We  maintain  our  OVERWEIGHT  call  on the rubber  products  sector  on the  back  of  a  favourable  structural  and  macroeconomic  environment. We  believe  earnings  will  be  capacity  driven  while  operating  efficiency will  be  required  to  outperform  peers.  As  such  we  like  Hartalega  and Kossan  for  their  economies  of  scale,  leadership  in  the  nitrile  glove segment and accelerated capex cycle.

Resilient  demand.  Global  glove  consumption  is  expected  to  remain strong,  led by demand from the healthcare segment,  and is anticipated to expand  8-10% per annum. Demand is  often touted as inelastic due to the  crucial  protective  role  that  gloves  provide,  especially  for  the healthcare sector. Thus, glove suppliers have a resilient earnings profile combining defensive qualities with steady earnings growth.

Additional  capacity.  We  believe  that  the  additional  capacity  from  the expansion  in  nitrile  production  will  be  absorbed  by  the  market.  The commissioning  of  new  production  lines  is  being  done  progressively, which  will  enable  the  glove  makers  to  time  upcoming  capacity  to  the prevailing demand landscape.  

USD  strength  is  a  boon.  The  strength  in  USD/MYR  will  benefit  the industry because revenue will have a greater sensitivity to the  greenbackrelative to costs. A 3% increase in the USD/MYR exchange rate could liftthe industry’s earnings by ~2-4%.

Karex  (KAREX  MK).  We  maintain  our  BUY  recommendation  on  the stock as we continue to like its  organic and inorganic  growth  potential. We  have a  higher  TP of MYR3.89  (from MYR3.43), ie 20x  FY16F P/E and a 14.4% upside,  on the back of  an expected 3-year FY14-17F EPS CAGR of 23.8%.

Risks.  Heightened competition among glove players could lead to lower ASPs  and margins  that, in particular, would not bode  well for Top Glove(TOPG MK, BUY, TP: MYR5.06)  and Supermax  (SUCB MK, BUY, TP: MYR1.87) as both are margin laggards in the industry.

Maintain  OVERWEIGHT.  We  continue  to  like  stocks  in  the  rubber products  sector  that have good earnings growth, strong balance sheets and decent dividend yields. Our Top Picks are Hartalega (HART MK, TP: MYR8.04),  Kossan  Ruber Industries (Kossan)  (KRI MK, TP: MYR5.12)and Karex. Maintain OVERWEIGHT.

Demand – Supply Structure

Demand Structure.  Global glove consumption is expected to remain resilient  –  led by demand from the healthcare segment  –  and the street  anticipates this  to expand 8-10% annually over the next few years. This demand will be supported by organic growth  from  the  developed  glove markets  such  as the  US  and  EU,  as  well  as  the rising healthcare spending levels in the emerging markets. Glove demands are often touted as inelastic due to the crucial protective role that gloves provide, especially for the  healthcare  sector.  This  has  been  further  reinforced  by  progressively  stringent health  regulations  imposed  by  countries.  Thus,  glove  suppliers  have  a  resilient earnings profile that makes them suitable for a defensive theme play.

Overall  increase  in  healthcare  awareness  and  hygiene  standards  will  continue  to encourage  glove  consumption,  especially  in  the  emerging  markets.  Per  capita consumption of  gloves  in the  Asia  and  China markets  is  trailing, representing  only 2.8% of the per capita consumption in the US (see Figure 2). Assuming that the glove usage  in  Asia  and  China  reaches  levels  utilised  in  the  EU,  both  Asia  and  China markets  could  potentially  be  as  large  as  470bn  pieces.  This  is more  than  2.5x  the current global glove market.

Unpleasant catalyst.  The recent Ebola virus outbreak in West Africa may create an unpleasant catalyst in glove demand. The latest official update  on 26 Dec  reported 19,000  cases  of  Ebola  infection  in  Africa  with  7,600  deaths.  Nevertheless,  our channel  checks  with  sources indicate  that  they  have  not  seen  any  surge  in  orders yet,  though queries  were increasing. Nonetheless, in the longer term, we thi nk that the epidemic will help to improve healthcare awareness, which, in turn, will contribute to resilient glove demand

Additional  capacity.  Amidst  the  robust  growth  in  rubber  glove  consumption,  the industry  is  also  experiencing  a  shift  in  user  preferenc e  from  latex  gloves  towards nitrile  ones.  This  shift is  due  to the  increasing rate  of  latex  allergy  among medical professionals. Major developed markets had experienced negative to minimal growth for  the  latex  gloves  segment  while  recording  large  positive  growth  for  the  nitrile equivalent in the last few years (see Figure 3). This shift is also reflected in Malaysian rubber  gloves  exports,  which  constitutes  roughly  60%  of  the  global  glove  market. Since 2008, nitrile gloves – as a percentage of Malaysian gloves exports – have seen their proportion increase to 50.2% in 2013 from 17.3% in 2008 (see Figure 4).

Major  Malaysian  glove  suppliers  have  been  aggressively  expanding  their  nitrile production in light of this shift in user preference. We forecast a 19bn pieces capacity expansion in 2015, ie a 21% growth from 2014 numbers.

This expansion has sparked fears of a supply glut. Nevertheless, we believe that the additional  capacity from the  expansion in  nitrile  production will be  absorbed  as  the commissioning of new production lines is  being done progressively. This,  in turn,  will enable  the  glove  makers  to  time  upcoming  capacity  to  the  prevailing  demand landscape.

Given  the  competitive  operational  environment,  major  Malaysian  glove  suppliers have  thus  far  managed  their  respective  expansion  plans  well  to  prevent  an oversupply  in the  market. As such, we expect much of the same strategy from them going forward. We believe that the glove suppliers  will  be proactive with regards to their upcoming capacity should demand  be  softer. Furthermore, we believe that the advocates  of  an  oversupply  scenario  have  not  fully  discounted  risks  of  possible capacity delays or unscheduled interruptions to existing  capacity such as those that plagued Supermax in the last four years.

Halyard Health Inc, formerly known as the healthcare division of Kimberly-Clark Corp (KMB US, NR), has announced plans to shut down one of its glove manufacturing plants  in Thailand that has  3bn  pieces  annual capacity by 2H15. This  ought to  help ease some of the additional capacity worries.

Margin Analysis
Competitive pressure  on margins.  While  we  do  not  expect  a  supply  glut,  we  do forecast  for  competition  between  glove  suppliers  to  heat  up  with  the  expected additional capacity. As with 2014, the increased competition will lead to lower ASPs as well as erosions in margins. Should heightened competition for sales volume lead to a price war, we believe that  Hartalega  –  the industry leader in  margins  –  will be poised to benefit the most.  As such, we believe that improving efficiency will be the key to outperforming peers.

Cost pressure. Nonetheless, unlike 2014 where the margins of rubber glove industry were  beset  by  tariff  hikes  in  electricity  (+15%)  and  natural gas  (+21%),  we  do  not foresee  significant  cost  headwinds  for  glove  suppliers  in  2015.  Prices  of  raw materials  are  forecasted  to  remain  subdued.  The  weaker  demand  and  stronger supply situation in the rubber market is expected to persist, thus keeping prices of natural  latex  low.  Meanwhile,  the  current  oil  price  weakness,  from  which  nitrile  is derived, is expected to keep prices of the latter favourable as well.

The  introduction  of goods and  services  tax  (GST)  will  have minimal impact  on the rubber glove industry,  as a significant amount of production is exported, thus  it is a zero-rated output tax.

Strength  of USD/MYR is a boon.  Expectations of interest rate normalisation in the US as well as a weaker Malaysian fiscal position, led by the fall in oil prices, have caused the MYR to weaken against the USD. As at 26 Dec, the USD/MYR exchange rate has appreciated 10.6% since 1 Sep 2014. The strength in USD/MYR will benefit the  rubber  glove  industry  because:  i)  the  rubber  glove  industry  is  predominantly export oriented  –  we predict 85-95% of total production  is  earmarked for export and quoted in USD, and ii) the cost structure of these producers is largely denominated in MYR.

Further, the MYR has weakened against major competing rubber gloves producing nations such as Indonesia and Thailand. This ought to  help boost competitiveness of Malaysian rubber products vs those of Indonesia and Thailand.

Our  sensitivity  analysis  indicates  that,  should  the  USD/MYR  exchange  rate strengthen  by  0.10,  Malaysian  rubber  gloves  producers  could  benefit  from  an increased earnings level of around 2-4%.

Source: RHB