We came away from Top Glove’s 3Q16 analysts’ briefing feeling positive that subsequent quarters’ earnings are set to gradually improve, driven by cost pass-through via hikes in ASPs, normalised margins, sustained demand growth for rubber gloves and efficiencies derived from internal production processes. The key takeaways from the briefing include: (i) 3Q16 results explained, (ii) cost initiatives in an effort to further enhance competitiveness and efficiency, and (iii) raising ASP to mitigate the effect of higher costs. Maintain OUTPERFORM. Our Target Price is RM6.68 based on unchanged 20x FY17E EPS (+1.5 SD above 5-year historical mean of 17x). 3Q16 results explained; lag impact on cost pass-through. The briefing shed some light on the 11% YoY and 5% QoQ sales volume growth and lower YoY net profit growth. 3Q16 revenue was driven by higher sales volume (+11% YoY) which grew across the board, led by nitrile (+20%) and latex powder free (+17%) and vinyl (+48%) and surgical (+58%), albeit with a smaller base. In tandem with growing demand, nitrile gloves accounted for 32% of total product mix and continued to gather momentum compared to the average of 22% over the last few quarters. In terms of profitability, 3Q16 net profit fell 14% YoY due to: (a) higher raw material latex prices (+3%) and (b) margins compression resulting from lower ASPs (-17%) due to price competition and the lag effect in passing cost through as a result of higher natural gas and raw material (latex). In terms of geographical markets, Europe (34% vs. 28% in 3Q15), North America (29% vs. 31% in 3Q15) and Asia (17% vs. 18% in 3Q15) continued to dominate overall sales. QoQ, 3Q16 volume growth came in at only 5% due to maximum utilisation for nitrile while the new Lukut, Port Dickson plant is expected to be delayed for three months due to shortage in electricity supply (16 lines totalling 2b pieces).

ASP hike to mitigate the effect of higher costs. Due to the lag effect in passing cost through as a result of higher natural gas and raw material (latex), Top Glove had since raised ASPs by between USD0.20 and USD0.25/1000 pieces, which should contain high operating costs and put brakes on further margin compression in subsequent quarters. Note that 3Q16’s sharp PBT margin erosion (-4% pts YoY; -8% pts QoQ) was dragged by lower ASPs due to price competition and delays in cost pass-through for natural gas and latex. Recall, while pricing adjustments were made accordingly, there was a time lag of two months before the cost increase could be shared out with customers. Furthermore, we gather that nitrile glove competition has subsided on the back of delayed incoming capacities, which could ease downwards pressure on ASPs. We expect and were guided that PBT margin is expected to normalise to between 15% and 17% (from 3Q16 11%) going forward. For illustrative purposes, assuming a revenue of RM680m (five quarters’ average is RM700m), normalised pre-tax profit of 16%, and effective tax rate of 20% (five quarters average), net profit is RM86m/quarter. Top Glove raised its rubber glove average selling prices (ASPs) by USD0.20-0.25/1000 pieces to mitigate the effect of hike in natural gas and minimum wage (effective July 2016). Ceteris paribus, assuming no cost pass through, the minimum wage is expected to cost Top Glove between RM36m and RM48 per annum or by 9-12% of our FY17E earnings.

Cost savings initiative to further enhance competitiveness and efficiency. In its quest to continue to remain efficient and contain any possibility of margins erosion, Top Glove is undertaking to build its own former (rubber gloves mould) and chemical dispersion plants. In the past, Top Glove faced bottle-necks in its production floor due to the slower-than-expected delivery of formers. Cost savings from having an inhouse rubber former is estimated at RM2-3m per annum. The estimated cost of these two ventures has been included in the estimated capex of RM150m per annum including building of a new factory and production lines as per our earnings model.

Maintain Outperform. Target Price is RM6.68 based on unchanged 20x FY17E EPS (+1.5 SD above 5-year historical mean of 17x). The PER valuation of Top Glove (13.8x FY17E PER) has lagged behind Hartalega (22.3x CY17E PER). We consider the under-performance unwarranted. The valuation gap should be narrow when we consider that Top Glove has higher level of total capacity and net profit compared to Hartalega. To sum up, 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, (ii) undemanding PER valuation at discount to peers, and (iii) solid management team. 

Source: Kenanga Research - 23 Jun 2016