Rubber Gloves – Malaysia - UOB Kay Hian 2019-01-10: More Rational Valuations Emerge From Steep Sell-Down

TOP GLOVE CORPORATION BHD (SGX:BVA)

Rubber Gloves – Malaysia - More Rational Valuations Emerge From Steep Sell-Down

The recent sell-down appears to have finally reflected sector fundamentals. Now that valuations appear more rational, we upgrade Top Glove and Kossan to HOLD from SELL.
Our unchanged UNDERWEIGHT sector rating is due to the sector’s bellwether, Hartalega, trading at lofty valuations and emerging signs of demand-supply imbalance.

Over the past couple of days, the rubber glove sector saw a considerable selldown amid the broader market steadily gaining ground. Hartalega Holdings (Hartalega), Kosan Rubber (Kossan), and TOP GLOVE CORPORATION BHD (SGX:BVA) average of 16% over the first three days of the week.
The sell-down is particularly unsettling, especially as Hartalega and Top Glove are FTSE Bursa Malaysia KLCI index components.
We believe the volatility stemmed from three recent developments which serve as a reminder of downside risk to lofty valuations, which has been the basis for our UNDERWEIGHT on the rubber glove sector.

Our UNDERWEIGHT call on the sector is due to the sector’s bellwether, Hartalega, trading well above our target price of RM4.02 (based on 24x 2019F PE). Apart from that, despite capacity expansion looking healthy and intact, emerging signs of a demand-supply imbalance is disconcerting.
While more sane valuations prevail post the recent sell-down, risk-reward profiles remain skewed with a negative bias. We trim our target prices (Hartalega: RM3.80, Top Glove: RM4.80, Kossan: RM3.45) in tandem with our new forex assumption of RM4.10/US$ (from RM4.20). Our previous target prices are RM4.02, RM5.00 and RM3.64 respectively.
(Using the FX rate of 1 RM to 0.3298 SGD as at 2019-01-10, we derive Top Glove's target price of 1.58 in SGD term.)

Top Glove now trades closer to our trimmed target price of RM4.80, pegged to 22x 2019F PE (+1SD above its five-year forward PE mean but below the sector’s 27x). The PE premium is fair as:
1. Top Glove has been making steady headway into generally faster-growing nitrile glove space, and
2. despite the negative development at Aspion, the group is still touted as the no.1 surgical glove player globally.
Meanwhile, the PE discount to the glove sector’s is due to Top Glove’s relatively stretched balance sheet (net hearing of 0.9x vs peers’ average of 0.1x).

Our adjusted target price of RM3.45 is pegged to 20x 2019F PE. The new PE yardstick is in line with Kossan’s 5-year forward mean PE of 20x but below the sector’s 27x.
We believe the discount is warranted, given the company’s relatively anaemic ROE of 18% vs sector’s 22% and its interests in other rubber-related businesses (conglomerate discount). Additionally, Kossan is smaller and is not a FBMKLCI index component.

In 3Q18 results, we saw first possible signs of emerging demand-supply imbalance.
- First, Hartalega saw utilisation rate drop to 88% (-4ppt q-o-q) while ASP was mildly adjusted by +1% q-o-q despite a jump in average nitrile cost (+7% q-o-q). ASPs are typically adjusted in lockstep to raw material costs, therefore the slower adjustment suggests softening demand leading to possible ASP compression.
- Second, with the resumption of vinyl glove supply in China, Top Glove’s vinyl division operating income plunged 70% q-o-q.
- Finally, lead time or forward orders (days between order and delivery) have gradually shortened over 2018.

This has been well factored in by the market as rubber glove companies have been guiding their capacity outlook for the next two years in detail.
While the first signs of slowing demand emerged in 3Q18, there seems to be a disconnect between the supply-demand imbalance and the recent sell-down.

Our calculations show that every 1% depreciation of the ringgit vs the US dollar could beef up glove makers’ earnings by 6% (this excludes the shared cost savings mechanism with customers which will consequently moderate any significant gain in margins). However, we assume a 2-3% impact to earnings, after factoring in the shared cost savings mechanism. Apart from that, we also revise our forex assumption to RM4.10/US$ from RM4.23/US$.

Australian firm Ansell was said to be investigating abuse allegations at its Malaysian suppliers. Ansell raised the possibility of replacing its suppliers. This is a recurring theme, which initially arose in mid-Nov 18. However, it was addressed by Malaysia Human Resource Minister, M Kulasegaran, who reiterated confidence in Top Glove operations' adherence to the relevant laws. The news comes on the back of the Human Resource Ministry's visit to 22 of Top Glove's 35 domestic factories over the weekend.
Broadly, the rubber glove producers have limited customer concentration risk, with no one customer contributing more than 10% of revenue.

Philip Wong UOB Kay Hian Research | https://research.uobkayhian.com/ 2019-01-10

SGX Stock Analyst Report HOLD UPGRADE SELL 1.58 SAME 1.58