Top Glove’s 9MFY15 (Aug) results beat expectations, reaching 83%/82% of our/consensus estimates respectively. We upgrade our recommendation to BUY (from Neutral) with a revised TP of MYR7.02 (19.7% upside) up from MYR5.47. Sales volume and revenue grew while margins expanded on the back of increased operating efficiency as well as favourable macroeconomic conditions.

• Beat expectations. Top Glove’s 3QFY15 earnings surged 28.9% QoQ on the back of 15.5% QoQ revenue growth. Its sales volume grew 10.0% QoQ and in particular, nitrile glove volume increased 30% QoQ. Our estimates suggest that Top Glove managed to lift its utilisation rate to 75.3% during the quarter (FY14: 73.2%). Its China operation also reported a turnaround, posting a 9MFY15 net gain of MYR4.4m (9MFY14: -MYR11.2m).
• Margins soar. Margins widened in 3QFY15, on the back of increased operating efficiency in addition to favourable raw material prices and the stronger USD. Its EBIT margin expanded to 15.4% (2QFY15: 12.9%). Top Glove guided that the higher margins would be sustainable as itexpects to reap further benefits from the automation drive. Having achieved its initial target of a 30% nitrile gloves product mix during 3QFY15, Top Glove now aims to achieve a 50% nitrile mix by FY20. Factory 30 (4.4bn gloves capacity) has been delayed for three months and is now slated for commissioning in Dec 2016.
• Potential M&A. Top Glove is currently sitting on MYR221.2m in cash and is on the lookout for opportunities that could add value to its existing operations, such as ceramic glove formers or packaging materials.
• Forecasts and risks. After revising our assumptions, we upgrade our earnings forecast by 13-23% for FY15-FY17. Key risks include an increase in the prices of raw materials , a weaker USD and heightened industry competition which could adversely affect margins and earnings.
• Upgrade to BUY. We lift our TP to MYR7.02 (19.7% upside, CoE: 8.9%, TG: 2%) from MYR5.47. We switch our valuation methodology to DCFEfrom a one-year forward P/E to better quantify the long-term growth potential of the rubber glove industry, which is undergoing aggressive capacity expansion. We are impressed with Top Glove’s margin expansion and believe that the stock could be re-rated on the back of further automation drive. Top Glove is currently trading at 13.7x FY16F P/E, which is below the sector average of 18.9x.

Investment case Resilient earnings profile. Since Top Glove’s ultimate customers are hospitals and medical units, the company is an indirect play on the growing global healthcare expenditures. As such, Top Glove has a resilient earnings profile that is non-cyclical and defensive. Top Glove pays approximately 3% dividend yield.

Strong glove demand. Malaysian gloves exports, which is the benchmark used to approximate global glove demand owing to the approximate 60% global market share enjoyed by Malaysian exporters, increased 8.6% YoY in 2014. In fact, the strong demand has continued into 2015, with industry players reporting orders ahead of incoming capacity. Top Glove reported a 10% QoQ increase in sales volume in its recently-announced 3QFY15 results.

Favourable macro environment. Latex prices are at multi-year lows, trading at USD1.30/kg vs a 5-year average of MYR2.03/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 USD1.00/kg from a 5-year average of USD1.37/kg – and which we expect to stay subdued due to lower oil prices. The strengthening of the USD benefits Top Glove,as >90% of its revenue is denominated in USD while roughly 40% of the company’s cost is denominated in MYR. The recent fall in energy prices has led to cheaper utilities input costs, as electricity tariff hikes were granted a temporary relief (annualised 4%) in Feb 2015.

Potential M&A activities. Top Glove has announced its intention to pursue M&A opportunities in 2015, expressing interest in acquiring companies that could add value to its existing businesses such as ceramic glove formers or packaging materials makers. It guided that it will be looking into acquiring one or two companies for the year, with a preference for local opportunities.

Investment Risks 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 put downward pressure on earnings and margins. Our analysis (see Figure 4) shows that supply would increase faster than demand between FY15 and FY17. Nevertheless, we believe that Malaysia will continue to grow its global glove market share at the expense of other glove manufacturing nations, due to: i) increasing technologicalefficiency of new production lines (faster line speeds and more automation), ii) greater competitive advantage from the weaker MYR. As such, we believe that increasing operating efficiency will be key to outperformance. Top Glove’s automation initiatives have hit a stride, with impressive 3QFY15 earnings. 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.

Valuations and recommendation Valuation through the DCFE method. Top Glove intends to add two new factories and lift its annual glove capacity to 52.4bn pieces by Dec 2016 from 44.6bn pieces currently. Of which, there would be an additional 1.4bn capacity of latex gloves and 6.2bn capacity of nitrile gloves. We used the discounted cash flow to equity (DCFE) method to best capture the growth. By discounting Top Glove’s free cash flow to equity with a cost of equity (COE) 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 MYR7.02 for the company, which represents a 19.7% upside from the current market price of MYR5.87. Our TP implies a FY16F P/E of 16.1x.

Sensitivity analysis. We relied our analysis on what we considered to be reasonable and conservative estimates. In Figure 6, we showed a sensitivity analysis by varying the discount rate (COE) and the terminal growth to show the impact on target price. We consider the 2% terminal growth used as conservative. We highlighted our current assumptions.

Revenue assumptions. There are two main parts of our revenue assumptions:i. Capacity expansion. Top Glove’s management projects its capacity to expand to 52.4bn pieces by FY17 from 44.6bn currently. In our model, we have also assumed an additional 1bn capacity expansion for every financial year, from FY18 to FY24, to account for future capacity ambitions. We have assumed a utilisation rate that stabilises around 75-76%, in line with the latest utilisation rate achieved in the company’s 3QFY15 results. Having achieved a 30:70 nitrile:latex mix in the recent quarterly results, Top Glovehas shared ambitions to increase the product mix to 45-50% nitrile in fiveyears. We have assumed the lower end of 45% to be conservative. ii. Average selling price (ASP). In our model, we assumed CAGR increasesof 0.6% and 1.4% from FY15-FY24 for nitrile and latex gloves ASPsrespectively. As part of the cost-sharing basis between Top Glove and their customers, a portion of savings/losses from forex as well as raw material movements are passed back to their customers. We have been conservative in our assumptions:

• The MYR is assumed to recover to 3.19 in FY24F against the USD,from 3.76 currently. This represents a CAGR increase of 1.8% over our DCF duration. A recovery in the MYR would increase its ASP as Top Glove passes 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 2.6% over our DCF duration. A rise in prices of nitrile feedstock would lift its ASP as Top Glove passes on losses from the increase in COGS.
• Latex prices are assumed to recover to their 10-year average of USD1.75/kg. This represents a CAGR increase of 4.4% over our DCF duration. A rise in prices of latex feedstock would increase ASP as Top Glove passes on losses from the increase in COGS.

The rise in our nitrile and latex ASPs assumptions are lower than the CAGR uplift of the respective forex and raw material prices as we factored in a CAGR decrease of 1.1% in “real” ASPs until FY24 to account for the heightened competition that we expect in the glove manufacturing industry.