Share prices of rubber glove makers appear to have decoupled from USD/MYR movements over the past one year. With the RM strengthening against the USD of late, probably one of the key concerns for investors is whether share prices of glove makers will fall in tandem. While there is strong positive correlation between glove stocks and stronger USD, that relationship is strongest over the 3-5 year period. However, over the past one year, it appears that the link has weakened (with Kossan and Harta even showing negative correlations), suggesting that these glove stocks might not be purely viewed as currency proxies. Moreover, given the strong demand coupled with players judiciously planning their capacity expansion, we expected sustained earnings growth to underpin current valuations.

New normal, glove makers trading at mid-teens to high-teens valuations. We expect glove makers to trade at mid-teens to high-teens valuations at least over the medium term in view of the sustained weakness in MYR against the USD. Specifically, glove makers have been trading at between 16x and 35x PER 1-year forward valuation. The charts depict that gloves makers can trade as high as +1.0 to +2.0 SD above their respective 5-year forward means, which coincides with the weakening of the MYR against the USD during the same period coupled with growth from new capacity expansion.

Strong industry 1H17 volume sales to further gain momentum in 2H17. Amplifying the earnings growth potential is the strong demand supported by new capacity expansion, re-stocking activities and positive operating environment in the absence of price competition. 1H17 exports of rubber gloves recorded a solid volume sales growth of 13-15% driven largely by nitrile volume sales (+26-29%).

Volume sales to pick up in upcoming quarters. We expect volume sales to pick up over the next few quarters underpinned by new capacity expansion and restocking activities following the lower raw material price. The lower-than-expected sequential volume sales growth could have been due to higher input latex cost and slower-than-expected new capacity expansion. The slower-than-expected ramp-up in new capacity which we highlighted a few quarters ago is expected to gradually come onstream in 2HCY17 and therefore, underpin forward sequential earnings growth. Recall, we have over the past three quarters highlighted that potential oversupply concerns appear to have been overplayed considering that capacity expansion plans of the four rubber gloves companies under our coverage are expected to be delayed and staggered.

2QCY17 results broadly within expectations. Results of glove makers under our coverage from the recently concluded 2QCY17 results season were broadly within expectations except for Supermax Corporation. Hartalega announced unprecedented record quarterly earnings due to availability of capacity from NGC’s plant 2 and 3 resulting in solid volume sales (+35%) compared to other players’ slower-than-expected ramp-up of new capacity. Supermax was hit by higher-than-expected taxes and operating costs of which we believe could be due to new start-ups overseas as well as advertising & promotional costs incurred in the contact lens division.

Our TOP PICK is Hartalega. Our target price is RM7.70 based on 29.5x CYE18 EPS (+1.0 SD above 4-year forward mean). The stock has been trading at PER of between 22.0x to 35.0x over the past four years. We believe the valuation is justifiable considering that Hartalega is head and shoulders above its peers in terms of profitability and margins. All in, we like Hartalega for: (i) its superior margins (PBT margins averaging 17-19% compared to the industry average of 11-13%), solid improvement in production capacity and reduction in costs, (ii) new capacity expansion to boost earnings (+12-18% in FY18 and FY19), as well as (iii) its dominant market positioning in the booming nitrile segment.

Source: Kenanga Research - 4 Oct 2017