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 15 July 2016 1 Jan 2016 (5th increase since Apr 2014) by an average of 6%. However, the quantum appears smaller this time around i.e. RM1.50/mmbtu (+6%) vs. past two hikes of RM2.07-3.73/mmbtu (+10-17%). Ceteris paribus, assuming “no-cost pass through”, an average 6% increase in natural gas tariff is expected to only marginally impact rubber gloves players’ earnings by 2-3%. However, we are not overly concerned since rubber gloves players have generally been able to pass on the cost increase, judging from past experiences. Hence, we maintain our OVERWEIGHT rating for the rubber gloves sector. Our Top Pick is Kossan Rubber with a TP of RM8.00 based on unchanged 19x FY17E EPS. We like Kossan for: (i) its undemanding valuations at 16.5x FY17E EPS compared to its closest nitrile-centric peer, Hartalega, which is trading at 22.9x CY17E EPS, (ii) its net profit growth averaging 14.2% for FY16E and FY17E, and (iii) its gradually rising dividend payout ratio (Kossan recently declared a final 6.5 sen tax-exempt dividend which brings its total full-year FY15 DPS to 12.0 sen, implying a 38% payout ratio – well ahead of its <20% payout ratios in the past five years), and (iv) the unprecedented earnings growth over the next two years underpinned by rapid capacity expansion. We also have OUTPERFORM calls for HARTALEGA (TP: RM4.83) and TOPGLV (TP: RM6.68).

Average 6% 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 15 July 2016 (5th increase since Apr 2014) by an average of 6%. However, quantum appears smaller this time around i.e. RM1.50/mmbtu (+6%) vs. past two hikes of RM2.07-3.70/mmbtu (+10-17%). Ceteris paribus, assuming “no-cost pass through”, an average 6% increase in natural gas tariff is expected to marginally impact rubber gloves players’ earnings by 2-3%. 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, July 2015 and Jan 2016. 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%. Generally, its takes approximately between one to three months to pass through the cost increase.

1QCY16 results broadly within expectations. Results of the glove makers from the recently concluded 1QCY16 results season were largely within expectations. However, Supermax was hit by plant upgrade and maintenance. An interesting highlight from this quarter results are that all players under our coverage suffered margin erosion due to price competition. ASPs fell between 5% and 16% across all the players in various segments. Correspondingly, sequential pre-tax margin across all the players fell between 1% and 5.1%-pts. However, demand for rubber gloves remains robust. Sales volume grew for HARTA (+32% YoY, +9% QoQ), KOSSAN (+10% YoY, +1.7% QoQ) and TOPGLOV (+11% YoY, +5% QoQ).

Higher ASPs and slower-than-expected capacity expansion. Due to the lag effect in passing cost through as a result of higher natural gas and raw material (latex), we understand that some players have since raised ASPs by between USD0.20 and USD0.50/1000 pieces, which should contain high operating costs and put brakes on further margin compression in subsequent quarters. 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 expect price competition in the nitrile glove segment to mildly subside on the back of delayed incoming capacities, which could ease downwards pressure on ASPs.

Our TOP PICK is KOSSAN. Maintain Outperform with TP of RM8.00 based on unchanged 19x FY17E EPS. We like Kossan for: (i) its undemanding valuations at 16.5x FY17E EPS compared to its closest nitrile-centric peer, Hartalega, which is trading at 22.9x CY17E EPS, (ii) its net profit growth averaging 14.2% for FY16E and FY17E, and (iii) its gradually rising dividend payout ratio (Kossan’s FY15 DPS of 12.0 sen, implying a 38% payout ratio – well ahead of its <20% payout ratios in the past five years), and (iv) the unprecedented earnings growth over the next two years underpinned by rapid capacity expansion.

Source: Kenanga Research - 30 Jun 2016