We came away from Top Glove’s company visit feeling positive on its earnings prospects driven mainly by sustained demand growth for rubber gloves. Tell-tale signs, in particular, the stronger-than-expected volume growth and the 6% QoQ weakening of the Ringgit against the USD, are pointing towards a superb set of fullyear FY15 results for Top Glove, due in mid-October. Separately, the solid industry volume growth, longer delivery lead days, sustained weakening of the Ringgit against the USD and higher margin product mix skewed towards nitrile could see further margin expansion in subsequent quarters. Interestingly, the PER valuation of Top Glove (17.8x FY16E PER) has lagged its peers such as Kossan (19.6x FY16E PER) and Hartalega (22x FD CY16 PER), which we believe is unwarranted. Top Glove at 17.8x FY16 earnings is trading at an average 15% discount to Kossan and Hartalega’s FY16 PERs. We are upgrading FY15-16E earnings and TP from RM7.90 to RM9.16.

Maintain OUTPERFORM. 4Q15 results likely to beat market as well as our expectations. Tell-tale signs, in particular, the stronger-than-expected volume growth and the 6% QoQ weakening of the Ringgit against the USD in 4QFY15, are pointing towards a superb set of full-year FY15 results for Top Glove due in mid-October. We expect Top Glove to report a 4Q15 net profit of between RM79.5-RM81.7m (+10-15% QoQ), which brings FY15 net profit to RM256.5m- RM258.7m. If this happens, the results would be sharply above our full-year FY15E net profit of RM239.8m and the market consensus of RM247.6m. We expect to see demand growth across Asia, US and Europe driven largely by nitrile gloves which presently account for 33% of product mix (note that nitrile accounts for 30% in 3Q15). The potent combination of favourable USD/Ringgit, longer delivery lead days and higher margin product mix skewed towards nitrile gloves could see further margin expansion in subsequent quarters. Note that 3Q15 EBITDA’s margin was 17% which is a peak.

Solid industry demand and longer delivery lead times to underpin growth going forward. Solid industry numbers and longer delivery lead times are indicating that demand will outstrip supply at least over the medium-term. Case in point is 1Q15 when the total exports of rubber gloves, synthetic rubber (SR) and latex-based natural rubber (NR) combined rose 20% YoY to 13.5b pairs and 10% to RM2.7b in value. Specifically, Malaysia exported 7.5b and 6.0b pairs of latex and SR gloves or an increase of 7% and 33% YoY, respectively in 1Q15. Separately, the Malaysian Rubber Glove Manufacturers Association (MARGMA) has forecasted a 20% export growth for rubber gloves, which is largely on track with volume growth recorded in 1Q and 2Q CY2015 for rubber glove makers under our coverage. We understand that the robust demand for nitrile has led to longer delivery lead times (the moment order was placed and delivery) has risen to between 50 to 60 days as compared to 40 to 50 days (9 months ago).

Capacity expansion plans are on track, raising capacity by 17% to 52.4bn pieces over the next two years. Management has earmarked an estimated capex of RM150-200m per annum for building of new factory and production lines. We have factored this capex guidance into our earnings model. In terms of new gloves capacity, Top Glove has plans to raise production capacity by additional 7.8bn pieces of gloves to 52.4b (+17%) by end Dec 2016. The two plants namely F27 (Lukut, Port Dickson) and F30 (Klang) will focus on producing 2.0b and 4.4b pieces of latex gloves, respectively. F6 plant (in Phuket, Thailand) will cater for the production of latex (1.4b pieces). With an estimated operating cashflow averaging RM350m p.a over the next two years, funding is not an issue. For illustrative purposes, assuming 8% net profit margin, ASP of RM85/1,000 pieces and utilisation rate of 80%, this new capacity could generate a total net profit of RM45m or 16% of our FY16 forecast.

Raising FY15E and FY16E net profit, Raised Target Price to RM9.16. In anticipation of better-than-expected performance, we are raising our FY15E and FY16E net profit forecasts by 8-10% taking into account of higher utilisation rate and better-than-expected margin (our EBITDA margin assumption is now 18% for FY15E and FY16E compared to 16.8% previously). Correspondingly, we raise our TP from RM7.90 to RM9.16 based on 20x revised FY16 EPS as we conservatively raise Top Glove’s target PER valuation from 19x to 20x (slightly above its 5-year historical mean average of 18x). Top Glove historical valuation at peak earnings averaging between 23-27x PER. The PER valuation of Top Glove (17.8x FY16E PER) has lagged its peers such as Kossan (19.6x FY16E PER) and Hartalega (22x FD CY16 PER). We consider the under-performance as unwarranted. Top Glove at 17.8x FY16 earnings is trading at an average 15% discount to Kossan and Hartalega’s FY16 PERs. The valuation gap should narrow when we consider that Top Glove has similar/higher total capacity and net profit level compared to Kossan and Hartalega. Furthermore, 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 products producer, (ii) undemanding PER valuation at discount to peers, and (iii) solid management.

Source: Kenanga Research - 25 Sep 2015