We maintain our OVERWEIGHT rating on the rubber gloves sector. Rubber glove stocks under our coverage have performed well YTD, led by KOSSAN (+47%), SUPERMX (+25%), HARTALEGA (+20%), and TOPGLV (+47%). Nevertheless, we see further upside in share price performance moving into 3Q15. Our investment case is based on: (i) sequential earnings growth to continue in coming quarters, underpinned by new capacity expansions matched and fueled by pent-up demand for rubber gloves and nitrile gloves, (ii) favourable USD/MYR exchange rate, and (iii) the sustained low raw material prices, especially latex. We expect glove makers to announce the second consecutive sequential quarterly growth in 2QCY15 due to the pent-up demand underpinned by new capacities, taking the que from Top Glove’s recently announced 3Q15 results and favourable forex rates. We have switched our TOP PICK from HARTALEGA to TOPGLOV. The PER valuation of TOPGLOV (16x FY16 PER) has lagged its peers such as Kossan (17.5 FY16 PER) and Hartalega (21x FD CY16 PER) and we consider the underperformance unwarranted. Top Glove at 16x FY16E earnings is trading at a discount to Kossan and Hartalega. The valuation gap should narrow when we consider that Top Glove’s net profit is similar to Kossan and Hartalega but with a dominant capacity size. We also have OUTPERFORM calls for HARTLEGA (TP: RM9.50), KOSSAN (TP: RM7.05) and SUPERMX (TP: RM2.30).

Solid results for gloves makers in the recently concluded 1QCY15. Results of glove makers from the recent 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.

Demand for gloves still intact, nitrile gloves continue to lead. We believe that the average 8-10% growth in demand p.a. for rubber gloves over the next few years is still intact. In 2014, the total exports of rubber gloves, synthetic rubber (SR) and latex-based natural rubber (NR) combined rose 8.6% YoY to 48.9b pairs and by 2.5% to RM10.7b in value. In 2014, Malaysia exported 24.9 billion pairs of SR gloves or an increase of 10% YoY. The Malaysian Rubber Glove industry has marked a milestone whereby for the first time SR gloves have overtaken NR gloves in terms of market share. This was evident from the lower NR to SR sales volume ratio of 61:39 in 2011 to 49:51 in 2014. The demand and strong double-digit growth rate of gloves are expected to continue, driven by nitrile gloves. We also expect latex-based gloves to continue to register positive volume sales as well due to the stable latex prices. Growth will be supported by higher health standards and expanding use of rubber gloves.

How much higher can rubber glove stocks trade? Based on historical valuation at peak earnings, rubber glove stocks namely Kossan, Hartalega and Top Glove trades at between 19x to 27x PER valuation (see chart below) or at +2SD above forward mean average. We believe rubber glove stocks are poised for a further re-rating and should trade at its previous peak PER valuation given that all players manage to evolve as such; (1) Automating their plants and production processes leading to better efficiency and productivity, potentially translating to better margins, (2) Standing testimony to rubber glove makers’ resilience and hence ability to transform and increasing product mix from purely latexbased gloves into the higher margin nitrile-based gloves, and (3) expected to report solid and record peak quarterly earnings. Both Kossan and Top Glove announced their best quarterly earnings since 2001. Kossan and Hartalega are currently trading at between 17.5x and 21.2x FY16 PERs which are close to their current peak PER valuation of 18.7x and 26.0x, respectively. However, Top Glove offers higher upside. Top Glove is currently trading at 16.0x FY16E EPS (lower than historical 5-year forward mean average of 18x) compared to its historical peak valuation averaging 23x.

Maintain OUTPERFORM on KOSSAN with TP of RM7.06. We believe KOSSAN’s new gloves production lines could potentially lead to higher margins from improvement in 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. We like Kossan for: (i) its superior net profit growth of 43% and 15% in FY15E and FY16E, and (ii) the unprecedented earnings growth over the next two years underpinned by rapid capacity expansion.

Maintain OUTPERFORM on Hartalega with TP of RM9.50 based on 24x FD CY16 EPS (at +2.0 SD above its historical forward average). We like HARTALEGA 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.

Our TOP PICK is Top Glove with an Outperform with TP of RM7.90. The PER valuation of Top Glove (16x FY16 PER) has lagged its peers such as Kossan (17.5x FY16 PER) and Hartalega (21x FD CY16 PER). We consider the under-performance unwarranted. Top Glove at 16x FY16E earnings, is trading at an average 18% discount to Kossan and Hartalega FY16E PERs. The valuation gap should narrow when we consider that Top Glove has capacity and net profit levels similar to Kossan and Hartalega. Correspondingly, due to the better-than-expected showing from Top Glove’s recently announced 3Q15/9M15 results which marks its second consecutive quarter of margins improvement demonstrating that the group’s automation journey started three years ago are bearing fruits compels us to conservatively raise Top Glove’s target PER valuation from 17x to 19x (slightly above 5-year historical mean average). Note that Top Glove’s share price rose 15% following the strong 3Q15 results. By the same token, our target price is raised from RM7.05 to RM7.90 based on 19x FY16E EPS. We like Top Glove for: (i) its ability to evolve from purely a dominant latex-based rubber gloves producer into a higher margin nitrile based product player, (ii) undemanding PER valuation’s discount to peers, and (iii) solid management. 

Source: Kenanga Research - 2 Jul - 2015