We came away from a company visit to HARTALEGA feeling upbeat over its earnings prospects for 2H16 which is underpinned by: (i) sustained demand growth for rubber gloves despite some minor glitches in 1H16, (ii) efficiencies derived from internal production processes, and (iii) the favourable USD/MYR exchange rate. The key takeaways from the company visit includes: (i) a switch in hedging policy to show a positive impact starting from 3Q16 onwards, (ii) high utilisation rate while longer delivery lead-days indicate solid demand, (iii) two to three months delay in full commercial operations at the two new plants, and (iv) Reinvestment Allowance (RA) under Budget 2016 could boost bottomline. Due to its resilient and defensive earnings, we roll forward our valuation base from CY16 to CY17. Our TP is raised from RM5.30 to RM6.00 based on unchanged 27x CY17 EPS (slightly above +1.0 SD above its 5-year historical mean average).

A few wrinkles in 2Q16 results, but a change in hedging strategy to boost 2H16 earnings. We expect 2Q16 results due in early November to post flat to slightly higher net profit due to volume growth derived from new capacity expansion but this is expected to be negated by forex losses and delayed delivery of quality formers from supplier as the supporting industry plays catch-up with the fast expanding glove industry. We expect Hartalega to report a 2Q16 net profit of between RM60- 70m (average +3.6% QoQ; +23% YoY), which brings 1H16 net profit to RM123m and RM130m which are 45% and 46% of our and consensus full-year net profit forecasts. However, we expect Hartalega to record an average of RM80-90m net profit for each quarter in 2H16 in the absence of low to minimal forex losses in subsequent quarters. In anticipation of a sustain strengthening of the USD/MYR exchange rate, we understand that Hartalega has now reverted back its hedging policy from six months to currently two months.

RA explained, expected to boost Hartalega’s bottomline. Under the recently announced Budget 2016, an extension of the Reinvestment Allowance (RA) (started in 1996 for 15 years which expired in 2012 for Hartalega) to enable manufacturing companies including Hartalega to continue claiming RA for reducing tax provided they continue to invest capex and claim RA on the capex in the three years period 2016-2018. Theoretically, manufacturers can claim up to 60% of their capex but the maximum claimable amount is up to 70% of their statutory income. For illustration purposes, assuming that Hartalega: (i) incurred capex of RM300m and achieve a net profit of RM320m in FY2017 (where they have met the criteria of 36 months in operations), (ii) the statutory income is net profit RM320m + depreciation RM66m and less capital allowance of RM85m equals statutory income of RM301m. The maximum claimable RA is 70% of statutory income (70% x RM301m = RM210.7m) and the RA claimable is 60% of capex (60% x RM300m capex = RM180m which means that the chargeable income is statutory income of RM331m less RM180m = chargeable income of RM151m. Any excess of RA can be carried forward to next year without requiring the need to invest in capex. Based on our back-of-envelope calculation, Hartalega’s FY17 effective tax rate could be lowered to 18% to 19% as compared to our FY17 forecast of 23.5%. A 1% reduction in our effective tax rate would raise our FY17 net profit by 1%.

Capacity expansion plans are on track, raising capacity by 56% to 22bn pieces over the next two years. We were given to understand that the full commissioning of the first two plants is expected to be delayed by two months. In an effort to mitigate further costs increases, Hartalega has further strengthened its production process to be more efficient. Hence, the delay is due to retrofitting of the new plant to incorporate new energy saving device design – a flanking manoeuvre to anticipate and mitigate future energy hikes, causing a slight delay in fully commissioning Plant 1 and 2. Presently, NGC has commissioned 17 lines. Upon full commissioning, the first two plants will add c.8b pieces (+56%) new capacity by 1Q2016 and providing the much-needed earnings growth boost in 2H16 and FY17. Hartalega is relatively confident that capacity for the first plant will be absorbed upon full commissioning. Management has earmarked an estimated capex of RM300m- RM350m per annum for building a new factory and production lines. We have factored this capex guidance into our earnings model. With an estimated operating cashflow averaging RM357m p.a over the next two years and a net cash of RM74m as at 31 Mar 2015, funding is not an issue.

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 1H15 when the total exports of rubber gloves, synthetic rubber (SR) and latex-based natural rubber (NR) combined rose 10% YoY to 25.9b pairs. Specifically, Malaysia exported 14.4b pairs of SR or nitrile gloves (+29% YoY) and 11.6b pairs of latex gloves (-2.9% YoY) in 1H15. 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 of 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) which has risen to between 50 to 60 days as compared to 40 to 50 days (9 months ago) including players like Hartalega.

Maintain Outperform, TP raised to RM6.00. Our Target Price is RM6.00 based on unchanged 27x CY17E EPS (slightly above its 5-year historical mean average of 18x). We like Hartalega for its: (i) highly automated production processes model, (ii) solid improvement in its production capacity and reduction in costs leading to better 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 believe Hartalega should trade at premium valuations for its superior profit margins which are head and shoulders above industry peers as well as its defensive and captive earnings stream.

Source: Kenang Research - 30 Oct 2015