We maintain our OVERWEIGHT rating on the rubber gloves sector. The positive outlook is driven by commercial production of new capacity expected to come on-stream by 1QCY15, which will drive earnings growth. We believe persistent concerns over falling demand, fears of oversupply and price wars are overplayed as addressed in our past quarterly strategy reports. As an indication, selected stock prices of rubber gloves stocks under our coverage are currently trading close to their previous highs. Our investment case is based on: (i) earnings growth to resume in subsequent quarters, underpinned by new capacity expansion fueled by sustained demand for rubber gloves, led by nitrile gloves, (ii) our analysis that the new capacity expansion is slower-than-expected, which should help maintain the supply-demand equilibrium, (iii) favourable USD/MYR exchange rate, and (iv) the sustained low raw material prices. Our Top Pick is HARTALEGA. We like HARTALEGA for its: (i) highly automated production processes model, (ii) solid improvement in its production capacity and reduction in costs leading to higher margins compared to its peers, (iii) innovation in producing superior quality nitrile gloves, and (iv) positioning in a booming nitrile segment with a dominant market position. We also have OUTPERFORM calls for KOSSAN (TP: RM5.13) and SUPERMX (TP: RM3.06).

3QCY14 results were below expectations. Rubber gloves stocks under our coverage delivered results below our, and market consensus, expectations in the recently concluded 3QCY14 reporting season. Hartalega’s results were lower due to higher-than-expected operating expenses arising from new recruitment of labour for the incoming NGC project. Kossan’s poor set of results were due to slower-than-expected commercial production of a new plant and higher-than-expected start-up cost incurred. Supermax’s underperformance was due to lower-than-expected sales volume. However, we are not perturbed and expect earnings growth to resume in subsequent quarters, underpinned by new capacity expansion.

New in-coming capacity to kick-start quarterly earnings growth. The stage is set for rubber gloves stocks namely, Kossan, Supermax and Hartalega to re-rate, underpinned by new in-coming production capacity, gradually starting in end 4QCY2014, which will kick-start subsequent quarterly earnings growth. After three quarters in the lull, we believe rubber glove players under our coverage will see a re-rating once commercial production of new capacity comes on-stream by 1QCY15. Hartalega’s NGC plant is expected to start commissioning by end Dec CY14. Kossan’s Plant (1) with 5 lines was completed in June with commercial production from August 2014. The remaining Plant (2) and (3) with a total of 12 lines are expected to be operational in September and November. On Supermax, we understand that one line, from the new plants namely Lot 6059 and Lot 6058, is expected to start commissioning. From our channel checks, demand for nitrile gloves is strong. Players are generally facing full capacity constraint and have to turn away customers due to the overwhelming demand taking advantage of the lower ASPs.

Slower-than-expected ramp up in new supply is positive to industry. In the past two quarters we have highlighted that concerns of industry oversupply have been overplayed. In fact, in-coming new supply had been slower-than-expected. 9MYTD; only Kossan and Top Glove have started commissioning their new plants gradually between 2QCY14 and 3QCY14, albeit at a slower pace. As such the slowerthan-expected ramp-up in new production capacity further reinforces our positive outlook on the sector by allaying concerns on competitive pressure and oversupply issues. Kossan’s scheduled new 5b pieces capacity has been delayed from March to end-Aug 2014 which gradually ramp the 1st plant. The remaining 2 plants, i.e. Plant (2) with 6 lines delivered in September and we understand that buyers have been found; and Plant (3) with a total of 6 lines is scheduled to be delivered in 1Q15. Supermax’s new plant, with an estimated 5.4b pieces production output, has been delayed and can only start commercial operations by 1Q 2015 with an estimated net incremental increase of 1.5b pieces (earlier projection was 2.5b pieces). Top Glove is scalling back and only expects 2b pieces new capacity by end-2014. Hartalega’s NGC plant is only expected to commence commercial production by end 4Q 2014 with a net incremental increase of 2.0b pieces by end 2014.

Weakening of Ringgit (RM) vs. US dollar (USD) is short-term positive to rubber glove players. YTD, the USD had risen by 6.7% against the RM (USD1 = RM3.49). 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. Ceteris paribus, a 1% weakening 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’ earnings 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 neutralised 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 (underpinned by consistent yoy sales volume growth). Note that since nitrile raw material prices are quoted in USD, this gives manufacturers a natural hedge as ASPs are also quoted in USD.

NBR tracks crude oil price. We believe nitrile butadiene rubber (NBR) prices have in previous months risen substantially due to the then high crude oil prices (by-products of ethylene are feedstock for NBR) and tight supply situation. Generally, NBR price moves in tandem with crude oil. Note that crude oil prices have fallen by 41% to USD59 per barrel off its high and hence we expect NBR price to follow suit. This augurs well for nitrile glove manufacturers.

Maintain OVERWEIGHT. Our TOP PICK is HARTALEGA with an OUTPERFORM and TP of RM7.73. We raised Hartalega TP to RM7.73 from RM7.36 based on higher CY15 PER of 21x compared to 20x previously to take into account of its ability to ramp up utilization from its new plants (at +>1.0 but <+2.0 SD above its historical average). We like HARTALEGA for its: (i) highly automated production processes model, (ii) solid improvement in its production capacity and reduction in costs leading to higher margins compared to its peers, (iii) innovation in producing superior quality nitrile gloves, and (iv) positioning in a booming nitrile segment with a dominant market position.

Source: Kenanga