Hartalega  has  front-loaded  its  capex  and  we  expect  this  to  bring forward their capacity expansion plans. Consequentially, management has guided that Hartalega would  be taking up a revolving credit facilityin FY16  (Mar)  to ease cash flow for the firm. We switch our valuation to DCF from one-year forward P/E. We downgrade to NEUTRAL (from Buy) with a lower TP of MYR8.48 (vs MYR8.60), 0.3% downside.

Front-loading  expansion.  Hartalega  has  ramped  up  its  capex,  and expects to commit up to MYR1.5bn for their Next Generation Complex (NGC)  between  FY15  and  FY17,  which  represents  70%  of  the  initial NGC  forecast  spend  of  MYR2.15bn  vs  the  previous  capex  budget  of 35% for the same duration. We expect this to bring forward their capacity expansion  plans  and  our  analysis  forecasts  a  larger  earnings contribution from FY17 onwards.  Management expects the NGC to add a total of 28.5bn pieces of gloves capacity by FY20.

Capex  inference.  Consequently,  management  has  guided  that Hartalega would need to  draw  down MYR100m-400m  of a credit facility in FY16  to ease cash flow for the firm.  Our  depreciation assumption hasalso increased by 1-13% for FY16-17.

Forecasts and risks.  Due to the front loading of capex, our FY15/16/17earnings  forecasts  have  changed  by  1.1%/-5.2%/10%  to
MYR213m/289m/372m. Key risks that might affect our forecasts include heightened  competition  within  the  rubber  gloves  industry  that  might adversely affect margins and earnings.

Valuation basis.  We switch our valuation analysis  to DCF  from a oneyear forward P/E.  We believe this basis would better quantify the longterm  expansionary  strategy  of  Hartalega.  In  our  analysis,  we  used conservative  assumptions,  specifically  for  its  timing  of  capacity increases, average selling prices (ASP) and costs .

Downgrade  to  NEUTRAL  on  valuation  grounds,  with  a  revised  TP  of MYR8.48  (0.3%  downside,  CAPM  8.9%,  terminal  growth  rate  2%)  vs MYR8.60.  Hartalega’s  share  price  has  risen  22%  since  Sep  2014. Although Hartalega’s growth prospects remain intact, we downgrade our recommendation  as we believe that much of the positive news has been priced in  at current prices. Hartalega trades  at 23.8x FY16F  P/E, above its historical 2SD trading band of 22.2x, while its peers are trading at an average of 14.7x.

Investment Case

Attractive  earnings  profile.  Amidst  the  uncertain  market  environment,  the  rubber glove sector offers investors a safe-haven earnings profile that exhibits resilience due to the association with the healthcare sector, coupled with growth characteristics on
the  back  of  aggressive  capacity-led  earnings  expansion.  Hartalega  expects  to increase capacity to 42.5bn pieces by FY20 from 14bn pieces  in FY14.  We expect EPS to grow at a CAGR of 30% in FY16-17F.

Front-loaded capex.  Hartalega has ramped up its capex expenditure, and expects to commit up to MYR1.5bn for their Next Generation Complex (NGC) between FY15and FY17, which represents 70% of the initial NGC forecasted cost of MYR2.2bn  vs the  previous  capex  budget  of  35%  for  the  same  duration.  We  expect  this  to  bring forward their capacity expansion plans and our analysis forecasts a larger earnings contribution from FY17 onwards

Favourable  macro  environment.  Latex  prices  are  at  multi-year  lows,  trading  at MYR4.30/kg  from a 5-year average of MYR6.36/kg,  and we expect them  to remain subdued in  the  medium  term  due  to an  oversupply  of  rubber  and  a  weaker  global automobile  market.  Likewise,  nitrile  prices  are  trading  at  multi-year  lows  at USD0.89/kg  from  a  5-year  average  of  MYR1.38/kg,  and  which  we  expect  to  stay subdued due to lower oil prices.  The strengthening of the USD benefits Hartalega as
>95%  of  its  revenue  is  denominated  in  USD,  while  roughly  54%  of  their  cost  is denominated  in  MYR.  The  recent  fall  in  energy  prices  has  led  to  cheaper  utilities input  cost.  Scheduled  gas  tariff  hikes  for  2015  were  postponed  by  the  Malaysian government,  while electricity tariffs were granted temporary relief (annualized 4%) in Feb 2015.

Investment Risk
Heightened competition.  While we believe that the oversupply concerns that hung over  the  industry  for  much  of  2014  were  overplayed,  we  do  anticipate  heightened competition  among the  rubber  glove  players  that  could potentially  apply  downward
pressure on earnings and margins.  Our analysis shows that supply would increase faster than demand between FY15 and FY17. Nevertheless, we believe that Malaysia will  continue  to  grow  her  global  glove  market  share  at  the  expense  of  other  glove
manufacturing nations,  due to:  i) increasing technology efficiency of new production lines (faster line speeds and more automation), and  ii) more competitive advantage from the weaker MYR. Hartalega,  who has a proven track record of delivering high margins  from  their  technology  innovations,  will  be  relishing  to  lead  the  technology efficiency charge, in our view.

Delays  in  expansion  plans.  Unforeseen  delays  to  upcoming  capacity  would negatively impact potential revenue stream.
Weakening  of  the  USD.  A  weaker  USD  would  negatively  impact  earnings  and margins.

Rise in the price of raw materials.  Stronger raw material prices would negatively impact earnings and margins.

Valuation and Recommendation
Valuation  through  the  DCFE  method.  Hartalega,  through  its  Next  Generation Complex (NGC) intends to expand glove manufacturing capacity to 42.5bn pieces by FY20  from  15.8bn  pieces  currently.  To  best  capture  this  growth,  we  used  the
Discounted  Cash  Flow  to  Equity  (DCFE)  method.  By  discounting  Hartalega’s  free cash  flow  to  equity  with  a  cost  of  equity  (CAPM)  of  8.9%  (4%  risk-free  rate,  5.4% equity risk premium, 0.9x Beta) and applying a 2% terminal growth rate, we derive an intrinsic  value  per  share  of  MYR8.48  for  the  company  which  represents  a  0.3% downside  from  the  current  market  price  of  MYR8.50.  Our  target  price  implies  a FY16F P/E of 23.6x.

Sensitivity  analysis.  We  relied  on  our  analysis  on  what  we  considered  to  be reasonable and conservative estimations. In  Figure 3, we show a sensitivity analysis by varying the discount rate (CAPM) and the terminal growth to show the impact on TP.  We  consider  the  2%  terminal  growth  rate  we  used  as  conservative.  We highlighted our current assumptions.

In  Figure 4, we show  the impact on FY16F  and FY17F  earnings by applying various USD/MYR exchange rate assumptions.

Revenue  assumptions  (Figure  5).  There  are  two  main  parts  of  our  revenue assumptions:
1)  Capacity expansion. Hartalega’s management has projected their capacity to expand  to 42.5bn by FY20 from  14bn pieces in FY14. Nevertheless, in our modelling, to be conservative and to account for unforeseen delays, we assumed that this goal would only  be achieved in FY22. Management has also  guided  that  capacity  utilization  would  be  around  a  more  comfortable level  of  82%  going  forward,  from  an  average  of  88%  for  the  first  three quarters of FY15. We have also maintained their production split between nitrile and latex gloves of roughly 90:10.
2)  Average  selling  price  (ASP).  In  our  modelling,  we  assumed  a  CAGR increase of 0.1% and 1% from FY15-FY24  for nitrile and latex gloves ASP respectively. As part of the cost-sharing basis between Hartalega and their customers,  a  portion  of  savings/losses  from  forex  as  well  as  raw  material movements are passed back to their customers. Our assumptions are:

The  MYR is assumed to recover  to 3.21 in FY24F from 3.60 currently.This represents a CAGR increase of 1.27% over our DCF duration.  A recovery  in  the  MYR  will  increase  ASP  as  Hartalega  pass  on  losses from forex.

Nitrile  prices  are  assumed  to  recover  to  their  10-year  average  of USD1.27/kg. This represents a CAGR increase of 2.7% over our DCF duration.  A  rise  in  prices  of  nitrile  feedstock  will  increase  ASP  as Hartalega passes on losses from increase in COGS.

Latex  prices  are  assumed  to  recover  to  their  10-year  average  of USD1.75/kg. This represents a CAGR increase of 3.9% over our DCF duration.  A  rise  in  prices  of  latex  feedstock  will  increase  ASP  as Hartalega passes on losses from increase in COGS.

The rise in our nitrile and latex ASPs assumptions are lower than the CAGRrise  of  the  respective  forex  and  raw  material  prices  as  we  factored  in  a CAGR  decrease  of  1.3%  in  ‘real’  ASPs  until  FY24  to  account  for  the heightened competition that we expect in the glove manufacturing industry.

Cost assumptions (Figure 6). Roughly 46% of Hartalega’s cost is  quoted directly or indirectly  in  USD,  which  primarily  includes  nitrile,  latex  and  chemical  expenses. Although  latex  prices  are  usually  quoted  in  MYR,  the  commodity  itself,  much  like other commodities, is sensitive to variations in the USD.

Using the same assumptions we used for the revenue stream: i) USD/MYR of 3.21 in FY24F from 3.60 currently, ii) nitrile prices to USD1.27/kg in FY24F from USD1.00/kg in FY15F, iii) latex prices to USD1.75/kg in FY24F from USD1.24/kg in FY15F and iv) an assumed CAGR of 1.4% increase in production technology efficiency, we arrive at the cost profile of Hartalega. Raw material such as nitrile and late x would constitute a higher proportion of COGS over the years, reflecting the  higher raw materials prices in our assumption. We also forecast depreciation to increase to  8.3% of COGS by FY24F from 6% in FY14  to reflect the front loading of capex. Further details of the depreciation is explained in our Depreciation & Amortization table (Figure 10).

Income  statement.  With  the  estimated  revenues  and  costs,  we  built  our  income statement (Figure 7). Management had guided that effective tax rate would fall to low 20%. As such, we assumed a gradual fall to 20% by FY24F (from 24.5% in FY14).

Source: RHB Research - 6 Apr 2015