We came away feeling positive from Top Glove’s 1Q17 post- results analysts’ briefing as subsequent quarters earnings are set to gradually improve, driven by cost pass-through via hikes in ASPs, abating price competition and sustained demand growth for rubber gloves. The key takeaways from the briefing include; (i) 1Q17 results explained, (ii) capex plans, (iii) foreign levy, and (iv) raising ASP to mitigate the effect of higher costs. Maintain OUTPERFORM. Our Target Price is RM5.92 based on an unchanged 20x FY17E EPS.

1Q17 results explained; ASPs +1% QoQ. The main takeaway from the briefing is that the 1Q17 results marked the second consecutive quarter of ASPs hikes (+7% in 4Q16) which could well be further indication of price competition abating. The briefing shed some light on the 5% QoQ sales volume growth which grew across the board, led by nitrile (+7%) and latex powder free (+6%) and vinyl (+20%) albeit with a smaller base which offset lower latex powdered (-2%). In 1Q17, nitrile gloves accounted for 35% (FY16: 32%) of total product mix suggesting that nitrile usage demand momentum continued to remain strong. In terms of profitability, recap that 1Q17 net profit rose 12% QoQ despite higher raw material latex prices (+13%), natural gas cost (+3%) and minimum wage (+3%).

Expecting higher ASPs in subsequent quarters to mitigate the effect of higher costs. We expect 2Q17 ASPs to continue to rise by between 3% and 5% due to the higher input latex cost. Due to the lag effect in passing cost through as a result of higher natural gas and raw material (latex), Top Glove had since conservatively raised ASPs by between USD0.60 and USD1.00/1000 pieces or an average of 3% to 5%, which should contain high operating costs and mitigate the effect of higher costs from raw material. 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 had subsided on the back of delayed incoming capacities, which we believe helped Top Glove’s 1Q17 ASPs. We expect and were guided that PBT margin is expected to normalise to between 13% and 15% (from 4Q16: 10%) going forward. For illustrative purposes, assuming a revenue of RM700m per quarter, normalised pre-tax profit of 15%, and effective tax rate of 19% (five quarters average), net profit is RM85m/quarter.

Minimal impact from foreign levy. Effective this year, employers are fully accountable for foreign workers levy and can no longer deduct their salaries to pay for levy. Ceteris paribus, assuming a "no cost pass- through" scenario, the new levy policy is expected to hit Top Glove’s bottom line by an estimated RM12m (based on an estimated 6,800 workers) or 3.3% based on our back-of-the-envelope calculation. Labour accounts for 9% of the overall production cost. As such, impact to total labour cost and total production is estimated at 3.5% and 0.5%, respectively.

Raising capacity by 18% to 56.8bn pieces. Management has earmarked an estimated capex of RM200-220m per annum for the building of new factory and production lines and automation. We have factored this capex guidance into our earnings model. Top Glove has plans to raise production capacity by additional 8.8 bn pieces of gloves to 58.8b (+15%). Over the next two to three quarters, earnings will be underpinned by the just-completed Factory 6 (Thailand; 1.4b pieces). Factory 30 (Klang), is being constructed and expected to commence production by April 2017. Thereafter, Factory 31 (Klang), for which Phase 1 will commence by August 2017 with a production capacity of 1.6b gloves per annum and Phase 2, by May 2018, with a production capacity of 2.8b gloves per annum, bringing the total production capacity to 4.4b gloves per annum.

Maintain OUTPERFORM. Target Price is RM5.92 based on 20x FY17E EPS. The PER valuation of Top Glove (18.2x 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.

Source: Kenanga Research - 06 Jan 2017