Top Glove (TOPG MK) - UOB Kay Hian 2018-03-19: Toppish Valuations

TOP GLOVE CORPORATION BHD BVA.SI

Top Glove (TOPG MK) - Toppish Valuations

There were no major surprises from Top Glove’s briefing last Friday. We stay bearish on the stock, given snowballing downside risks, which we reckon are not being adequately considered by the market. These include:
1. currency headwinds,
2. potential vinyl glove supply recovery, and
3. possible inventory build-ups at customer level.
Also, we are still concerned about its elevated valuations.
Maintain SELL and target price of RM8.00.

Top Glove hosted a results briefing last Friday and as usual, it was well attended by various stakeholders. Also, management took the opportunity to sign the US$310m syndicated credit facilities with eight banks to partially fund the acquisition of Aspion (2.5x oversubscribed). Apart from this, there were no major surprises from the briefing as discussions revolved mainly on 1HFY18 operational review and reiterating its outlook.
Key takeaways include:
1. emerging markets continued to spur overall volume growth,
2. vinyl glove supply disruption in China is starting to abate,
3. expansion plans over the next 1-2 years are generally intact.

In 1HFY18, robust demand came primarily from emerging markets: Asia ex-Japan (volume: +61% y-o-y), Eastern Europe (+41% y-o-y), and Middle East (+34% y-o-y). Product appetite in these regions was skewed towards those made from natural rubber (powder free +19% y-o-y, powdered +15% y-o-y), fuelled by rising healthcare awareness and spillover effect from the shortage of global vinyl gloves.
However, developed markets such as North America (flat y-o-y) and Western Europe (+14% y-o-y) saw much slower volume growth due to the maturity of these areas combined with a more competitive operating environment.

Sharing the same observation with Top Glove, we note the recovery of vinyl glove supply in China is beginning to take shape.
To recap, the directive to convert residential heating systems to gas from coal in northern cities has created intense gas shortage over the past couple of months. This was due to infrastructure and logistical challenges. Hence, the central government was forced to prioritise residential gas users at the cost of industrial customers amid the cold winter weather. Recall, Northern China is a major production area of vinyl products.

The gas supply situation has improved as a slew of LNG plants had resumed operations in early-March, and state-run Sinopec has started commercial operations at its latest LNG import terminal in Northern China.
Also, the government is taking steps to ensure uninterrupted gas supply in the future (like speeding up the construction of network of pipelines and gas storage). Hence, vinyl glove players should be able to kick-start their businesses again albeit at a higher cost of production.
Nevertheless, we find Chinese vinyl gloves would still be cheaper vs nitrile ones by 10- 20%. In turn, this may prompt price-sensitive F&B customers to switch back to the more economical glove offerings, hurting Malaysian rubber glove players in the process.

With the 23% hike in gas prices for non-power sectors in Malaysia from Jan 18, Top Glove saw its corresponding costs in 2QFY18 jump by 15% q-o-q. On the other hand, foreign workers levy imposed on employers (also from the start of the year) had limited impact on the company as we estimated labour expense only increased < 5% q-o-q.
To recap, energy and labour expenses make up 14% and 10% of Top Glove’s total production costs respectively. Our calculation suggests that every 10% rise in energy and labour costs could reduce its FY18-20 earnings by 6-8% and 6-7% respectively (assuming the extra costs are not passed on to customers). To retain the same levels of profits, we estimate ASP has to increase by 1% for each of the scenarios.

Although there were various cost pressures and headwinds since the start of the year, Top Glove has managed to keep its operating margins at 13%, mainly thanks to more natural rubber glove sales as latex prices were soft.
Another offsetting factor was positive ASP revision. That said, 3QFY18 margin may be compressed since latex prices have started to climb in March (now average at RM4.88/kg vs February's RM4.57/kg) and we expect prices to continue to gain traction to RM5.00-5.50/kg over the next couple of months. This is in conjunction with the seasonal wintering period from February to May.
Similarly, nitrile cost has been inching up as well (now at an average US$1.18/kg vs February's US$1.12/kg). Our expectation is for it to settle at US$1.10-1.20/kg level.

At present, Top Glove and Aspion are running at capacity utilisation rates of 90% and 70-80% respectively.
For Top Glove, besides organic expansion via Factories 31 and 32, it plans to penetrate into Vietnam in the next 1-2 years. The intention is to build a factory there to house the production of 1-2b vinyl gloves. Besides, it is targeting to acquire another two small companies in 2018.
For Aspion, the aim is to increase its current 4.6b gloves capacity to 6b (new surgical gloves’ production lines) by 2019.
Overall, we laud Top Glove’s clear plans for the future but we reckon it needs to be watchful with the ballooning debt level (net gearing estimated to rise to 0.6x from net cash position post-acquisition of Aspion).
For FY18, management is guiding double-digit % growth (1HFY18: +36% y-o-y) and EBITDA margin of 15-16% (1HFY18: 16%).

No change to our forecasts. Key upside risks include:
1. market share gains,
2. more sizeable value-accretive M&As, and
3. US dollar appreciating markedly against the ringgit.

This is +0.5SD above its 5-year forward mean PE of 16x but below the sector’s 28x. The premium is fair as:
1. Top Glove has been making steady headway into the generally faster-growing nitrile glove space, and
2. the acquisition of Aspion propels the group into becoming the no.1 surgical glove player globally.
That said, the discount to the glove sector is warranted, considering its relatively stretched balance sheet (net gearing of 0.6x vs peers’ average of 0.1x). Likewise, our PE-ROE regression analysis suggests pegging the stock to 18-20x forward PE.
Despite the SELL call, we acknowledge Top Glove still appeals to long-only investors, given its good track-record in sustaining growth over an extended period of time.

Chan Jit Hoong CFA UOB Kay Hian | http://research.uobkayhian.com/ 2018-03-19

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