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 15 July 2019 to 31 December 2019 by an average of 5.3%. Ceteris paribus, assuming a “no-cost pass-through”, an average 5.3% increase in natural gas tariff is expected to only marginally impact rubber gloves players’ earnings by 0.2-0.5%. Generally, it takes approximately between one to three months to pass through the cost increase. Glove players can easily raise their average selling prices by 0.5-1.0% to pass higher tariff cost through. Based on current valuations, we believe all the negatives are largely priced in. We expect subsequent quarters to show sequential earnings improvement led by higher ASPs. Maintain OVERWEIGHT. We have OUTPERFORM calls on HARTA (OP; TP: RM5.85) and KOSSAN (OP; TP: RM5.25). Our Top Pick in the sector is HARTA (OP; TP: RM5.85) for: (i) its “highly automated production processes” model, which is moving from ‘good’ to ‘great’ as they are head and shoulders above its peers in terms of better margins and cost reduction management, (ii) constantly evolving via innovative products development, and (iii) its booming nitrile gloves segment.

Average 5.3% natural gas tariff hike 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 15 July 2019 to 31 December 2019 by an average of 5.3%. Fuel accounts for an average of 10% of production cost, of which natural gas accounts for an average of 7% of the production cost. Ceteris paribus, assuming “no-cost pass-through”, an average 5.3% increase in natural gas tariff is expected to only marginally impact rubber gloves players’ earnings by 0.2-0.5% based on our back-of-envelope calculations. Generally, it takes approximately between one to three months to pass through the cost increase. Glove players can easily raise their average selling prices by 0.5- 1.0% to pass higher tariff cost through.

Oversupply concerns overplayed. From our analysis which we highlighted in our Rubber Gloves 3Q19 Strategy report, there are nascent signs indicating that oversupply concerns appear overplayed considering that capacity expansions of the four rubber gloves under coverage are expected to be delayed and staggered.

ASPs pressure, temporary rough patch. In the last two years, the sector has become a victim of its own success. The frantic pace of capacity expansion has resulted in a mild oversupply situation for rubber gloves leading to ASPs compression and flattish or lower profits amongst players over the past two quarters. However, we take comfort that this is nothing more than just a temporary rough patch. With the rubber gloves players becoming aware of the intense competition since five months ago, measures were taken to mitigate the impact such as; (i) slowing down new capacity expansion, (ii) more measures to maintain margins, including automation and other cost reduction initiatives, and (iii) intensifying sales efforts to penetrate emerging economies. Having experienced various cycles of oversupply, we believe players are now better at responding to competitive pressures. We see the ASPs pressure problem in the sector fully sorting itself out within another quarter. Recall, while pricing adjustments were made, there was a time lag of two months before the cost increase could be shared out with customers.

Reiterate OVERWEIGHT. Our investment case is based on: (i) our analysis that the new capacity expansion is slower-thanexpected, which should help maintain the supply-demand equilibrium and (ii) earnings growth to resume in subsequent quarters, boosted by higher ASPs. Based on current valuations, we believe all the negatives are largely discounted while rubber gloves stocks are currently trading between slightly above mean, which appears undemanding.

Our Top Pick in the sector is HARTA. We like HARTA for: (i) its “highly automated production processes” model, which is moving from ‘good’ to ‘great’ as they are head and shoulders above its peers in terms of better margins and cost reduction management, (ii) constantly evolving via innovative products development, and (iii) its booming nitrile gloves segment. Our TP of RM5.85 is based on unchanged 36x CY20 EPS (at +1.0SD above 5-year historical forward mean).

Maintain OP on Kossan. We like Kossan because it is trading at an unwarranted 28% discount to peers’ PER average considering that its net profit growth is the highest at 23.7% compared to peers average at 12%. Our TP of RM5.25 is based on 25.5x FY20E EPS (+1.0SD above 5-year historical forward mean).

Source: Kenanga Research - 15 Jul 2019