We gathered that all the three glove players under our coverage, namely Top Glove, Hartalega and Kossan Rubber, have recently taken steps to slash their annual installed capacities by decommissioning outdated facilities. We believe this should partly help to ease the prevailing excess capacity condition in the market. However, we continue to believe that the industry’s overall utilisation rates will remain below the breakeven levels due to weaker global demand for gloves. Moving into 2HCY23, we are not expecting a meaningful turnaround in profitability. Losses should persist on the back of pricing pressure from China, muted demand as well as elevated electricity and labour costs. All told, we are Underweight on the glove sector and maintain our Underperform calls on all the three glove stocks under our coverage.

• A recap on recent results. The recent results reported by gloves players under our coverage suggested that the sector is still facing headwinds. Kossan and Top Glove remained in the red while Hartalega reported a 96% drop in core net profit after adjusting for one-off impairment losses from decommissioning of its Bestari Jaya facility. All the players were still running at low utilisation rate due to prolonged gloves oversupply situation with customers’ resistance against ASP hike.

• Phasing out outdated facilities. Hartalega has announced to decommission its Bestari Jaya (BB) facility, which accounts for ~30% total capacity and consolidating its operations at the Next Generation Integrated Glove Manufacturing Complex (NGC) in Sepang. Top Glove has taken steps to decommission 2 old production lines with 5bn pieces capacity annually, and temporarily shutting down 17 out of 49 factories which runs 35bn pieces capacity annually. This will shave off ~40% of its total capacity from 100bn to 60bn pieces per annum. Meanwhile, Kossan had scrapped off 2 old plants in 2022, and will be phasing out another 3 plants this year, resulting in a ~27% reduction in total capacity to 24.5bn pieces from 33.5bn pieces annually.

• Gloves oversupply persists and customers are still reluctant to place sizeable orders. We believe the move in shaving off production capacity should help to ease the prevailing excess capacity condition in the market. Despite this, we are not expecting the Malaysian producers to achieve breakeven level anytime soon as utilisation rates should remain low (at around 50% or below) due to the weak global demand. Customers are still reluctant to place sizeable orders as they are able to receive their deliveries in shorter time period. However, we note that the discontinuation of older facility should lead to lower operating cost and hence, help to ease the pressure of escalating costs in the near term.

• Price competition from China. Chinese glove makers have gained significant global market share over the past 2 years from 10% in 2020 to 20% in 2022. This was mainly due to their aggressive undercutting and capacity expansion plan. The Chinese producers have the cost advantage over their Malaysian peers due to the use of cheaper source of energy (coal versus natural gas) that enable them to price at about 20% discount. The current ASP for Malaysia gloves is at ~USD20-21/1k pieces, while Chinese gloves are being priced at ~USD16/1k pieces. Any attempt to raise prices by the Malaysian glove players has resulted in significant pushback which lead to lower sales volume as customers divert their orders to the Chinese producers.

• Easing cost pressure but not sufficient to turnaround. Electricity costs have gone up 40% in the recent quarter. Meanwhile, Malaysia glove players have undergone manpower rationalisation by reducing headcount to lower labour cost. Raw material prices are trending down while the natural latex prices are expected to stay flat from May 2023 onwards as the wintering season ends. We also note that natural gas prices have been trending down from USD2.22/MMBtu in March 2023 to USD2.18/MMBtu in May 2023, which will translate to lower gas tariff in the 2HCY23. All said, we believe cost pressure would ease in 2H but this may not be sufficient to mitigate the impact of a weak ASP and sales volume.

• Potential favourable forex movement for glove players. The weakening of MYR against USD is expected to benefit the rubber glove sector as sales are mostly denominated in USD. The strengthening of USD would translate to higher MYR revenue. However, as some of the raw material cost is also quoted in USD, this would partially offset the positive impact arising from a stronger USD.

• Glove players are still in net cash position. Kossan remains the most resilient with a 59.26% net cash-to-market cap. Top Glove has the lowest net cash, hence making it more challenging for the group to endure a prolonged period of overcapacity condition in the market.

• Likely to remain loss-making in the near-term. Although the worst may be over, we are not turning positive on the sector yet, as we expect earnings will remain under pressure in the coming quarters. While Malaysia glove players have started to raise ASPs from February 2023, we believe that the ability to pass on further cost to customers will be limited as the Chinese players are still selling at discount to their Malaysian peers. Also, as cost is not likely to surge and remains stable, it will be more difficult to justify for any upward revision in ASP. Given our view that global demand should not grow exponentially to mop up the excess installed capacity post Covid-19 pandemic, we do not foresee the Malaysian glove players to deliver significant earnings recovery and revert to pre-pandemic profits over the next 1-2 years.

• Underweight on the sector. For Hartalega and Top Glove, we have revised up our net loss forecasts CY23F and reduced our earnings estimates for CY24- 25F. Meanwhile, we cut our CY23-25F earnings forecasts for Kossan. We change our valuation methodology to PBR as negative earnings will render PER impractical. PBR is seen as a more stable measure of value in an environment of volatile profitability for the glove sector. We value Kossan and Hartalega near their 1-year historical mean but -1SD for Top Glove, in view of its low utilisation rate and net cash position. Pegging Kossan and Hartalega at 0.7x and 1.3x CY23F PBR, we derive our new TPs of RM1.08 and RM1.70 respectively. We value Top Glove at 1x CY23F PBR to derive a TP of RM0.63. We maintain our Underperform calls on all the three stocks and hence, Underweight on the glove sector.

Source: PublicInvest Research - 4 Jul 2023