We maintain our optimism on the fundamentals of the global rubber product sector. In particular, we are pleased to note that rubber gloveplayers have managed to secure orders in advance for their upcoming capacity enhancements. Nonetheless, we downgrade the sector to NEUTRAL (from Overweight) on valuation grounds and recommend that investors accumulate only on dips.

• 1Q15 earnings for the rubber products sector were in line with our forecasts with all stocks under our coverage posting a QoQ increase in earnings. Overall, earnings were driven by capacity expansion that helped offset falling ASPs, increased operating efficiency and favourable macro-economic conditions. Of these, the former two elped industry players to record better margins during the quarter (see Figure 1).
• Middle East Respiratory Syndrome (MERS) has led to a renewed interest on rubber glove stocks in recent days. Nevertheless, we opine that the MERS outbreak would not have a material impact on earningsand any investor interest would only impact valuations in the interim.
• Healthcare proxy. Malaysian glove exports grew 8.6% YoY in 2014, of which 86.7% of total export was medical-related – vs 85.3% in 2013 –which highlights the increasing importance of gloves within the healthcare industry. Industry players remain optimistic on demand prospects and forecast that global glove demand will grow at an average rate of 8% pa going forward.
• Strong fundamentals. We maintain our optimism on the fundamentals of the global glove sector and, in particular, are pleased to note that rubber glove players have managed to secure orders in advance for their upcoming capacity enhancements in 2015. We are not overly concerned about the much-touted oversupply issue, since we believe that theplayers would be pragmatic with their expansion plans and time it to suit the prevailing demand landscape.
• Recommendations. We downgrade the rubber products sector to NEUTRAL (from Overweight) on valuation grounds, due to downgrades for both Hartalega and Kossan Rubber Industries (Kossan).
• Risks. The key upside risk to our view is the re-rating of the sector driven by liquidity as investors switch into defensive stocks during periods of market uncertainty, despite the lack of new catalysts in the industry. Other upside/downside risks include a stronger USD/MYR, spike in raw material prices and delays in capacity expansion plans.
• Strategy. As we remain confident on the fundamental prospects of the industry, we recommend that investors accumulate on dips, when valuations are more attractive. Our Top Picks for the sector are Karex (KAREX MK, BUY, MYR3.63) and Riverstone (RSTON SP, BUY, TP: SGD1.54), which have successfully translated their respective competitive advantages into higher margins while also expanding capacity aggressively.

1Q15 recap Earnings recap. 1Q15 earnings of rubber products players were in line with ourforecast. Earnings improved QoQ for all stocks under our sector coverage, led by Kossan (+19.8%), Top Glove (+15.2%), Hartalega (+10.9%), Supermax (+24.3%, due to tax provisions), Riverstone (+20.7%) and Karex (+4.6%). Overall, earnings were driven by capacity expansion that helped offset falling ASPs, increased operating efficiency and favourable macro-economic conditions – and the former two have helped industry players record better margins during the quarter.

Improved margins were primarily led by better operating efficiencies, such as fasterdipping lines that boosted production line speed, and improved economies of scalesuch as a better logistics supply chain from upcoming capacity expansions. Karex, in particular, has also benefitted from a higher-margin product mix.

Macro-economic drivers were favourable during the quarter with lower raw material prices, while the USD strength helped to boost earnings (>90% revenue in USD while <60% cost in MYR). The price of latex was down 7.0% QoQ while that for nitrile fell 8.6% QoQ (see Figure 2). Meanwhile USD rose 7.6% against the MYR QoQ (see Figure 3).

Capacity expansion on track. Hartalega is commissioning two new lines per month, which would add a total capacity of 8bn pieces in 2015, while Kossan’s Plants 2 & 3 (4bn pieces in total) will run at full capacity in Jun 2015 and management expects a stronger 2H earnings. In the meantime, Top Glove has commissioned Factory 29 in Jan 2015, adding 2bn capacity for the year while we expect Supermax’s Plant 10 & 11 to achieve full commercial production by end-2015. Riverstone, the world’s largest clean-room gloves manufacturer, is expecting the 1bn capacity from the second phase of its expansion to come online in 4Q15. Karex’s Hat Yai capacity expansion, which would have increased total capacity to 5bn from 4bn, has been delayed. Initially slated for commissioning in early June, it will now be commissioned later in the month.

Middle East Respiratory Syndrome (MERS) Update. At the time of writing, there have been four confirmed deaths, as well as 41 infected patients while thousands more are under quarantine from the MERS outbreak in South Korea. 900 schools have been shut in the country. The MERS outbreak has led to a renewed interest in the rubber glove stocks in recent days. Nevertheless, we opine that the MERS outbreak would not have a material impact on earnings and any investor interest would only impact valuations in the interim due to the following reasons: i. The spread has so far been contained locally in South Korea, with only one reported case in China. ii. Scientists and experts have classified the MERS Coronavirus as “not very contagious”, which normally spreads upon “close proximity”. Furthermore,they are confident that the sophisticated and modern healthcare system of the country would be able to cope. In fact, two weeks into the MERS outbreak, the South Korean Government has managed to trace the patients and quarantine those that were in contact with these patients. The high number of people under quarantine is indicative of the cautious nature and the effectiveness of the South Korean healthcare system. iii. The global responses to pandemic outbreaks have improved since the Severe Acute Respiratory Syndrome (SARS) outbreak in 2003. Subsequent outbreaks such as the highly contagious Ebola were successfully contained in their respective local geographies, largely in part to better community awareness as well as more efficient standard operating procedures. iv. Rubber glove manufacturers have shared that while it is still too soon to gauge the impact of MERS, the last pandemic that translated into a spike inglove demand with a material impact on earnings was SARS in 2003 –some 11 years ago – even though there have been outbreaks of other diseases since. Should the MERS outbreak spread to become a global pandemic, we opine that Top Glove would stand to benefit the most from a sudden spike in rubber glove demand. This is due to the spare capacity that the company has, with utilisation rates of around 70% while other players such as Hartalega, Kossan and Riverstone areoperating at a >80% utilisation rate.

Source: RHB Research - 8 Jun 2015