players impact to GST is neutral. Generally, all goods exported out of Malaysia will be zero-rated. This means that the registered exporter does not collect GST on its exports. However, manufacturers, including rubber glove players would have to pay for GST on his business purchases or raw material costs before selling their product but is able to claim credit for the GST paid on the inputs. This means that manufacturers may have to carefully plan their cash flow and turnaround time.

Weakening of Ringgit vs. US dollar is a positive for 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 has weakened by 9% to RM3.26 from an average of RM2.99 against the dollar over the past several weeks. 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, nitrile gloves continue to lead. We believe that the average 10% demand growth p.a. for rubber gloves over the next few years can be sustained. In 2012, the total exports of gloves, synthetic rubber (SR) and natural rubber (NR) combined, rose 14.9% YoY to 40.7b pairs and 3.6% to RM9.8b in value. In 2012, Malaysia exported 18.6 billion pairs of SR gloves or an increase of 26% YoY. The overall demand is expected to continue to be led by NR gloves, although SR gloves have consistently been nibbling at the former’s market share. While latex-based gloves or NR gloves are still dominant (as a percentage to the overall exports of rubber gloves) in Malaysia, the trend is moving towards SR gloves. This was evident from the lower NR:SR sales value ratio of 61:39 in 2011 to 57:43 in 2012, and the sales volume ratio of 58:42 in 2011 compared to 54:46 in 2012.

Maintain OVERWEIGHT. Our TOP PICK is Kossan with an OUTPERFORM call and a higher TP of RM7.86 (RM6.88 previously) based on 16x FY14 EPS (14x previously) underpins by unprecedented future earnings growth arising from capacity expansion over the next two years and potential margins expansion from new plant. We maintain OUTPERFORM call on Hartalega and a higher TP of RM8.13 as we attach a higher PER rating from 18x to 20x CY14 EPS. The 20x PER is at a 20% premium to Top Glove’s 1-year forward PER of 16.4x due to Hartalega’s superior margins and better average three-year ROE of 33% vs Top Glove’s 18%. We have OUTPERFORM call for Supermax (TP: RM2.82) but MARKET PERFORM on Top Glove (TP: RM6.36).

KEY POINTS

Solid 2QCY13 demand and results were largely within expectations. Results from the gloves makers from the recently concluded 2QCY13 results season were mainly within our expectations, with four of the stocks under our coverage coming in generally within ours and the consensus expectations. Sales volume grew strongly YoY across the board led by Kossan (21% YoY, +1% QoQ), Hartalega (+23% YoY, +5% QoQ), Supermax (+11% YoY, +5% QoQ) and Top Glove (+17% YoY, +7% QoQ) due to capacity expansions as well as stronger demand fuelled by lower ASPs due to easing raw material prices. Interestingly, Supermax’s 2Q13 margins improved QoQ on the back of an estimated 3-5% increase in the ASP, which was already communicated to customers in Jan 2012 but took effect only from the second quarter (we highlighted this in our Supermax 1Q2012 results note).

No worries about potential high energy costs going forward. Looking ahead, we believe that rubber glove players may face higher production costs following the recent increase in fuel pump prices, which is in line with the Government subsidy rationalisation programme. Effective Jun 2011, the government has raised gas price by 7% to RM16.07 per mmbtu from RM15 per mmbtu. There will be a subsequent 8-19% price increase every 6 months until 2015. However, the dateline for the last review in December 2011 has passed and yet to be effected. At the same time, in 2011, the electricity tariff rate was raised by 8-10%. The hike in energy prices was expected, in line with the Government’s subsidy rationalization programme. We are not overly concerned on any potential hike in gas price since energy cost makes up 8-9% of production costs. The table below indicate that earnings of rubber glove players pre and post implementation of the hike in gas price back in 2011. However, take note that during 2011, latex price shot up the roof starting from 2H, which could also explain the sharp drop in earnings of Top Glove as they was most affected since product mix skewed towards natural rubber.

Demand for gloves still intact, nitrile gloves continue to lead. We believe that the average 10% demand growth p.a. for rubber gloves over the next few years can be sustained. In 2012, the total exports of gloves, synthetic rubber (SR) and natural rubber (NR) combined, rose 14.9% YoY to 40.7b pairs and 3.6% to RM9.8b in value. In 2012, Malaysia exported 18.6 billion pairs of SR gloves or an increase of 26% YoY. The overall demand is expected to continue to be led by NR gloves, although SR gloves have consistently been nibbling at the former’s market share. While latex-based gloves or NR gloves are still dominant (as a percentage to the overall exports of rubber gloves) in Malaysia, the trend is moving towards SR gloves. This was evident from the lower NR:SR sales value ratio of 61:39 in 2011 to 57:43 in 2012, and the sales volume ratio of 58:42 in 2011 compared to 54:46 in 2012. The quantity of NR gloves exported in 2012 rose 7% to 22.2n pairs YoY due to the low cost of the raw material input. The demand and strong double-digit growth rate of gloves are expected to continue with nitrile gloves taking the lead. We also expect latex-based gloves to continue to register positive volume sales as well due to the stable latex price.

Rubber glove players impact to GST is neutral. Generally, all goods exported out of Malaysia will be zero-rated. This means that the registered exporter does not collect GST on its exports. However, manufacturers, including rubber glove players would have to pay for GST on his business purchases or raw material costs before selling their product but is able to claim credit for the GST paid for the inputs. This means that manufacturers may have to carefully plan their cash flow and turnaround time.

Oversupply concerns in CY2014 appear overplayed. Looking at the new gloves capacity coming on-stream towards end-CY2014, we are not overly concerned of a potential oversupply situation at least in CY2014. Based on the back-of-the-envelope calculations, applying the same sales volume growth of 15% achieved in 2012 Malaysian exports of 81.4b pieces of rubber gloves to 2013 and 2014, this would yield an increase of 12.2b and 14.1b pieces, respectively. Note that in 1H 2013, the average sales volume growth was between 18-20% which outpaced the 15% growth assumption we illustrated above. As such the expected 14.1b pieces volume growth is slightly less than the totalled estimated new capacity of rubber glove players under our coverage of 16.4b. Hence, we believe any oversupply concerns in CY2014 appear overplayed. Furthermore, most glove manufacturers can only run at an average maximum utilisation rate of 90% as they require some downtime for maintenance while industry capacity expansions are only coming in progressively throughout CY2014. This implies the addition of only 14.8bn pieces (90% of 16.4b pieces) at end-CY2014.

Weakening of Ringgit (RM) vs. US dollar (USD) is short term 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 has weakened by 9% to RM3.26 from an average of RM2.99 against the dollar over the past several weeks. 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. However, we believe the impact from currency movements (RM vs USD) to glove players’ earning is neutral over the long-term. This is because glove players typically hedge the currency on a consistent basis, hence in theory any negative or positive impact will be offset over time. Despite the de-pegging of the Ringgit back in 2005 (Recall – the peg was at RM3.80 against USD1.00), glove players were still able to maintain their margins as well as registering yoy earnings growth (underpin by consistent yoy sales volume growth).

Expecting raw material inputs to trade lower or maintain current price levels going forward. We expect both input raw material price of latex and nitrile to stay soft at least over the medium term. We understand that there is abundant supply of nitrile raw material and we do not anticipate a shortage of nitrile for the remaining of 2013. China is going ahead with adding eight more crude oil based naphtha crackers (Butadiene is input raw material for nitrile is produced through hydrocarbon i.e., natural gas or naphtha) within the next two years with four already rolling off the press in the first quarter of 2013 namely China Maoming Petrochemical Shihua 100k tonnes capacity in Guangzhou, YPC-GPRO 100k tonnes capacity in Nanjing, Sichuan Petrochemical 100k tonnes capacity in Sichuan and Zhejiang Transfer Synthetic National 150k tonnes capacity in Hangzhou. Formosa Petrochemicals in Taiwan, Titan Petrochemicals and Pertamina in Indonesia, Thailand PTT Global Chemicals and Bangkok Synthetics are also planning to increase capacity. These indicate that there will be no shortage of supply of nitrile raw materials over the next two years. Similarly, latex price appears to trend or remain sustained low throughout the remainder of 2013 and over the medium term. Slowdown from China, the biggest rubber user, consuming 3.85 million tons last year, representing 34% of global demand due to the slower-than-expected economic growth there. According to RCMA Commodities Asia Group, a Singapore-based company that has traded rubber for nine decades, rubber is headed for the biggest glut on record as supply exceeds demand for a third year and Southeast Asian exporters ended curbs on shipments. The surplus will expand 57% to 490,000 metric tons this year, enough to meet U.S. demand for six months. As such, the surplus is expected to push down prices of natural rubber or at least remain low over the medium to long term. China, the largest buyer, will import 14% less in the seven months ending in December than a year earlier, the Association of Natural Rubber Producing Countries estimates.

Top pick Kossan, target price raised to RM7.86. YTD, Kossan’s share price has appreciated >100%, outperforming its peers which only rose an average 35%. We believe Kossan should be trading at higher PER multiples and be further re-rated, underpin by unprecedented future earnings growth arising from capacity expansion over the next two years and potential margins expansion from new plant of which the market has yet to factored in. As such, we are raising our TP by 13% from RM6.88 to RM7.86 by applying a higher PER of 16x FY14 EPS (from 14x). Currently, Top Glove and Hartalega are trading at 16.4x and 20.3x on FY14E earnings respectively. We believe Kossan’s historical 40% PER valuation discount to Top Glove and Hartalega should narrow considerably when we consider the following: (i) Kossan’s superior net profit growth of 18% and 27% in FY13 and FY14, respectively, as compared to an average of 13% and 13% for Top Glove and Hartalega in FY13 and FY14 (Supermax’s FY13 and FY14 average net profit growth is 14%), (ii) Kossan’s unprecedented earnings growth underpinned by capacity expansion over the next two years, and (iii) improving dividend payout policy - it is gradually raising its dividend payout ratio (Kossan recently declared a final seven sen tax-exempt dividend. This brought its total full-year FY12 DPS to 12.5 sen, implying a 38% payout ratio – well ahead of its <20% payout ratios in the past three years.

Potential margins expansion from new gloves production lines due to revised production scheduling. We believe Kossan’s new gloves production lines could potentially lead to higher margins due to improved productivity and efficiency as the lines are designed to focus on larger orders with fewer clients (compared to previous production scheduling model) for a single product type and specification, thus reducing idle downtime from frequent machinery setting adjustments to accommodate diverse specifications. This could lead to an output of 35,000 pieces of gloves per hour, which is higher than its existing average production line speed of 29,000 gloves per hour, a robust 20% enhancement. Its current production style comprises shorter production lines catering to a large customer base with diverse products, which reduces reliance risk on few larger clients. However, such an arrangement limits margin expansion due to more downtime on frequent machinery setting adjustments.

Two bets for the price of one. Kossan is not just a rubber glove play but a bet on its TRP division, which is growing strongly and is expected to contribute positively to overall earnings. This is because the TRP division has been growing at >20% QoQ at the pre-tax profit level over the past few quarters. For FY12, the division’s pre-tax profit rose 62% YoY and accounted for 14% of the group’s pretax profit compared to 12% in FY11. We are positive its TRP division expansion into Indonesia’s booming automotive sector, which is expected to see high demand for engine parts. For the automotive industry, the TRP division has experience in producing parts, including anti-vibration application in the forms of mounting bushes and hangers. These products include engine mounting for damping and antivibration, shock absorbing bushes for shock absorbers and chassis, exhaust hanger, under-hood profiles and sponge. Kossan is also looking to market its TRP products in Indonesia for the heavy industries covering construction and infrastructure, i.e. bridges, which include engineered rubber products such as bridge bearing and railway pads, compression seals and expansion joints.

We like Hartalega for: (i) its “highly automated production processes” model, (ii) the solid improvement in its production capacity and reduction in costs, leading to better margins compared to its peers, (iii) its superior quality nitrile gloves through product innovation and (iv) its dominant position in a booming nitrile segment.

Hartalega target price raised to RM8.13. The share price of Hartalega has appreciated >40% since our last upgrade. We are upgrading its TP from RM7.32 to RM8.13 as we attach a higher PER rating from 18x to 20x CY14 EPS (at +2.0 SD of its historical average). The 20x PER is at a 20% premium to Top Glove’s 1-year forward PER of 16.4x target due to its superior margins (Hartalega’s pre-tax margins averaged at 29% vs Top Glove’s 12% and industry peers of 13% over the last three years) and better average threeyear ROE of 33% vs Top Glove’s 18%. Note that Top Glove in its prime days as industry leader trades at >20x PER. We believe Hartalega is the new leader whereby the industry is undergoing changes in terms of product mix, shifting more towards nitrile gloves where Top Glove appears to be lagging behind.

We also like Supermax because it is trading at 11x FY14 EPS (30% discount to the sector average) compared to an average 14% net profit growth over the next two years. SUPERMX’s YTD share price performance (+37%) is still lagging other players such as Kossan (+106%) and Hartalega (+57%). Since our upgrade report in Feb 2013, the stock has risen by 30%. A re-rating of the stock is imminent as the latest 2Q13 results registered margin improvement, which dispelled market scepticism that SUPERMX was unable to implement cost pass-through to counter the higher cost from the minimum wage policy. Maintain OUTPERFORM with a TP of RM2.82 based on 12x FY14 EPS (The targeted PER is at +1.0SD level above the 5-year historical average).

Supermx’s new capacity net margin ranges between 9% to 11%. In anticipation of intense competition, management guided that the average selling price (ASP) for the new gloves capacity is priced such that net margin ranges between 9% and 11%. Although this is slightly below our 11.9% net margin forecast in FY14, we are not overly concerned. This is because SUPERMX is gradually automating its production processes starting from Lot 6070. Next, the two new plants in Lot 6058 and Lot 6059 in Meru, Klang when completed by early 1Q14 is expected to be fully automated from mechanical stripping to packing of gloves, which will lead to improvement in production efficiency. As such, we believe overall margins could improve due to better productivity and efficiency from the new plants. Additionally, unlike other glove players, SUPERMX does not face the risk of high downtime on production lines since they do not cater much for clients requesting for a single product type and special specification needs, thus reducing idle downtime from frequent machinery setting adjustments to accommodate such requirements.

We maintain MARKET PERFORM on Top Glove and TP of RM6.36 based on 15x CY14E EPS. We believe Top Glove is finding difficulty in raising its ASPs in the challenging latex-based gloves market (70% of the product mix) to mitigate impacts from the minimum wage policy.

Source: Kenanga