We  recently  had  lunch  with  Top  Glove’s  management  along  with  a group  of  investors.  We  learned  that  its  nitrile  capacity  expansions  at two plants are on track for completion. Top Glove’s share price has also retraced by about 23% since our downgrade in Oct 2013. Accordingly , we  upgrade  our  call  to  BUY  (from  Neutral).  Our  FV  of  MYR5.67  is unchanged, based on a 17x FY15F EPS. 
 

• Zeroing  in  on  nitrile.  Management  guided  that  the  expansion  of  its existing  plant  in  Lukut,  Port  Dickson,  ie  Factory  27,  is  on  track  for completion  by  May.  Meanwhile,  the  construction  of  a  new  factory  in Klang,  Selangor, ie  Factory 29, is  on track for completion by December. Factory 27  will add another 0.6bn  pieces of nitrile gloves while Factory 29  will  produce  1.6bn  pieces  of  such  gloves.  This  will  bring  its  total installed production capacity to 43.5bn pieces  by end-2014.  In  turn, this will lift its nitrile product mix to 27% from 23% currently.
• Minimal  impact  from  natural  gas  price  hike.  On  11  April,  Gas Malaysia (GMB  MK, NR) announced an average increase  in  natural gas prices  of  around  20%  for  industrial  consumers  like  rubber  glove manufacturers.  Top  Glove  guided  that  this  could  increase  total production costs by approximately 1.4%, which translates into more than MYR1.0m  a  month.  However,  management  stated  that the  increase in costs can easily  be  passed on to customers by a revision of 1-1.5% in ASPs  of  its  gloves.  Note  that  energy  only  comprises  5-6%  of  the company’s total production costs.
• Upgrade to BUY. We upgrade our call to BUY (from Neutral), given that Top Glove’s share price has retraced by some 23% since our downgrade in Oct 2013. W e believe that the market has largely priced in the weaker than expected sales volume growth. The company is now trading  at an implied 14x  1-year forward P/E, below its  historical 5-year average P/E of 17x. Top Glove deserves to trade at its historical average trading band because of its solid management team  and healthy balance sheet.  The company is also working on increasing its nitrile capacity and improving the  technology  at its plants  to increase operating efficiencies. Our FV of MYR5.67 is based on a 17x FY15F EPS.

Company Update

Not giving up on China just yet.  As we reported previously, in 1QFY14,  Top  Glove ceased operations at Factory 8 in Zhangjiagang and consolidated it into Factory 15 in Xinghua.  With  the  scaling  back  of  its  China  operations,  we  saw  its  vinyl  gloves division  record  losses  of  MYR5.2m  in  1QFY14  and  MYR5.4m  in  2QFY14.  These losses  were  also  attributed  to  a  challenging  business  environment  whereby  the Chinese Government  implemented a  policy  that limits the usage of coal  as a source of  energy  for  industries.  To  our  positive  surprise,  due  to  higher  utilisation  rates  of around  70-80%,  Top  Glove’s  China  plants  have  started  contributed  positively  in March, albeit slightly. Management expects this trend to continue and will focus on expanding its market presence in China.

Focusing on nitrile.  Top Glove guided that the expansion of its existing  Factory 27 plant  in Lukut  is on track for completion in May and will add another   0.6bn pieces of nitrile gloves to its total production capacity. At the same time,  the construction of a new factory in Klang, Selangor, ie  Factory 29, is slated for  completion by December. This  new  plant  will  add  another  1.6bn  pieces  of  nitrile  gloves  to  its  total  installed production capacity. Together, both plants will increase the company’s  total installed production  capacity  to  43.5bn  pieces  by  end-2014.  In  turn,  this  will  shift  its  nitrile product  mix  to  27%  (from  23%).  Moving  forward,  the  company  will  continue  to expand as it targets for a more balanced product mix of 50% nitrile and 50%  natural rubber  (NR).  This,  in  turn,  will  further  support  its  leading  market  position  as  the world’s largest glove manufacturer and potentially lift future earnings.

Demand  for  gloves  to  remain  resilient.  We  expect  overall  demand  for  gloves  to remain  strong  and  robust,  and  to  grow  at  an  annual  rate  of  8 -10%  in  the  coming years. We believe that this will be backed by natural organic growth from matured markets like  the  US and EU. The  increase in healthcare awareness from developing nations  could  also  enlarge  demand  further.  Note  that  penetration  rate  for  NR  in developing  countries  still  remains  high  at  about  90%.  Nitrile  gloves,  which  do  not have  the  protein  allergy  problem  encountered  with  NR  gloves,  are  fast  gaining traction and our channel checks anticipate demand   to  increase by 20% per annum. Apart  from  that,  given  easing  raw  material  prices,  we  also  expect  demand  for  NR gloves to remain solid and chalk up positive sales growth.

Due to the increasing demand and higher  nitrile  capacity, Top Glove’s nitrile sales volume increased 38% y-o-y  in  1HFY14. Other than strong demand for nitrile from markets such as the EU and North America, the company also witnessed an increase in sales contributions from countries  like Brazil (one of its biggest markets accounting for  11%  of  sales),  the  Middle  East  and  Asia.  As  of  2QFY14,  we  see  sales contributions from developing countries in Asia increasing to 14% vs 11% in 2QFY13.

Minimal impact from natural gas hike. On 11 April 2014, Gas Malaysia announced an average increase of natural gas prices of around 20% for industrial consumers  –such  as  rubber  glove  manufacturers  –  to  MYR19.07/m  metric  British  thermal  units (mmbtu)  from MYR16.07/mmbtu.  Management  guided that  this  could increase total production costs by approximately 1.4%,  which translates  into more than MYR1m a month as the company  currently  uses 35% natural gas for its operations.  However, Top Glove  believes  that the increase in costs can be passed on to customers by a revision of 1-1.5% in its gloves’  ASPs. Note that energy only comprises 5-6% of total production costs.

Concerns  over  prolonged water rationing  subdued.  Due to low water levels,  the Selangor  State  Government has  implemented  water rationing throughout the  Klang Valley  in  an effort to conserve water.  During the meeting, management stated that two of its plants in Banting, Selangor, with production capacity of 4bn pieces   in total, are  currently facing water supply shortages. A  few of its plants in Klang, Selangor, are  also  facing  disruptions.  Assuming  that  the  water  rationing  continues, management  opines  that  production  costs  could  increase  by  around  MYR10m,  as costs  incurred in obtaining and transporting the water  are  10x more than the normal 
water rate.  However, management  guided that water supplies are set to  resume  as per the norm by next week.

Key risks. Key risks include: i) price competition within the industry that could lead to margins  compression, ii) a sudden spike in raw material prices (ie nitrile and latex),and iii) a depreciation of the USD against the MYR.

Upgrade  to  BUY.  We  upgrade  our  call  to  BUY,  given  that  the  share  price  has retraced by some 23% since our downgrade in Oct 2013. We believe that the market has largely priced in the  weaker than expected sales volume growth. Top Glove now trades at  an implied 14x  1-year forward  P/E, below its historical  5-year average P/E of 17x. The company deserves to trade at its historical average trading band because of its solid management team  and healthy balance sheet.  Top Glove is also working on increasing its nitrile capacity and improving the technology at its plants to increase operating  efficiencies.  Our  unchanged  FV  of  MYR5.67  is  based  on  a  17x  FY15F EPS.

Financial Exhibits

SWOT Analysis

Company Profile
Top Glove Corporation is an investment holding company. The principal activities of its subsidiaries are  the  manufacturing and sale of medical gloves.

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Source: RHB