Rubber Gloves – Malaysia - UOB Kay Hian 2019-03-22: 4Q18 Report Card ~ Slowing To A Halt

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TOP GLOVE CORPORATION BHD (SGX:BVA)

Rubber Gloves – Malaysia - 4Q18 Report Card: Slowing To A Halt

• The 4Q18 reporting season saw all glove producers’ earnings coming in within expectations. Notably, ASPs were flattish as margins mildly contracted.
• We think the sell-down in valuations fairly reflects industry fundamentals but there may be earnings downside as this is only the onset of a downcycle owing to demand-supply imbalance.
• Maintain UNDERWEIGHT.

WHAT’S NEW

4Q18 results round-up.

• All 3 companies under our coverage reported results that were within expectations. Sector top-line grew at a muted 2.8% q-o-q with volume growth of 1.9% q-o-q, primarily against enlarged capacity from Hartalega’s Plant 5.
• RM/US$ movement was favourable as well (+2.0% q-o-q), but ASPs were marginally lower (-0.5% q-o-q). This resulted in sector net margins contracting 40ppt q-o-q to 18.8%. It was most pronounced at Hartalega, the bellwether to the sector, which was weighed by higher raw material costs as well.
• Sector core earnings grew in line with top-line growth, at 2.5% q-o-q.

Telltale signs of demand-supply imbalance persist.

• First, Hartalega saw ASPs being adjusted downward by 2% q-o-q against flattish raw material cost (-0.5% q-o-q).
• Second, vinyl glove supply in China resumed in 3Q18 - companies cited rising competition while Top Glove’s impact was more tangible with China operations seeing revenue plunge -83% q-o-q.
• Finally, lead time or forward orders (days between order and delivery) have gradually shortened over 2018.

ACTION

Maintain UNDERWEIGHT

• Maintain UNDERWEIGHT on the sector is due to the sector’s bellwether, Hartalega, trading well above our target price of RM3.80 (based on 24x 2019F PE). Apart from that, despite ambitious capacity expansion outlook, emerging signs of a demand-supply imbalance are disconcerting.
• Recent valuations reflecting a downcycle are more palatable (the sector is trading close to its 5-year PE average of 23.2x). However, risk-reward remains negatively skewed, seeing as there may be a delayed consensus earnings downgrade, and to be realised only in the quarters ahead.

Hartalega:

• Maintain SELL and target price of RM3.80, based on 24x 2019F PE, a slight premium above the sector's 23x. The premium can be justified by its strong operating efficiency and ability to generate a high ROE of 25% (peers’ average: 17%).
• Our bearish call is premised on the view that Hartalega’s lofty valuation (33x 2019F PE) is highly vulnerable to negative developments or would significantly underperform when market risk aversion eases.

TOP GLOVE CORPORATION BHD (SGX:BVA):

• Maintain HOLD and target price at RM4.80, pegged to 22x 2019F PE, +1SD above its five-year forward PE mean but in line with the sector’s 23x. The alignment is fair as:
  1. Top Glove has been making steady headway into the 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.
• (Entry price: RM4.10)
• (Using FX rate of 1RM to SGD0.3322, we derive target price of 1.36 in SGD term)

Kossan:

• Maintain HOLD and target price at RM3.45, based on 20x 2019F PE. The PE yardstick is in line with Kossan’s 5-year forward mean PE of 20x but below the sector’s 23x. We believe the discount is warranted, given the company’s anaemic ROE generation (18% vs sector’s 22%) and its interests in other rubber-related businesses (conglomerate discount). (Entry price: RM3.10)

ESSENTIALS

Top Glove - Potential exclusion from the FBMKLCI Index?

• We highlight the possibility of Top Glove being excluded from the FBMKLCI Index.
• According to FTSE Bursa Malaysia Index series ground rules, a stock component is removed should its market cap ranking of eligible securities drop to ≤ 36th position. As of 21 Mar 19 market close, Top Glove’s market capitalisation ranking was 35th. However, this will depend on the market capitalisation ranking as of the last trading day in May, which is Friday 31st May.
• FBMKLCI-linked funds with tracking mandates could be required to zerorise the stock’s weightage, thereby resulting in a possible de-rating.

Emerging downcycle poses a lull to sector valuation in the near term.

• During the glove sector’s previous upcycle in 2015, sector PE re-rated from 13x forward PE to peak at 28x in late-15. However, due to oversupply in the industry (Hartalega’s utilisation rate dropped to ~80% from its usual run rate of ~88%), the sector de-rated by 8x PE to 18x PE and remained in a lull for 18 months.
• In 2017, it subsequently re-rated due to glove supply constraints in China arising from tighter environmental restrictions. Fast-forward to early-19, valuation has taken a step down, close to the 5-year PE forward average of 23.2x. However, given that the glove sector appears to be only at the onset of a downcycle, we anticipate the lull in valuations to persist in the near to medium term.

Uncertainties ahead over volatile input cost.

• Our calculations show that every 1% appreciation of the ringgit vs the US dollar could lower glove makers’ earnings by 2-3%, after factoring in the shared cost savings mechanism (ex-cost savings mechanism: 6%). Our current ringgit assumption is RM4.10/US$ for 2019 and 2020.
• Separately, current natural rubber prices have surged 18% q-o-q relative to average prices during Top Glove’s 2QFY19. This follows the International Tripartite Rubber Council’s (comprising Thailand, Indonesia and Malaysia which account for 70% of the world’s natural rubber production) aim to curb exports in a bid to prop natural rubber prices.
• While the agreement lasted for only four months, glove companies (more so for Top Glove with natural rubber gloves making up 50% of total output) may not be able to efficiently cost pass through the sudden surge in prices (every 1% increase in rubber prices could reduce FY19 EPS by up to 2%). This ultimately could see a slight deterioration in margins in 3QFY19 followed by a recovery in the subsequent quarters.

SECTOR CATALYSTS

• If the closure of vinyl glove plants at China becomes permanent (which we think otherwise), Malaysia glove players deserve a valuation re-rating.
• Benign competition and resilient margins are huge positives for the sector. That said, over the longer term, this is unlikely to happen, in our view.

Philip Wong UOB Kay Hian Research | https://research.uobkayhian.com/ 2019-03-22

SGX Stock Analyst Report HOLD MAINTAIN HOLD 1.36 DOWN 1.580