Maintain OVERWEIGHT. Our investment case is based on: (i) our analysis that the new capacity expansion industry-wide is slower-than-expected, which should help maintain the supply-demand equilibrium, (ii) expected earnings growth driven by new capacity expansion and higher ASPs, and (iii) US-led uptick in demand due to trade war where the US accounts for between 28%-55% of glove players group sales. Due to the intense competition in the latex segment, we would focus on players which are largely nitrile-centric including HARTA and KOSSAN. We have OUTPERFORM calls on HARTA (OP; TP: RM5.85); KOSSAN (OP; TP: RM5.25) and SUPERMX (OP; TP: RM1.75). Our Top Pick in the sector is HARTA (OP; TP: RM5.85). 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 peers in terms of better margins and costs reduction, (ii) constantly evolving via innovative products development, and (iii) its nitrile gloves segment, which is booming.

2QCY19 results were a mixed bag. The recent 2QCY19 results season for glove makers under our coverage came in mixed. The star performer was Kossan which recorded a 30% YoY net profit growth, underpinned by new capacity expansion in plant 16, 17 and 18. Hartalega saw a small sequential growth in 1Q20 (FYE Mar), we are expecting better performance in subsequent quarters on the back of uptick in demand and potential margins expansion emanating from operating efficiency and better economies of scale due to increased capacity and higher volume sales. Supermax’s 4Q19 was hit by competition in the latex segment and an up-trending input rubber latex price and a one-off cost which dragged down overall 4Q19 bottom-line. Top Glove suffered 2nd consecutive quarterly earnings disappointment.

Expect US demand to surge from trade-war effect. Due to the impact of trade war whereby effective Sept 1, a 15% tariff will be imposed on Chinese-made medical and vinyl gloves, local rubber glove players expect to see an uptick in demand for gloves of which the positive impact is expected to be felt from the Dec-ending quarter period. Theoretically, the tariff hike is expected to increase the price for Chinese-made gloves, which could compel a switch of US gloves demand to Malaysia glove players where US accounts for between 28%-55% of glove players’ group sales.

Uptick in nitrile demand but intense competition for latex to hit margin. Looking ahead, the keen competition in the latex segment could negatively impact latex gloves margin. The robust demand for nitrile gloves has led to longer delivery lead times to between 45 to 50 days as compared to 30 to 40 days previously. Although we are positive on growth in subsequent quarters underpinned by uptick in nitrile demand driven by re-stocking activities, players like TOPGLOV and SUPERMX could continue to be plagued with competitive pressure from low margin latex gloves (accounts for estimated 50% of product mix for both players) which could offset the gains in the nitrile segment. Investors should focus on nitrile-centric players. Due to the intense competition in the latex segment, we recommend players which are largely nitrile-centric including HARTA and KOSSAN which product mixes hinge largely towards nitrile at 95% and 75% share, respectively. Conversely, TOPGLOV and SUPERMX which are largely latex-centric with product mix between nitrile and latex are estimated at 50% : 50% are expected to face margins pressure.

Oversupply concerns overplayed, ASPs pressure temporary rough patch. From our analysis, 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. 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 excess supply for rubber gloves leading to ASP compressions and flattish or lower profits over the past two quarters. However, with the rubber gloves players becoming aware of the intense competition since four months ago, measures were taken to mitigate the impact of competition including; (i) slowing new capacity expansion, (ii) measures to maintain margins, including automation and other cost reduction initiatives, and (iii) intensifying sales efforts to penetrate emerging economies.

Our Top Pick in the sector is HARTALEGA. 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 reduction in costs, (ii) constantly evolving via innovative products development, and (iii) its nitrile gloves segment, which is booming. Our TP is RM5.85 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 7%. Our TP is RM5.25 based on 25.5x FY20E EPS (+1.0SD above 5-year historical forward mean).

Source: Kenanga Research - 2 Oct 2019