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 Jan 2016 (4th increase since Apr 2014) by an average of 17%. Ceteris paribus, assuming “no-cost pass through”, an average 17% increase in natural gas tariff is expected to only marginally impact rubber gloves players’ earnings by 3-5%. However, we are not overly concerned since rubber gloves players have generally been able to pass on the cost increase, judging from past experiences, such as in May 2014, Nov 2014 and July 2015. Hence, we are maintaining our OVERWEIGHT rating for the rubber gloves sector. Our Top Pick is Top Glove with a TP of RM15.60. Top Glove’s historical valuation at peak earnings averaged at between 23-27x PER. The PER valuation of Top Glove (19.5x FY17E PER) has lagged its peers and it is trading at an average 25% discount to Kossan (23x FY17E PER) and Hartalega (27x CY17E PER). We consider the under-performance as unwarranted. 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. 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 discounted PER valuation to peers, and (iii) its solid management. We also have OUTPERFORM calls for HARTALEGA (TP: RM6.40) and SUPERMX (TP: RM3.80).

Average 17% 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 Jan 2016 (4th increase since Apr 2014) by an average of 17%. Ceteris paribus, assuming “nocost pass through”, an average 17% increase in natural gas tariff is expected to marginally impact rubber gloves players’ earnings by 3-5%. However, we are not overly concerned since rubber gloves players have generally been able to pass on the cost increase judging from past experiences, such as in May 2014, Nov 2014 and July 2015. Fuel accounts for an average of 10% of production cost, of which natural gas accounts for an average of 7% of the production cost. Based on our back-of-envelope calculations, 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.

Rubber glove stocks can trade at previous peak valuations. Based on historical valuation at peak earnings, rubber glove stocks namely Top Glove, Hartalega, Supermax and Kossan trades at +2SD above historical mean. We believe rubber glove stocks are poised for a further re-rating and should trade at their previous peak PER valuations given the following factors: (1) Automation of plants and production processes leading to better efficiency and productivity potentially translating to better margins, (2) Standing testimony to rubber gloves makers’ resilience and hence ability to transform and increasing its product mix from purely a latex-based gloves producer into the higher margin nitrile gloves, and (3) Expectations of solid and record peak quarterly earnings ahead.

Maintain OVERWEIGHT. Our TOP PICK is Top Glove with an OUTPERFORM and TP raised to RM15.60. We upgrade our target price from RM14.20 to RM15.60 based on 22x FY17E EPS (previously 20x). We believe the PER expansion is justifiable considering that Top Glove has shown the best quarterly earnings growth and the biggest quarterly profits amongst its peers. Top Glove’s historical valuation at peak earnings averaged at between 23-27x PER. The PER valuation of Top Glove (19.5x FY17E PER) has lagged its peers and is trading at an average 25% discount to Kossan (23x FY17E PER) and Hartalega (27x CY17E PER). We consider the under-performance as unwarranted. 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. 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.

Supermax, Maintain Outperform, TP Raised to RM3.80. We upgrade our TP from RM2.83 to RM3.80 based on 17x FY17E EPS (+2.0SD above historical average). We raised the PER valuation from 13x to 17x inline with the industry strong prospects and valuations of players moving towards +2.0 SD above historical mean. Growth going forward is expected to be driven by two new plants and we understand that the building structures for Plant #10 and Plant #11 i.e. Lot 6059 and 6058 in Meru, Klang are up and the first batch of lines has been commissioned. Lot 6059 and 6058 will have 24 and 16 production lines producing 3.2b and 2.2b pieces of nitrile gloves p.a., respectively, bringing the total nitrile production capacity from 6.9b (including the 1.4bn in Lot 6070) to 12.3b pieces p.a. or 52% of the total installed capacity.

Hartalega, Maintain Outperform, TP raised to RM6.40. We upgrade our TP from RM6.00 to RM6.40 based on 28.5x CY17E 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 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: Kenanga Research - 23 Dec 2015