We  recently  met  up  with  Hartalega’s  management  and  gather  that construction  on  its  next-generation  integrated  glove  manufacturing complex (NGC) is slated to begin  in 4QCY14. While we are positive on this  venture,  we  believe  that  timely  execution  is  key  in  bringing  the group  back  on  the  production  growth  path.  Maintain  NEUTRAL,  with unchanged TP of MYR7.40.

• NGC  to  lift  earnings.  During  our  recent  meeting,  Hartalega’s management  reaffirmed  that  the  NGC  is  progressing  as  planned,  with construction  of  its  first  production  line  scheduled  to  commence  in 4QCY14.  The  NGC,  located  in  Sepang  in  Selangor,  will  consist  of  72 production  lines  which  would  boost  the  company’s  annual  installed capacity to 42.5bn pieces by 2020.
• Nitrile demand to remain resilient. Given the prevalence of  allergies to natural rubber (NR)  in the US, we continue to see the demand for nitrile gloves rising over the  next  few years at the expense of  NR. A decade ago, NR gloves accounted for 81%  of the examination gloves imported into the US, while nitrile made up the remainder. Today, it is the  reverse, with  nitrile gloves making up ~82% of  all US  glove imports in 2012. This is to Hartalega’s  benefit, as  90% of its production capacity  is for  nitrile gloves.
• Concerns  over  industry  overcapacity  are  exaggerated.  While  we believe that there is no over-capacity in the nitrile glove segment, we are concerned  about  the impact on  the segment’s  declining average selling prices (ASPs) as a result of intense  price  competition  in the short-term. Hartalega’s  lead  in  nitrile  technology  and  innovation  will  enable  it  to maintain  a  margin premium over its peers, although competition will see some erosion in their absolute margins.
• Maintain  NEUTRAL.  We  make  no  changes  to  our  forecasts  at  this juncture,  and  continue to like Hartalega for its: i) leading  position in the thriving  nitrile  market  ii)  highly  automated  production  lines ,  and  iii) continuous efforts  to  improve operating  efficiency. That said, we believe that  margins  will  continue  to  come  under  downward  pressure  due  to intensified competition in the nitrile glove segment  amid declining  ASPs. Our unchanged TP of MYR7.40 is pegged to the existing 19x FY15 EPS, which is +1.5SD of the stock’s historical 5-year trading band.

Revenue flattens as ASPs fall. Hhatalega reported mediocre 3QFY14 results on 12 Feb,  mainly attributed  to  flat  3QFY14 revenue growth (-4.7% q-o-q; 3.2% y-o-y),  as well as average selling prices (ASPs)  that were  about 5%  lower  on the back of lower 
material  costs.  On  a  YTD  basis,  its  revenue  of  MYR826.8m  and  net  profit  of MYR184.1m were 8.5% and 6.7% better y-o-y respectively, mainly attributed to better operating efficiency,  coupled with increased output from its new production lines  at
Plant 6.

NGC to boost earnings.  During our recent meeting with its management, Hartalega reaffirmed that the NGC is progressing along as planned , with construction on its first production line to commence in  4QCY14. Hartalega’s NGC in Sepang, Selangor will 
consist of 72 production lines with a combined installed capacity of 28.5bn pieces. This  will  boost  the  company’s  annual  installed  capacity  to  42.5bn  pieces  by  2020. Figure 1 shows the gradual capacity  from  NGC  combined with the existing Bestari 
Jaya plant.

Management  has  allocated  MYR1.8bn-MYR2.0bn  in  capex  for  its  new  facility, Although the amount may seem substantial, we reiterate that the  facility will be built over eight years,  and we believe that funding will not  be  an issue given Hartalega’s operating  cash  flow  of  some  MYR300m  annually.  All  in,  we  maintain  our  positive stance  on  the  group’s  capacity  expansion,  which  is  expected  to  increase  15% annually  over  the  next  eight  years  as  we  believe  that  this  would  enhance  the company’s earnings visibility and production moving forward.

Nitrile demand to remain resilient.  Due to the prevalence of  NR-relatged  allergies in the US, we continue to see demand for nitrile gloves go up over the next few years at  the  expense  of  NR.  We  gather  that  the  switch  is  also  due  to  advancements  in glove making technology,  which  has  enabled  glove manufacturers to produce nitrile gloves  which  are  ~66%  lighter  than  NR  gloves  (3.0g  nitrile  gloves  vs.  5.0g  NR gloves), which has in turn given  them a cost advantage  as  less raw material  is now being  used. According to industry statistics,  in 2003,  NR gloves accounted for about 81%  of  all  examination  gloves  imported  into  the  US,  with  nitrile  making  up  the remainder. Today, the reverse  is  true as nitrile gloves  now made  up  some  82% of US’ glove imports in 2012. We believe that the US is a good indicator of global rubber glove demand given that it is the single largest glove user, consuming almost 30-35% of all gloves produced in Malaysia.

Sales  grow  steadily.  We  gather  that  nitrile  glove  demand  is  set  to  grow  at  20% annually over the coming years, and this is positive for Hartalega given its position as the world’s largest nitrile glove producer, with an annual installed production capacity of 14bn pieces.  In tandem with the increase  in  synthetic gloves imports  by  the US, Hartalega’s  nitrile sales  have risen  by a CAGR of 61.8% since 2005. Note that  the group  currently  commands  a  18%  share  of  the  nitrile  glove  market  in  the  US. Management  expects  sales  volume  for  FY14  to  grow  by  over  10bn  pieces,  which would  mean  a  10-12%  y-o-y  increase  from  FY13.  Moving  forward,  we  expect Hartalega’s sales to continue to improve given its healthy capacity expansion , with its upcoming  NGC as well as  healthy growth of nitrile gloves  demand  from the US and EU.

New  nitrile  demand  to  be  matched  by  supply.  With  new  glove  demand  being skewed  towards  nitrile  gloves,  most glove  makers  have  responded  by  bumping  up their  nitrile  production  capacity.  Based  on  nitrile  capacity  expansion  plans,  we estimate  that the  new nitrile supply from glove makers will  amount to  14.1bn pieces for  FY14.  This  will  be  soaked  up  by  new  global  demand  of  an  estimated  13.8bn pieces  this  year.  Assuming  a  20%  y-o-y  growth  for  nitrile  gloves  up  to  2016,  we reckon  that  there  would  be  no  oversupply  as  the  upcoming  nitrile  capacity  will  be consistently  taken  up  by  growing  global  demand  for  such  gloves,  as  shown  in  the chart below.

Concerns of industry overcapacity are exaggerated.  While we believe that there will not be overcapacity  in the nitrile glove segment  over the next  few years, we are concerned  about  the  impact  of  Hartalega’s  declining  ASPs  owing  to  intense competition  and  a  price  war  in  the  industry  (see  Figure  5).  We  anticipate  that Hartalega  could  potentially  be  affected  as its EBITDA margins are the currently the highest in the sector.  Most  of the other glove manufacturers  fetch  EBITDA margins ranging  from  10-15%  (see  Figure  6),  Hartalega’s  lead  in  nitrile  technology  and innovation has allowed it to enjoy  margins that are twice as high. Although  the group has alleviated the pressure  on  margins by improving efficiency at its production lines and  developing  nitrile  gloves  of  superior  quality,  we  believe  that  this  will  enable Hartalega  to  maintain  its  margin  premium  over  its  peers,  although  competition  will see some erosion in their absolute margins.

Risks. The key risks are: i) a spike in raw material prices, ii) depreciation in the USD, and iii) price competition within the industry. Maintain  NEUTRAL.  We  continue  to  like  Hartalega’s:  i)  leading  position  in  the thriving nitrile market,  ii) highly automated production lines,  and iii) continuous efforts to  improve  operating  efficiency.  That said, we believe that margins will continue to come under pressure in the upcoming quarters due to intensifying competition in the nitrile  glove  segment,  which  will  exert  downward  pressure  on  its  ASPs.  We  also believe that the timely implementation of  the group’s  NGC is vital for  it  to realise its goal of bringing back production growth  in the next  few years. Our  unchanged TP of MYR7.40  is  pegged  to  an  existing  19x  FY15  EPS,  which  is  +1.5SD  of  the  stock’s historical 5-year trading band.

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Company Profile
Hartalega Holdings Bhd manufactures a wide range of latex gloves and is the world’s largest nitrile glove producer.

Recommendation Chart

Source: RHB