INVESTMENT HIGHLIGHTS

• Expect 1QFY20 normalised earnings to remain stagnant quarter-on-quarter

• We opine that the group have to absorb the higher cost of production due to the oversupply market situation

• Current focus is on increasing the sales volume and production efficiency to reduce cost per unit

• Maintain NEUTRAL with a revised TP of RM4.77

Expect 1QFY20 normalised earnings to remain flattish. To recall, Hartalega recorded a weak 4QFY19 earnings which came in at RM91.4m, which translate into a decline of -23.7%qoq and -21.7%yoy. Moving forward, we are expecting 1QFY20 normalised earnings to come in between RM87.0m to RM97.0m which would account for about 20.0% to 22.0% of our full-year FY20 earnings forecast. On a comparable basis, we view that 1QFY20 normalised earnings to remain stagnant on a quarter-over-quarter basis. This would also mean that on a year-on-year basis, we are expecting an earnings reduction of more than 22.0%.

Supply surplus in the 1HCY19. We are anticipating the group’s average selling price (ASP) to remain depressed in the near-term i.e. below RM100 per thousand pieces (vs 4QFY19 of RM96.0 per thousand pieces). Despite the ‘cost-pass through’ practice in the glove industry, we believe that the group was unable to fully pass through to its customers the higher cost of production during the last quarter which arose from the upward revision of gas tariff and minimum wage. This is largely due to the supply surplus of nitrile glove particularly in the 1HCY19. Note that we are estimating a +3.0%qoq increase in production cost which the group will have to absorb.

Competition to stiffen up for nitrile glove segment. We gathered that 2HCY19 is expected to be better in terms of supply-demand dynamic driven by industry players’ effort to regulate expansion. Based on our channel checks, the local glove manufacturers have delayed about 6.0b of planned capacity expansion in FY19 (about -30.0% cut from the initial plan). Nonetheless, we believe that Hartalega would be in a difficult position to meaningfully increase its selling price as its bigger peers are aggressively expanding its nitrile glove manufacturing capacity. This would inadvertently lead to lower profit margin.

Production capacity to improve by more than +20.0% by FY22. With ASP to remain under pressure, Hartalega has been very conservative in its capacity expansion plan, particularly in CY19 in relative to its bigger peers. Despite this, the group’s main focus is still on increasing its capacity and increasing production efficiency to meet its medium to long term target of lower production cost per unit. The group has set aside capital expenditure (capex) for plant expansion and automation of RM630.0m and RM115.0m respectively for the next three years. The capex for plant expansion is allocated for the construction of Plant 6 (4.7b pieces) and Plant 7 (2.6b pieces) which is targeted to start production in the 1HCY20 (FY20) and 2HCY20 (FY21) respectively. These will increase its current capacity from approximately 34.0b pieces to 42.0b pieces by FY22. In addition, the group is also currently looking to acquire suitable land for future expansion beyond Plant 7.

Continuous focus on production efficiency. The group prides itself as a leader in technology innovation in the glove industry. Hartalega remains the best in terms of productivity with efficiency level at 3.3 workers per million pieces per month (WPM) in comparison to the industry average of 5.3. The greater efficiency is largely contributed by its Next Generation Integrated Glove Manufacturing Complex (NGC) plants (supply about 70.0% of its total capacity) which achieved about 2.6 WPM. With the intensified investment into automation, the group targets to further reduce the number of workers at NGC to 2.3 WPM. Among the initiatives to reduce the dependency on labour are installations of robotic auto packing system that replace the manual process of inserting a stack of gloves into a box.

Earnings forecasts. We are revising our FY20F and FY21F earnings downward by -15.1% and -6.2% respectively due to the downward pressure on ASP as the higher production costs cannot be fully pass on to customers. We do not expect much room for the ASP to increase in the near to mid-term in view of the intensifying competition.

Target Price. We revised our target price to RM4.77 per share (previously RM4.65) as we rolled forward our valuation based year to FY21. Our TP is derived via pegging our FY21F EPS of 15.4sen to PER21 of 31.0x, which is -1.0SD below its three-year average historical PER. We prescribed a discount to Hartalega’s historical PER valuation in light of the diminishing differential between its profit margins in comparison to its peers.

Maintain NEUTRAL. We remain concern on the declining ASP in view of the industry oversupply situation which has also affected the group’s profit margin. This is due our expectation that 1QFY20 earnings growth will stagnant in comparison to 4QFY19. On a longer-term basis, we opine that the industry players’ effort to regulate the expansion drive, coupled with the resilient demand for rubber gloves globally, will restore the supply-demand dynamic. In addition, we applaud the group’s effort to continue to be the leader in technology innovation in the glove industry which gives them the upper hand in managing the production cost. Valuation wise, the stock is currently trading close to its three year historical average PER of 37.4s. Therefore, we believe that there is limited upside for the stock. All in, we are maintaining our NEUTRAL recommendation on Hartalega.

Source: MIDF Research - 31 Jul 2019