Gas Malaysia in an announcement to Bursa Malaysia informed that the Government has approved a natural gas tariff revision for non-power sectors in Peninsular Malaysia with effect from 1 July 2015 (3rd consecutive increase since Apr 2014) by an average of 10%. Ceteris paribus, assuming “no-cost pass through”, an average 10% increase in natural gas tariff is expected to marginally impact rubber gloves players’ earnings by merely 1-2%. However, we are not overly concerned since rubber gloves players have generally been able to pass on the cost increase judging from past experiences in natural gas tariff hikes, such as in May 2014 and Nov 2014. Hence, we are maintaining our OVERWEIGHT rating for the rubber gloves sector. The stage is set for rubber gloves makers to post decent-to-solid quarterly earnings growth over the next few quarters. Our investment case is based on: (i) resumption of earnings growth in coming quarters, underpinned by new capacity expansions matched and fueled by sustained demand for rubber gloves, led by nitrile gloves, (ii) favourable USD/MYR exchange rate, and (iii) the sustained low raw material prices, especially latex. Our Top Pick is HARTA with a TP of RM9.50. We continue to like HARTA 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: RM7.06) and SUPERMX (TP: RM2.30).

Average 10% tariff hike for natural gas for non-power sectors. Gas Malaysia Berhad in an announcement to Bursa Malaysia informed that the Government has approved a natural gas tariff revision for non-power sectors in the Peninsular Malaysia taking effect from 1 July 2015 (3rd consecutive increase since Apr 2014) by an average of 10%. This is the third increase for natural gas hike within a year. Recall, the previous increase was back in Nov 2014 with an average of 2.3%. Ceteris paribus, assuming no cost pass-through, the hike in natural gas tariff is expected to hit rubber gloves players’ earnings by 1-2%. However, we are not overly concerned since rubber gloves players generally have been able to pass on the cost increase judging from past experience in natural gas tariff hikes back in May 2014 and Nov 2014. Fuel accounts for an average 10% of production cost, of which natural gas accounts for an average of 7% of the production cost. Based on our back-of-envelope calculation, players need to raise their average selling prices by 1-1.3%. Generally, its takes approximately between one to three months to pass through the cost increase. However, the weakening of the Ringgit (RM) against the US Dollar (USD) makes its relatively easier for glove makers to pass cost through.

Solid results for gloves makers in the recently concluded 1QCY15. Results of gloves makers from the recently concluded 1QCY15 results season were mainly within or marginally above expectations, underpinned by both volume growth from new capacity expansion and favourable USD/MYR exchange rate. Note that sales volume grew strongly YoY for Kossan (30% YoY, +5% QoQ), Hartalega (+11% YoY, +6% QoQ) and Top Glove (+5% YoY, -3% QoQ). We expect the continuous weakening of the RM against the USD and new capacity expansion to drive subsequent quarters’ earnings growth.

Maintain OVERWEIGHT. Our TOP PICK is HARTA with an OUTPERFORM and TP of RM9.50 based on 24x FD CY16 EPS (at +2.0 SD above its historical forward average). We expect share prices of rubber gloves players, specifically both KOSSAN and HARTA to continue to gain further momentum, underpinned by subsequent quarters’ sequential earnings growth trajectory driven by gradual ramp up in the new capacity expansion. We like HARTA for its: (i) highly automated production processes model, (ii) solid improvement in its production processes 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.

Maintain OUTPERFORM on KOSSAN with a TP of RM7.06 based on 19x FY16 EPS (at +2.0 SD above its historical forward average). Although it has already gained 45.4% YTD, we continue to like it. We expect strong subsequent quarters’ results and potential margin expansion to attract market attention. We like KOSSAN for its: (i) superior net profit growth of 43% and 15% in FY15E and FY16E, respectively, and (ii) unprecedented earnings growth over the next two years underpinned by rapid capacity expansion.

Source: Kenanga Research - 10 Jun 2015