We maintain our OVERWEIGHT rating on the rubber gloves sector. The stage is set for a solid 2H17 following three quarters of anemic quarterly earnings growth. We expect Top Glove and Hartalega to lead the way, judging by their past two quarterly results, which are gathering momentum spearheaded by higher ASPs and margin expansion pointing towards a solid 2H17. Moving into 2H17, we expect earnings growth to be driven by new capacity expansion following the slower-than-expected ramp up. Our investment case is based on: (i) analysis that the new capacity expansion is slower-thanexpected, 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 (17.1x FY17E PER) has lagged behind Hartalega (27.4x 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.

Mixed set of 4QCY16 results. Results of the glove makers from the recently concluded 4QCY16 earnings season were mixed. Top Glove and Hartalega earnings came in within expectations and showing marked sequential net profit improvement. However, Kossan and Supermax came in below expectations. The bright spots from 4Q16 results include consecutive sequential ASPs improvement as well as margins expansion across all players under our coverage after facing intense price competition in the nitrile segment resulting in lower margins over the past few quarters. However, sales volumes across all players were largely flat to lower due to insufficient capacity as a result of slower-thanexpected incoming capacities and plant maintenance. Sales volume was flat sequentially including TOPGLOV (+9% YoY, -1% QoQ), HARTA (+19% YoY, +1% QoQ) and KOSSAN (-3% YoY, +2% QoQ).

Volume sales to pick up in upcoming quarters. We expect volume sales to pick up in next few quarters underpin by new capacity expansion. The slower-than-expected ramp in new capacity of which we highlighted few quarters ago is expected to gradually come on stream in 2H 2017 and therefore underpin forward sequential earnings growth coupled with higher ASPs and margin expansion. Recall, we have over the past three quarters highlighted potential oversupply concerns appears overplayed considering that capacity expansion plans of the four rubber gloves companies under our coverage are expected to be delayed and staggered. Moving into 2H 2017, Top Glove and Kossan new plant is expected to be ready by early 2H 2017. In anticipation of higher demand, we expect Hartalega’s plant 3 to be completed fasterthan-expected.

Natural latex price to taper off post wintering months but expected to remain high. Latex price appears to be trending 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 to as high as RM8.18/kg (+27% YTD 2017). Latex price has since taper-off from its peak of RM8.18/kg to presently RM6.98/kg. Based on industry checks, natural latex price is expected to hover between RM6.00/kg and RM7.00/kg in 2H17.

Expecting higher ASPs. Due to the lag effect in passing cost through as a result of higher natural gas and raw material (latex), we expect players to raise ASPs, which should help to contain high operating costs. The slower-than-expected ramp-up in new capacity has helped players to raise ASPs as well. 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.

R&D vital for rubber glove players over the longer term. We believe going forward, players need to intensify and leverage on Research & Development (R&D) in an effort to sustain or raise ASPs to fend-off price competition. Players, including Kossan and Hartalega, have continuously innovated and intensified their R&D efforts. Case in point; Kossan is emphasizing on its patented accelerator-free nitrile glove and other unique types of glove. Hartalega has been producing thinner and lighter nitrile gloves from 4.7g in 2005 to 3.7g in 2007 and currently, 3.2g. We wouldn’t be surprised if Hartalega continues to innovate in terms of production processes and as well as introducing new higher value products.

Our TOP PICK is Top Glove. We like Top Glove because; (i) the PER valuation of Top Glove (17.1x FY17E PER) has lagged behind Hartalega (27.4x 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; and (ii) the continuous improvement in ASP

Source: Kenanga Research - 28 Mar 2017