We maintain our OVERWEIGHT rating on the rubber gloves sector. Rubber glove stocks under our coverage have performed well YTD, led by TOPGLV (+72%), KOSSAN (+70%), HARTALEGA (+40%) and SUPERMX (+16%). The sustained weakness in Ringgit against the US Dollar coupled with longer delivery lead days implying robust demand is expected to drive sequential earnings growth and provide impetus for further upside in share price performance moving into 4Q15. 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, especially nitrile gloves, (ii) longer delivery lead days, (iii) favourable USD/MYR exchange rate, and (iv) sustained low raw material prices especially latex. The PER valuation of Top Glove (17.8x FY16E PER) has lagged peers such as Kossan (19.6x FY16E PER) and Hartalega (25.4x FD CY16 PER), which we believe is unwarranted. Top Glove at 17.8x FY16E earnings is trading at an average 15% discount to Kossan and Hartalega’s FY16 PERs. The valuation gap should narrow considering that Top Glove has similar/higher total capacity and net profit level compared to Kossan and Hartalega. Hence, our Top Pick is Top Glove (TP: RM9.16). We also have OUTPERFORM calls for HARTALEGA (TP: RM5.30) and KOSSAN (TP: RM8.16). SUPERMX is at MARKET PERFORM (TP: RM2.38).

Solid results for gloves makers in the recently concluded 2QCY15. Results of glove makers from the recent 2QCY15 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 (37% YoY, +5% QoQ), Hartalega (+15% YoY, +5% QoQ) and Top Glove (+5% YoY, -3% QoQ). We expect the continuous weakening of the MYR against the USD and new capacity expansion to drive subsequent quarters’ earnings growth.

Demand for gloves still intact, 1Q15 Malaysia gloves exports recorded 20% YoY growth. We believe that the average 8-10% demand p.a. for rubber gloves over the next few years is still intact. In 1Q15, 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. The Malaysian Rubber Glove industry has marked a milestone in 2014 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 to be driven by nitrile gloves. We also expect latex-based gloves to continue to register positive volume sales as well due to the stable latex price. Growth will be supported by higher health standards and expanding use of rubber gloves. Separately, the Malaysian Rubber Glove Manufacturers Association (MARGMA) has forecasted a 20% export growth in rubber gloves, which is largely on track with volume growth recorded in 1Q and 2Q of CY2015 of rubber glove stocks under our coverage. Based on our channel checks, glove players under our coverage are facing longer delivery lead times (the duration order is placed and delivered) has risen to an average of between 50 to 60 days as compared to 40 to 50 days (9 months ago) implying robust demand.

How much higher can rubber glove stocks trade? Based on historical valuation at peak earnings, rubber glove stocks namely Kossan, Hartalega and Top Glove are trading at between 19x to 28x PER valuation or at +2SD above forward mean average. We believe rubber glove stocks are poised for a further re-rating and should trade at their previous peak PER valuations given that all players have evolved successfully and also on the following factors:- (i) Automating their plants and production processes leading to better efficiency and productivity, potentially translating to better margins, (ii) Resilience and hence ability to transform and increasing product mix from purely latex-based gloves to the higher margin nitrile-based gloves, and (iii) 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 19.7x and 25.4x FY16 PERs which are close to their current peak PER valuation of 19.8x and 28.0x, respectively. However, Top Glove which offers higher upsides is currently trading at 17.8x 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 RM8.16 based on 22x FY16 EPS (at slightly above +2.0 SD above its historical forward average). We like KOSSAN because: (i) of its superior net profit growth of 43% and 15% in FY15E and FY16E, respectively, (ii) KOSSAN’s unprecedented earnings growth is underpinned by rapid capacity expansion over the next two years, (iii) it is gradually raising its dividend payout ratio, and (iv) the fact that KOSSAN is not just a glove play but a bet on its technical rubber product (TRP) division, which is growing rapidly.

Maintain OUTPERFORM on HARTALEGA and TP of RM5.30 based on 27x FD CY16 EPS (at slightly below +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 and TP of RM9.16 based on 20x FY16 EPS (slightly above its 5-year historical mean average of 18x). The PER valuation of Top Glove (17.8x FY16E PER) has lagged its peers such as Kossan (19.6x FY16E PER) and Hartalega (25.4x 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 FY16 PER. 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. Tell-tale signs, in particular, the stronger-than-expected volume growth and the 6% QoQ weakening of the MYR against the USD, are pointing towards a superb set of full-year FY15 results for Top Glove, due in mid-October. Our implied target PER of 20x for Top Glove is still below its peak earnings’ valuation averaging between 23x-26x. 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; (ii) undemanding PER valuation discount to peers; and (iii) solid management. 

Source: Kenanga Research - 6 Oct 2015