We maintain our OVERWEIGHT rating on the rubber gloves sector. After two quarters in the lull, we believe rubber glove players under our coverage are poised for a re-rating. Persistent concerns over fears of oversupply and intense price competition are overplayed and had been addressed in our previous quarterly strategy report. As an indication, stock prices of rubber gloves companies under our coverage have rallied between 5% and 18% over the past two months. 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 RM7.50 based on 19.5x FY17E EPS. We like Kossan for its undemanding valuations at 18x FY17 EPS or 30% discount compared to the closest nitrile-centric peer, Hartalega, which is trading at 25.8x CY17E EPS.

2QCY16 results broadly below expectations. Results of the glove makers from the recently concluded 2QCY16 results season were largely below expectations. All rubber glove makers were hit by intense price competition in the nitrile segment resulting in lower margins. ASPs fell between 5% and 16% across all the players in various segments. Correspondingly, sequential pre-tax margins fell for the second consecutive quarter across all the players of between 100ppt and 510ppt. However, demand for rubber gloves remained robust. Sales volume grew strongly for HARTA (+26% YoY, -2% QoQ), KOSSAN (+2.3% YoY, -1.5% QoQ), TOPGLOV (+11% YoY, +5% QoQ) and Supermx (+10% QoQ).

Expecting higher ASPs. We expect glove makers’ margins to return to the 14-17% range compared to low teens in previous two quarters. Tell-tale signs of potential oversupply concerns appear overplayed considering that capacity expansions of the four rubber glove makers under coverage are expected to be delayed and staggered. In anticipation of the price competition, players have over the last 18 months undertake intensive research & development efforts to mitigate lower margins via introducing new value-added products to the market place. 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 raised ASPs by 3-5%, 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.

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 glove makers 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 reinforced 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 RM7.50 based on 19.5x FY17E EPS. We like Kossan for its undemanding valuations at 18x FY17 EPS or 30% discount compared to the closest nitrile-centric peer, Hartalega, which is trading at 25.8x CY17E EPS.

Source: Kenanga Research - 5 Oct 2016