We maintain our OVERWEIGHT rating on the rubber gloves sector. The sustained weakness in Ringgit against the USD coupled with longer delivery lead days (implying robust demand) are expected to drive sequential earnings growth and provide the impetus for further upside in share price performance moving into 1Q16. Our investment case is based on: (i) earnings growth 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. Our TOP PICK is TOP GLOVE. The PER valuation of Top Glove (19x FY17E PER) has lagged behind its peers such as Kossan (22x FY17E PER) and Hartalega (27x CY17 PER), which we believe is unwarranted. Top Glove at 17.8x FY16E earnings is trading at an average 20% discount to Kossan and Hartalega’s FY17 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: RM15.60). We also have OUTPERFORM calls for HARTALEGA (TP: RM6.40) and SUPERMX (TP: RM3.80). KOSSAN is at MARKET PERFORM (TP: RM9.11).

Solid results for gloves makers in the recently concluded 3QCY15. Glove makers reported a solid 3QCY15. Results of the gloves makers from the recently concluded 3QCY15 results season were mainly within expectations except for Supermax, which came in above. The good set of results for Kossan, Hartalega, Top Glove and Supermax were underpinned by both volume growth from new capacity expansion and favourable USD/MYR exchange rate. Sales volume grew strongly for Kossan (+33% YoY, +10% QoQ), Hartalega (+35% YoY, +15% QoQ) and Top Glove (+15% YoY, +1% QoQ). Supermax’s results came in above expectations driven by volume growth from new plants and favourable USD/MYR exchange rate.

Rubber glove stocks should 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 further re-rating and should trade at their previous peak PER valuations given the following factors; (i) automation of plants and production processes leading to better efficiency and productivity and potentially translating to better margins, (ii) rubber gloves makers’ resilience and ability to transform and increasing product mix from purely latex-based gloves into the higher margin nitrile gloves, and (iii) expectations of solid and another record-peak quarterly earnings ahead.

Our TOP PICK is TOP GLOVE with an OUTPERFORM and TP of RM15.60. Top Glove’s historical valuation at peak earnings averaged at between 23-27x PER. The PER valuation of Top Glove (19x FY17E PER) has lagged behind its peers and is trading at an average 20% discount to Kossan (22x 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 its : (i) ability to evolve from purely a dominant latex-based rubber gloves producer into a higher margin nitrile-based products producer, and (ii) undemanding PER valuation at discount to peers.

Maintain OUTPERFORM on HARTALEGA with TP of RM6.40 based on 28.5x CY17 EPS (at +2.0 SD above its historical forward average). We believe Hartalega’s new gloves production lines in NGC could potentially lead to higher margins due largely to its focus on only two products, thus reducing idle downtime from frequent machinery setting adjustments to accommodate diverse specifications. 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.

Maintain OUTPERFORM on SUPERMAX, TP is RM3.80 based on unchanged 17x FY16E EPS (at +2.0 SD above its historical forward average). We like Supermax for: (i) potential re-rating catalyst upon commercial production of its new plant, which dispelled market skepticism of persistent delays in the new plant, (ii) steep 30% discount to the sector average, and (iii) being a beneficiary of the strengthening USD against MYR. 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 have 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.

Maintain MARKET PERFORM on KOSSAN with TP of RM9.11 based on 22x FY16 EPS (at +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. 

Source: Kenanga Research - 6 Jan 2016