Reiterate UNDERWEIGHT due to rich PER valuations and flat sequential earnings growth. Rubber glove stocks under our coverage have performed well since early 2017 till now, led by HARTA (+116%), TOPGLV (+139%) and KOSSAN (+24%). 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. Our analysis suggests that strong surge in price movements of the glove stocks have been mainly due to changes in the P/E multiple and not so much on earnings growth. Near-term headwinds including gas tariff hikes, and potential higher minimum wage could derail earnings. On the flipside, key upside risk is stronger-than-expected demand. We have UNDERPERFORM calls on HARTA (UP; TP: RM5.00); TOPGLV (UP; TP: RM9.40); KOSSAN (UP; TP: RM6.85) and SUPERMX (UP; TP: RM2.20).

Valuations stretched at mid-teens to high-teens valuations. Rubber glove stocks under our coverage have performed well since 2017, until now, led by HARTA (+116%), TOPGLV (+139%) and KOSSAN (+24%) in line with the strong demand and a more stable supply-demand dynamics underpinning earnings recovery. Due to the run-up in share prices, the PER valuations appear stretched vis-à-vis earnings growth. However, earnings growths of rubber gloves players are growing at an average of between -1% and 10% over the past eight quarters. We believe the share prices have appreciated ahead in anticipation of the upcoming quarter reporting season.

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. The chart below depicts that price movements of the glove stocks were mainly due to changes in the P/E multiple and not so much on earnings growth. For example, Hartalega’s PER expanded from 18x to 40x but EPS only rose an average 10% over the past eight sequential quarters. Similarly, Top Glove’s PER expanded from 17x to 30x but EPS only averaged 9% growth over the past eight quarters.

Capacity slowly building up again. 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 emerging 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.

Demand led across the board mainly from nitrile and natural rubber. From our checks with rubber glove players under our coverage, demand is mainly from nitrile and natural rubber instead of vinyl. Contrary to market expectations of a massive industry switch from vinyl to rubber gloves, Top Glove’s 2Q18/6M18 demand growth was led largely by emerging markets that are not predominant vinyl glove consumers. Specifically, demand growth for natural rubber gloves stems from emerging markets, where healthcare awareness and hygiene standards are rising steadily, particularly Asia (ex-Japan) and Eastern Europe, which respectively saw 60% and 40% boost in sales volume for 1H18 compared with 1H17 of which they are not vinyl gloves consuming nations.

Potential headwinds from minimum wage. We expect headwinds including potential higher minimum wage which could derail earnings of glove players. Any hike in the 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-lines 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.

Reiterate UNDERWEIGHT. Anecdotal evidence suggests that rubber gloves stocks’ share price rally was led largely by massive PER expansion in view of the pedestrian earnings growth over the past eight quarters and 12-month period. Our analysis suggests that price movements have been mainly due to changes in the P/E multiple, and not so much on earnings growth. We have UNDERPERFORM calls on HARTA (UP; TP: RM5.00); TOPGLV (UP; TP: RM9.40); KOSSAN (UP; TP: RM6.85); and SUPERMX (UP; TP: RM2.20).

KEY POINTS

Valuations stretched at high-teens valuations. Rubber glove stocks under our coverage have performed well starting from 2017, until now, led by HARTA (+116%), TOPGLV (+139%) and KOSSAN (+24%) in line with the strong demand and a more stable supply-demand dynamics which underpinned earnings recovery. We believe our initial analysis of a more stable capacity expansion leading to supply-demand equilibrium, which eventually saw ASPs rising again validates our Overweight rating on the sector in the beginning of 2017. However, due to the sharp run-up in share prices of rubber glove makers, PER valuations appears stretched vis-à-vis earnings growth at average of between -1% and 10% over the past eight quarters. We believe the share prices have appreciated ahead in anticipation of the upcoming quarter results season.

Rubber gloves players’ share prices start declining after hitting the +2.0SD mark. Based on past historical observation over the past five years, after glove makers’ 1-year forward PER hit the +2.0SD mark, share prices started trending downwards as depicted in the chart below.

Massive PER expansion but pedestrian earnings growth over the past eight quarters and 12 months. Anecdotal evidence suggests that the rally in rubber glove makers was led largely by massive PER expansion compared to pedestrian sequential earnings growth over the past eight quarters and 12 month. The chart below depicts that price movements of the glove stocks have been mainly due to changes in the P/E multiple and not so much on earnings growth. For example, Hartalega’s PER expanded from 18x to 40x but EPS only rose an average 10% over the past eight sequential quarters. Similarly, Top Glove’s PER expanded from 17x to 30x but EPS only averaged 9% over the past eight sequential quarters.

Demand across the board led mainly by nitrile and natural rubber. From our checks with rubber glove players under our coverage, demand is mainly from nitrile and natural rubber instead of vinyl. Contrary to market expectations of a massive industry switch from vinyl to rubber gloves, Top Glove’s 2Q18/1H18 demand growth was led largely by emerging markets that are not predominant vinyl glove consumers. Specifically, demand growth for natural rubber gloves stems from emerging markets, where healthcare awareness and hygiene standards are rising steadily, particularly Asia (ex-Japan) and Eastern Europe, which respectively saw 60% and 40% boost in sales volume for 1H18 compared with 1H17 of which they are not vinyl gloves consuming nations. Another player sees demand sustaining growth from the United States and Europe which are predominantly nitrile and natural rubber gloves consumers. As such, there might not be an aggressive switch from vinyl to rubber gloves.

Capacities building up again. 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 emerging 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.

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 the hike in 1H2018 (+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.

Weakening of Ringgit (RM) vs. US dollar (USD), a positive to rubber glove players. The recent weakening of the MYR against the USD is a near-term negative to rubber glove players over the short to medium term period. Since rubber gloves players’ sales are USD-denominated, theoretically, an appreciating ringgit against the dollar will lead to less revenue receipts for glove makers. Ceteris paribus, a 1% appreciation of RM against USD will lead to an average 1-2% decrease in the net profit of rubber glove players.

Mixed set of 1QCY18 results. Results of the glove makers under our coverage from the recently concluded 1QCY18 results season were broadly within our expectations. All players’ PBT margin eroded by 1.1ppt to 3.3ppt due to higher fuel cost namely natural gas (+22%). Typically, players faced a 1-2 months’ time lag in cost-pass-through arising from the increase in price of natural gas. However, Kossan Rubber’s results appear to be below consensus following two earlier scheduled delays. Its glove former issue that affected Plant 16 has been resolved with all lines expected to be commercially ready by July 2018. Hartalega Holdings’ results were in line but appear disappointing despite commercialisation of new capacity. All players registered sequential net profit growth of between -7% to +3.3%.

Reiterate UNDERWEIGHT. 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. Our analysis suggests that strong surge in price movements of the glove stocks have been mainly due to changes in the P/E multiple and not so much on earnings growth. Near-term headwinds including appreciation of MYR against the USD, gas tariff hikes, and potential higher minimum wage could derail earnings. On the flipside, key upside risk is the stronger-than-expected demand. We have UNDERPERFORM calls on HARTA (UP; TP: RM5.00); TOPGLV (UP; TP: RM9.40); KOSSAN (UP; TP: RM6.85); and SUPERMX (UP; TP: RM2.20).

Source: Kenanga Research - 6 Jul 2018