We maintain our OVERWEIGHT rating on the rubber gloves sector. After two quarters of weak sequential quarterly earnings, two of the four rubber glove players under our coverage reported encouraging set of results. Specifically, Top Glove and Hartalega shows marked improvement in ASPs and margins. Persistent concerns over oversupply and intense price competition were overplayed and had been addressed in our previous quarterly strategy report. The sustained weakness in MYR against the USD will lend credence to subsequent sequential earnings improvement. 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, (iii) higher ASPs expectation, and (iv) sustained weakness of Ringgit (RM) vs. US dollar (USD). Our TOP PICK is TOPGLOV with an OUTPERFORM rating. Target Price is RM5.92 based on 20x FY17E EPS. The PER valuation of Top Glove (17.9x FY17E PER) has lagged behind Hartalega (26.4x CY17E PER). The valuation gap should narrow when we consider that Top Glove has higher level of total capacity and net profit compared to Hartalega.

3QCY16 results broadly below expectations. Results of the glove makers from the recently concluded 3QCY16 results season were largely below expectations except for Hartalega. All rubber glove makers were hit by intense price competition in the nitrile segment resulting in lower margins. However, Top Glove and Hartalega recorded marked improvement in its 1Q17 and 2Q17 margins, respectively, due to economies of scale emanating from higher volume sales. Kossan was hit by lower-than-expected volume growth due to downtime as a result of revamp work on one of the plants involving two production lines. Only Top Glove and Hartalega saw marked sequential pre-tax margins and ASPs improvements. Sales volume grew strongly for HARTA (+26% YoY, +9% QoQ), KOSSAN (-3% YoY, +3% QoQ), TOPGLOV (+7% YoY, +5% QoQ) and Supermx (+4% QoQ).

Expect incoming new capacities to slow down. Tell-tale signs of potential oversupply concerns appear overplayed considering that capacity expansion plans of the four rubber gloves companies under our 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 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 estimated 2-3b pieces each in 2016 and 2017. The plant 4 is only expected to commence commercial production by 4Q17. 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.

Natural latex price to taper off post wintering months but expected to remain high. Latex price appears to trend upwards during the seasonal wintering months starting end-Dec till May (please see chart below). In anticipation of shortage in latex production supply during the wintering months, latex price has risen 48% to RM6.45/kg presently. Based on industry checks, natural latex price is expected to hover between RM5.50/kg and RM7.00/kg in 2H17.

USD FDA ban on latex to further fuel demand for nitrile gloves. The U.S. Food and Drug Administration (FDA) announced a proposal to ban powdered medical gloves starting Jan 2017. Specifically, FDA has determined that powdered surgeon gloves, powdered patient examination gloves, and absorbable powder for lubricating surgeon gloves present an unreasonable and substantial risk of illness or injury. This is positive for glove makers as: (i) nitrile generally offers better margins compared to latex gloves, and (ii) more importantly, it alleviate the fears of oversupply in the nitrile market segment.

Expecting higher ASPs. 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.

Our TOP PICK is Top Glove. We like Top Glove because; (i) the PER valuation of Top Glove (17.9x FY17E PER) has lagged behind Hartalega (26.4x CY17E PER). The valuation gap should narrow when we consider that Top Glove has higher level of total capacity and net profit compared to Hartalega; (ii) the continuous improvement in ASPs (2nd consecutive quarterly ASPs improvement in the recently announced 1Q17 result) is pointing towards further margins expansion in subsequent quarters; and (iii) the sustained weakness in MYR against the USD will lend credence to subsequent sequential earnings improvement.

Source: Kenanga Research - 5 Jan 2017