We maintain our OVERWEIGHT rating on the rubber gloves sector. Rubber glove stocks under our coverage have performed poorly YTD, led by SUPERMX (-34%), TOPGLOV (-31%), HARTA (-25%) and KOSSAN (-26%), hit by concerns of oversupply fears and price competition. Consequently, due to the retracement, valuations of rubber glove players under our coverage currently appear compelling and undemanding. Hence, we are not perturbed and believe current valuations present a buying opportunity and expect their share prices to recover in subsequent quarters. Our investment case is based on : (i) analysis that the new capacity expansion is slower-than-expected, which should help maintain the supply-demand equilibrium, (ii) earnings growth underpinned by new capacity expansions matched and fueled by pent-up demand for rubber gloves, especially nitrile gloves, and (ii) higher ASPs expectations. Our TOP PICK is KOSSAN with an OUTPERFORM rating. Our target price is RM8.00 based on 19x FY17E EPS. We like Kossan for: (i) its undemanding valuations at 16.3x FY17 EPS or 30% discount compared to the closest nitrile-centric peer, Hartalega, which is trading at 23.8x CY17E EPS, (ii) its net profit growth averaging 14.2% each in FY16E and FY17E, (iii) its gradually rising dividend payout ratio, and (iv) the unprecedented earnings growth over the next two years underpinned by new capacity expansion.

Mixed bag of 1QCY16 results. Rubber gloves stocks under our coverage delivered a mixed bag of results in the recently concluded 1QCY16 reporting season. Kossan and Supermax came in largely within our and market consensus expectations. However, Hartalega and Top Glove came in below expectations. Both Top Glove and Hartalega were hit by lower-than-expected ASPs due to price competition. An interesting highlight from this quarter results is 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 2% and 8%-ppt. 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).

Expecting higher ASPs. Due to the lag effect in passing higher cost due to more expensive natural gas and raw material (latex), we understand that some players have since raised ASPs, which should help to 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.

Demand for gloves still intact. We believe that the average 8-10% growth in demand p.a. for rubber gloves over the next few years is still intact. In 2015, the total exports of rubber gloves, synthetic rubber (SR) and latex-based natural rubber (NR) combined rose 16.3% YoY to 57.1b pairs and by 12.5% to RM11.9b in value. In 2015, Malaysia exported 25b pairs of SR gloves or an increase of 31% YoY. YoY, 2015 SR sales volume ratio has widened compared to NR sales volume ratio from 51:49 to 58:42. We also expect latex-based gloves to continue to register positive volume sales as well due to the stable latex prices. Growth will be supported by higher health standards and expanding use of rubber gloves.

Expect incoming new capacities to slow down. Tell-tale signs of potential oversupply concerns appear overplayed considering that capacity expansion of the four rubber gloves under coverage are expected to be delayed and staggered. Kossan’s FY16 new capacity estimated at 2b pieces is coming from the two plants operating back in mid 2015. Top Glove’s new Lukut, Port Dickson plant is expected to be delayed for three months due to shortage in electricity supply (16 lines totaling 2b pieces). Currently Hartalega’s plant 3 will add an estimated of 2-3b pieces each in 2016 and 2017. The plant 4 is only expected to commence commercial production by 4Q 2017. As such the slower-than-expected ramp-up in new production capacity further reinforces our positive outlook on the sector by allaying concerns on competitive pressure and oversupply issues. Separately, from our channel checks, we gather that players’ average utilisation rate is 80-85%. Furthermore, most glove manufacturers can only run at an average maximum utilisation rate of 90% due to required downtime for maintenance while industry capacity expansions are only coming in progressively throughout over the next two years.

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 16.3x FY17E EPS compared to its closest nitrile-centric peer, Hartalega, which is trading at 23.8x 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 new capacity expansion.

Source: Kenanga Research - 12 Jul 2016