Rubber Gloves – Malaysia - UOB Kay Hian 2021-03-17: Confluence Of Factors Prompts Downgrade To MARKET WEIGHT

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TOP GLOVE CORPORATION BHD (SGX:BVA)

Rubber Gloves – Malaysia - Confluence Of Factors Prompts Downgrade To MARKET WEIGHT

• Industry prospects remain intact against a backdrop of undemanding valuations. But we acknowledge that:
  1. unparalleled share price surge,
  2. normalising valuations after peak quarterly earnings, and
  3. negative sentiment permeating through the sector may be too steep to overcome.
• We downgrade the sector to MARKET WEIGHT from OVERWEIGHT. We normalise our target prices based on 2023 valuations and dividend-related windfall earnings.
• Top pick: Top Glove (SGX:BVA).

Glove makers' 4Q20 results round-up.

• Sector earnings came in largely above expectations across the board. Sector top-line grew 49% q-o-q on the back of higher ASPs of 53%. Volume growth of 2.4% q-o-q was primarily due to new capacity arising from Hartalega and Supermax. It more than offset Kossan’s slight volume contraction due to an outbreak of COVID-19 in its production facilities.
• US$/RM was slightly unfavourable (-2.3% q-o-q). However, sector EBITDA margin improved only marginally (8.1ppt) as latex and nitrile costs were +25% and +76% higher q-o-q. Against improved margins, core earnings outpaced revenue, at 71.9% q-o-q.

Downgrade to MARKET WEIGHT as sector approaches peak quarterly earnings.

• Glove valuations have moderated over the past 6 months, almost 3-4 quarters ahead of anticipated peak quarterly earnings in 2-3Q21. It is in contrast to previous glove cycles which suggest that valuations moderate in tandem with peak quarterly earnings. Therefore, it implies both limited upside and downside. This is amid a backdrop of earnings that are gradually normalising alongside ASPs.
• Furthermore, our revised valuation methodology on glove companies that factors in the present value of dividends and mean P/E valuations on normalised 2023 earnings suggests decent upside to existing valuations. But as highlighted, sentiment is expected to downtrend. This prompts us to downgrade the sector to MARKET WEIGHT from OVERWEIGHT.
• Our top sector pick is Top Glove for its attractive valuations and the potential lifting of the sale ban by US authorities to catalyse valuations.
• We also like Supermax for its ambitious expansion plans coupled with a re-rating laggard to its peers.

Top Glove’s ASPs to peak in 2Q21, followed by sector ASPs in 3Q21.

• We expect quarterly average nitrile ASPs to peak for Top Glove in 2Q21, followed by the remaining glove producers in 3Q21. After this, ASPs could moderate by 3-5% m-o-m till the year end. This is amid delivery lead times in the range of seven months (which has shortened considerably from 17 months within a quarter).
• The steep moderation in delivery lead times is attributed to:
  1. consolidation of multiple urgent orders from a single customer into a single order,
  2. fast vaccination rollouts and high efficacy rates, and
  3. incoming new capacity.
• Meanwhile, the spot volume mix could moderate as well, as it did with Top Glove. In contrast, latex ASPs are not seeing any revisions yet as incoming capacity has primarily skewed towards nitrile gloves. For now, the trajectory for ASPs is largely within our expectations. See the chart in PDF report attached below that depicts the earnings sensitivity to various ASP normalisation rates.

New SOTP-derived target price to better reflect normalising earnings.

• The glove sector earnings are seeing a windfall but are expected to normalise gradually over the next two years. We adopt a SOTP-valuation that we think will better reflect the unique circumstances underlying the sector. See the details of revisions in report attached below.
• Our new target price for the companies under our coverage is the present value of:
  • the expected dividends over 2021-23, and
  • 2023 earnings pegged to the company’s respective mean of its 5-year P/E as a reflection of normalised earnings.
• Target price revisions:
  • Top Glove: From RM7.60 to RM6.30.
  • Hartalega: From RM13.50 to RM 9.30.
  • Kossan Rubber: RM5.00.
  • Supermax: From RM7.80 to RM5.00.

Nitrile cost moderates in tandem with ASPs.

• While the cost of nitrile had surged close to 78% q-o-q in 4Q20 off the back of supply constraints, it has since eased compared with Jan 21. This should alleviate the input cost for nitrile gloves and buffer margins going forward against the backdrop of moderating ASPs. In contrast, the cost of latex (4Q: +25% q-o-q) is expected to climb further as it heads into the wintering season.

Light at the end of the tunnel with CBP.

• In relation to Top Glove’s Withhold Release Order (WRO) issued by the US Customs and Border Protection (CBP), management believes it is close to resolving the issue. The appointed independent consultant assessed that there were no systemic forced labour practices by Top Glove. The extended WRO has not derailed sales significantly as the WRO applies only to three subsidiaries. As a result, sales to North America have declined only marginally by 4ppt to 22% vs pre-COVID-19 levels (26%).

Additional listings on the horizon.

• Top Glove has proposed the issuance of 1.495b new shares, raising up to HK$14.95b (or RM7.77b). It is in pursuit of a dual primary listing on The Stock Exchange of Hong Kong (HKEX).
• While we are positive over Top Glove’s intention to pursue an additional listing on HKEX, the potential dilution to earnings per share of up to 12.2% is particularly punitive as the utilisation of proceeds could have been funded by its internally generated funds based on our estimates.
• Similarly, Supermax intends to list on the Singapore stock exchange. But it remains to be seen if there is an element of new shares being issued, which could be dilutive.
• Both aim for its additional listings to be completed by mid-21.

Previous cycles suggest moderation but subsequent P/E re-rating.

• Based on the previous two glove cycles in 2007-11 and 2013-17, there are three notable observations.
  • First, valuations largely tracked sector earnings. But this time around, valuations have already moderated by almost three quarters before peak quarterly earnings in 2-3Q21.
  • Second, once valuations started normalising, they did not drop below the -1 standard deviation of its 5-year mean. This suggests limited downside to our valuations that we have pegged to the mean.
  • Third, after every subsequent cycle, the glove sector valuations have re-rated. From a sector P/E mean of 11.4x (2007-11) to 17.8x (2013-17), and now at 26.8x (2015-19). We expect sector valuations to further re-rate going forward as the sector continues to be underpinned by structurally favourable drivers in the long run.

Existing regulated short selling (RSS) position on glove producers is minimal.

• There are only RSS positions on Top Glove and Supermax, both at < 0.05% of the respective outstanding shares.

Philip Wong UOB Kay Hian Research | https://research.uobkayhian.com/ 2021-03-17

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