Gas Malaysia in an announcement to Bursa Malaysia informed that the Government has approved a natural gas tariff revision for non-power sectors in Peninsular Malaysia with effect from 1 July 2018 to 31 December 2018 by an average of 0.5%. However, the quantum increase appears insignificantly small this time around compared to 1H2018’s hike (+22%). Ceteris paribus, assuming “no-cost pass through”, an average 0.5% increase in natural gas tariff is expected to only marginally impact rubber gloves players’ earnings by 0.2-0.5%. Anecdotal evidence suggests that rubber gloves stocks’ share price rally was led largely by massive PER expansion compared to pedestrian earnings growth over the past eight quarters and 12-month period. On the flipside, key upside risk is stronger-thanexpected demand. We have UNDERPERFORM calls on HARTA (UP; TP: RM5.00); TOPGLV (UP; TP: RM9.40), SUPERMX (UP; TP: RM2.20); and KOSSAN (UP; TP: RM6.85).

Average 0.5% tariff hike for natural gas for non-power sectors. Gas Malaysia in an announcement to Bursa Malaysia informed that the Government has approved a natural gas tariff revision for non-power sectors in Peninsular Malaysia with effect from 1 July 2018 to 31 December 2018 by an average of 0.5%. However, the quantum appears smaller this time around compared to 1H2018’s hike (+22%). Ceteris paribus, assuming “no-cost pass through”, an average 0.5% increase in natural gas tariff is expected to only marginally impact rubber gloves players’ earnings by 0.2-0.5%. Fuel accounts for an average of 10% of production cost, of which natural gas accounts for an average of 7% of the production cost. Based on our back-of-envelope calculations, players need to raise their average selling prices by 0.5%. Generally, its takes approximately between one to three months to pass through the cost increase.

Massive PER expansion but pedestrian earnings growth over the past eight quarters and 12-month period. Anecdotal evidence suggests that rubber gloves stocks’ share price rally was led largely by massive PER expansion compared to pedestrian earnings growth over the past eight quarters and 12-month period. For example, Hartalega’s PER expanded from 18x to 44x but EPS only rose an average 10% over the past eight sequential quarters. Similarly, Top Glove’s PER expanded from 17x to 32x but EPS only averaged 9% growth over the past eight sequential quarters. Following a period of capacity consolidation starting back in mid-year 2016 which led to falling ASPs, nascent signs of glove-makers ramping up capacities are building up again. The robust demand is attracting players to ramp up production. In anticipation of higher demand and switching from vinyl gloves, players are raising capacities again.

Potential headwinds from minimum wage. We expect headwinds, including potential higher minimum wage, which could derail earnings of glove players. Any hike in minimum wage could derail glove players’ earnings since labour accounts for 9% of production cost. For illustrative purposes, if the present minimum wage is hiked by 50% to RM1,500/month, ceteris paribus, assuming ‘a no cost pass-through’ scenario, the minimum wage policy is expected to hit glove players’ bottom-line by 3-12% on a full-year basis based on our back-of-the-envelope calculations. However, in the past, glove makers had managed to gradually pass cost through via higher ASPs.

Downgrade Top Glove from Market Perform to Underperform. All-in, we believe positives have been priced in. Based on an unchanged TP of RM9.40 based on 24.5x FY19E EPS (+1.5SD above 5-year forward historical mean), we downgrade Top Glove from Market Perform to Underperform. The stock is trading at 32.1x and 29.6x on FY18E and FY19E EPS, respectively, which is +2.0SD above 5-year historical mean.

Downgrade Kossan from Market Perform to Underperform. Based on an unchanged TP of RM6.85 based on 20x FY19E EPS, we downgrade Kossan from Market Perform to Underperform. The stock is trading at 24.8x and 23.8x on FY18E and FY19E EPS, respectively, which is +1.5SD above 5-year historical mean.

Reiterate UNDERWEIGHT. Near-term headwinds include potential higher minimum wage and rising new capacities are seen to undercut ASPs and hence derail earnings. On the flipside, a key upside risk is the stronger-than-expected demand. We have UNDERPERFORM calls on HARTA (UP; TP: RM5.00); TOPGLV (UP; TP: RM9.40), SUPERMX (UP; TP: RM2.20); and KOSSAN (UP; TP: RM6.85).

Source: Kenanga Research - 14 Jun 2018