Coming away from our meeting with Hartalega’s management, we emerged more sanguine on its prospects. We were reaffirmed of the group’s growth trajectory on the back of sustained progress with capacity expansion at the Next Generation Integrated Glove Manufacturing Complex in Sepang. Additionally, we took further comfort that the group has lately been responding better to volatilities in external factors and that its sustained emphasis on cost management would remain instrumental in buoying margins. Following our added optimism, we fine-tune our average selling price and margin assumptions and correspondingly upgrade our FY17/FY18/FY19 earnings estimate by 10%/14%/13% which implies earnings growth of 28%/21%/18%. And as we roll forward our base year valuation to CY18 with an unchanged PE multiple of 22.0x, we arrive at a higher TP of RM6.05/share from RM4.50/share previously. Now with a decent upside potential of 21.5%, we upgrade our recommendation on the stock from Sell to Buy. Meanwhile, in the prelude to the group’s upcoming 4QFY17 results release in early May 2017, we could anticipate core net profit to come within the range of its preceding quarter as we foresee the QoQ climb in raw material prices to offset expected sales volume growth and upward revision to average selling prices.

Capacity Expansion at the NGC on Track

Reaffirming sustained progress with capacity expansion at the Next Generation Integrated Glove Manufacturing Complex (NGC) in Sepang, management alluded that commissioning of new production lines thus far, has been on track. The group is currently halfway through the commissioning of Plant 3 (see Table 1) with 7 of its 12 production lines operational. Closely in line with its targeted commissioning pace of 1 line per month, we note that 4 production lines were successfully commissioned during 4QFY17. As previously guided, full commissioning of Plant 3 is expected by 3QCY17 and after that, the group will proceed with the commissioning of Plant 4 over 4QCY17 to 3QCY18. Meanwhile, as for Plant 5 and Plant 6, management reiterated that it would adopt a wait-and-see approach to avoid expanding too rapidly. Nonetheless, their commissioning remains tentatively scheduled over 2019 to 2020. All in, barring disruptions to the group’s expansion plans, we project its capacity to grow from 23.5bn gloves per annum in FY17 to 40.7bn gloves per annum by FY21, translating into a CAGR of 14.7%.

Management Comfortable with Current Pace of Expansion

At this point in time, we acknowledge that management is comfortable with its pace of expansion. While new capacity is naturally expected to be absorbed by the market’s sustained growth in demand for rubber gloves, support is also expected from active marketing efforts (i.e. trade exhibitions) to grow the group’s presence in existing and new markets. Among others, the group views Eastern and Southern Europe countries like Italy and France as greenfield markets. While the growth in demand for nitrile gloves in these countries has been robust at double digit rates in recent years, we understand that the group has relatively lower presence in these parts of the world.

Better Response to Volatilities & Cost Management Remains Instrumental

We understand that the group has lately been responding better to volatilities in external factors (i.e. foreign exchange and raw material prices). This likely being the result of easing market competition as well as the group’s increased frequency of reviewing selling prices to every month from every 2 months previously as a measure of added prudence. Henceforth, while sequential margin fluctuations due to volatilities in external factors are inevitable, we opine that it would not be as severe as was observed not long ago in 4QFY16 (see Figure 3). Meanwhile, we also learned that the group’s sustained emphasis on cost management would remain instrumental in buoying margins. Exemplifying measures being undertaken, we note that the group is progressively imparting know-how in areas such as process workflow and automation from the more efficient plants at the NGC to older plants in Bestari Jaya, Selangor which today is still its key revenue contributor at about 60%. Overall, in consideration of the aforementioned, we opine that the group should deliver stronger earnings in the foreseeable term. Accordingly, we have finetuned our average selling price and margin assumptions and correspondingly, upgrade our FY17/FY18/FY19 earnings estimates by 10%/14%/13% which implies earnings growth of 28%/21%/18%.

4QFY17: Estimated to Be Within Range of Preceding Quarter CNP

For 4QFY17, we foresee the climb in raw material prices (nitrile butadiene rubber +33.5% QoQ; natural rubber latex +31.0% QoQ) to largely offset the earnings growth expected from the sustained growth in sales volume (installed capacity projected to have enlarged by 4.4% QoQ) and guided upward revisions to average selling prices (ASPs) of about 10% QoQ effected during the quarter. Our expectation is premised on our back-of-the-envelope calculations suggesting a 3.8% revision in ASPs to offset every 10% change in raw material prices which account for 38% of the group’s cost structure. In view of this, we could anticipate the group’s 4QFY17 core net profit to come within the range of its preceding quarter. Also, considering the relative stability of the Ringgit against the USD (-1.4% QoQ), we do not anticipate material forex losses.

Valuation & Recommendation

We arrive at a higher TP of RM6.05/share (from RM4.50/share) upon rolling forward our base year valuation to CY18 with an unchanged PE multiple of 22.0x, closely aligned to its 5-year historical average PE. We like the group for its manufacturing capabilities, superior margins, and earnings growth prospects which we project for FY17/FY18/FY19 at 28%/21%/18%. Now with a decent upside potential of 21.5%, we upgrade the stock to Buy. Downside risks to our call includes sustaining high utilisation rates as new capacity comes along and volatile fluctuations in foreign exchange and raw material prices.

Source: TA Research - 25 Apr 2017