The Covid-19 pandemic outbreak has led to sharp spike in rubber gloves demand in recent months, as distributors and government agencies scramble to purchase more medical gloves, in fear of a dire shortage of protective gears. The desperation for gloves has driven ASP higher and we expect the price uptrend to continue as demand for gloves remains strong. We adjust Hartalega and Kossan’s earnings forecast for FY20-FY22F by 11-124% to account for the higher ASP assumption and operational efficiency. We maintain our Neutral call on Kossan and Hartalega, but we upgrade Top Glove to Trading Buy, as our TP implies an upside of 25% following a retracement in its share price since our recent downgrade. We cut our rating on the sector to Neutral, as we believe the supernormal profit is not sustainable in the long run while current valuation has ran ahead of the fundamentals.

• Supply shortage. Fuelled by a shortage in global supply, the glove makers are currently experiencing a sector-wide ASP uptrend. However, we reckon that the quantum of ASP increase differs for glove makers under our coverage universe, with Top Glove having the most flexibility in terms of ASP revision. This is particularly due to the difference in client profile, as Top Glove has a more diversified customer base, with its largest customer contributing to less than 4% of its topline, hence it is able to adjust ASP upwards more swiftly compared to its peers.

The players are also seeing a spike in ad-hoc orders due to government agencies and NGOs rushing in to replenish their inventories at a rate faster than drawdowns, CSR initiatives to distribute to the needy countries as well as preparation for a potential second wave of Covid-19. Note that these ad hoc orders are generally priced at a 50-150% premium as compared to the normal recurring orders. The increase in ad-hoc orders only started to gradually pick up in the month of May and the glove makers have guided that all incoming new capacities will be allocated to cater for spot orders.

• Overwhelming orders. Glove players are experiencing an overwhelming amount of orders since the start of the global pandemic. Top Glove has secured orders for delivery up until 2QCY21, while Kossan has orders lined up until 1QCY21. As for Hartalega, the Group has also been allocating capacity to clients ahead of time, and the orders will only be locked in c.2 months prior to the delivery of goods, similar to the industry-wide practice. Although some of the orders locked in ahead of time were secured with a certain amount of deposit for some glove makers, however, we do not rule out the possibility of buyers having the option to push back on deliveries should Covid-19 starts to subside, which would delay revenue recognition.

• Raw material prices. The glove makers benefitted from low raw material cost in 1H2020 as the implementation of lockdown measures have resulted in a slump in prices for commodities such as latex and crude oil. However, latex prices have gradually recovered since late-March as China started to relax its lockdown measures, coupled with the effects of wintering period. Note that wintering period falls between the month of February and May and it typically reduces production yield by 45-60% from its peak period, leading to higher prices.

Despite the end of wintering period, we expect raw material prices to continue trending upwards as we believe that the gradual reopening of economies will help to support the global automotive sector’s recovery and The International Rubber Study Group (IRSG) has revealed that the tire manufacturing sector accounts for 71% of the world’s rubber usage. Therefore, we are of view that the rubber prices will not slump in 2H20. While the quantum of ASP increase in the coming months should sufficiently cover the impact of higher raw material cost, margin expansion could be lower than expected.

• Downgrade to Neutral. We believe the glove players to continue delivering record high profit in the coming quarters, mainly supported by the ASP increase. As such, we raise our FY20-22F earnings forecast for Kossan and Hartalega by 11-124% to reflect the impact of higher ASP and operational efficiency as the glove makers ramp up their operations to fulfill the influx of orders. However, we caution that such strong profits are unsustainable in the long-run and we expect earnings to peak in CY21F, therefore we reckon it is not justifiable to continue valuing the glove players at +2SD of its respective 5- year historical mean. Meanwhile, we reduce our PE multiple for both Hartalega and Kossan to 38x and 26x respectively, which is at +1SD of its 5-year historical mean. We also downgrade our recommendation on the rubber glove sector from Overweight to Neutral, taking into consideration that the exceptional earnings cannot be maintained for an extended period of time.

• Hartalega. We adjust our earnings forecast for FY21-22F by 35-124% to account for the higher ASP assumption as well as operational efficiency. Our TP is subsequently raised to RM11.10, with an implied PE multiple of 38x (at 1SD of its 5-year historical mean), based on a CY21F EPS of 29.2sen. Maintain Neutral.

• Kossan. Similarly, we also lift Kossan’s FY20-21F earnings projections by 11-70% to take into account the effects of higher ASP, as well as better economies of scale as the Group continues to ramp up its production. Our TP remains unchanged at RM8.80, as we cut our PE multiple to 26x (at +1SD of its 5-year historical mean), based on a CY21F EPS of 33.9sen. Maintain Neutral.

• Top Glove. We maintain our earnings forecast for Top Glove, with an unchanged TP of RM19.30, implying a PE multiple of 31x (+1SD of its 5- year historical mean) on CY21F EPS of 62.3sen. Top Glove’s share price has retraced since our previous downgrade and given an upside potential of 25%, we upgrade Top Glove to Trading Buy as we expect its earnings growth to be relatively stronger than its peers, considering its flexibility in raising ASP.

Source: PublicInvest Research - 26 Jun 2020