Although increasing competition within the glove industry would help consolidate supply and pricing power over the long run, we remain NEUTRAL on the sector as:

1. Increasing cost pressures amidst heightened industry competition could crimp margins,

2. Recent MYR forex volatility has curbed the risk appetite for the sector,

3. We expect flattish 1Q16 sector earnings growth, as earnings from added capacity could be offset by increasing cost and ASP pressures.

Recommendation. We remain NEUTRAL on the rubber products sector due to the recent volatility of the MYR, although we see interesting trading opportunities on stocks in the sector. We are of the view that when the MYR stabilises, stock valuations can edge closer to their respective intrinsic values, as investors refocus on sector fundamentals. Supermax remains our sector Top Pick, on the back of superior earnings growth (3-year EPS CAGR of 22%), as well as lower valuations vs peers (Figure 5). We also like Karex for its strategic business diversification.

4Q15 earnings recap. 4Q15 rubber products sector earnings were in line with expectations (Figure 1), posting a marginal 2.3% QoQ contraction from the absence of new capacity growth, as well as cost savings pass-through to clients which led to lower average selling prices (ASPs). Going forward, we expect 1Q16 sector earnings to be relatively flattish QoQ, as earnings growth from added capacity could be weighed down by higher costs plus ASP pressures from heightened competition – particularly within the nitrile glove segment.

Increasing costs amidst greater competition. While we forecast slower FY16 sector production output growth of 15.6% (2015: 21.1%, Figure 3), our industry channel checks reveal increased concerns of price competition. We believe this could complicate cost pass-through between manufacturers and clients, as the former maintain price competitiveness to gain market share in spite of the higher cost environment – namely, the increase in natural gas tariff (from government subsidy removal), as well as labour cost increases (minimum wage hike coupled with foreign labour levy) in 2016, which could crimp margins.

Short term pain, long term gain. Nevertheless, we believe the increasing competition is healthy for the industry over the long run, which would help weed out weaker manufacturers (to concentrate supply) and allow better glove pricing power. As the industry has relatively low barriers to entry and homogenous products, cost efficiency (either from improved technology or economies of scale) would be a major differentiating factor, where we believe better operating margins could translate into better pricing power vs other global manufacturers. Condoms for growth. We continue to like Karex for its strategic diversification into the own brand manufacturer (OBM) segment while maintaining their dominant position in the original equipment manufacturer (OEM) market, where we forecast 3-year EPS growth of 26%. We are also positive on their acquisition of TheyFit® intellectual property, which we think would complement their OBM ambitions.

Risks. The key upside risk to our view would be the re-rating of the sector, driven by liquidity buoyed by market risk aversion; downside risks include a stronger MYR, a spike in raw material prices and delays in capacity expansion plans.

Source: RHB Research - 22 Mar 2016