Malaysia Glove Sector - UOB Kay Hian 2022-03-18: The Bottom Is Near; Upgrade To Market Weight As Reward-to-risk Appears Balanced

TOP GLOVE CORPORATION BHD (SGX:BVA)

Malaysia Glove Sector - The Bottom Is Near; Upgrade To Market Weight As Reward-to-risk Appears Balanced

4Q21’s ASP-led woeful earnings were further weighed by soft volume output. Positively, the sector is expected to bottom over the immediate term. Meanwhile, sector valuations are trading below -2 standard deviation of its pre-pandemic five-year P/E mean.
While sentiment could decline in tandem with the sector bottoming out, we think downside risks to earnings have largely been factored in. Thus, the reward-to-risk payoff appears balanced at this juncture, prompting us to upgrade the sector to MARKET WEIGHT.

Sector earnings came in well below expectations. This was due to the sharp moderation in ASPs and soft volume sales, which was hampered by industry dynamics, supply chain disruptions and the sales ban by the US Customs and Border Protection (CBP) on Supermax.
The sector’s top-line contracted 47.5% q-o-q off a 39% decline in ASPs and 13% contraction in volume sales. Sector EBITDA and PAT margins of 27.5% and 17.6% remain elevated vis-a-vis pre-pandemic (2019) levels of 17.5% and 10.2% respectively.

Over the last few months, capacity expansion of the Big-4 glove companies for 2022 has been reduced from 15.6% to 6.5%, of which capacity is likely only to be introduced in 2H22 onwards. The Malaysian Rubber Glove Manufacturers Association’s (MARGMA) projected global demand for rubber gloves of 15-20% for 2022 has been downward adjusted to 10-15%, higher than pre-COVID-19 levels (2019). This implies demand normalising by a double-digit percentage for 2022. Given this backdrop and sluggish utilisation rates of 60-70%, we do not rule out further deferment of capacity addition.
New entrants emerge but struggle for profitability. Across the seven public listed companies that entered into the foray over the past year, these companies made an average loss of RM6m with a -7.4% profit margin in 4Q21. Given these dynamics, we do not expect these new entrants to have a lasting and significant impact on the existing glove producers.

The smaller glove producers continue to enjoy higher-than-pre-pandemic margins but continue to trail their larger peers. Given that ASPs continue to moderate, margins are likely to moderate to or below pre-pandemic margins. Notably, the influx of cash and subsequent investments over the past two years does not appear to have translated into operation efficiency. This suggests that the established Big-4 should maintain its overall competitiveness. Net gearing for the smaller glove producers, however, has improved to a net gearing position of 0.28x from -0.25x.
China glove producers have endured mixed fortunes, with Medical Intco keeping track with the Big-4 unlike Blue Sail. 4Q21 financials have yet to be released. In the quarter, the US re-imposed tariffs on China-made gloves and thus, margins could see additional pressure on top of pre-existing deterioration in demand-supply dynamics. Given this development, it appears Medical Intco may be the only viable threat to industry dynamics, seeing that it has been aggressively adding capacity expansion over the past two years.

The Malaysia Human Resource Minister, M. Saravanan mentioned that the minimum wage in Malaysia will be raised to RM1,500 from RM1,200 in a month or two’s time, but with certain sectors gaining exemption. Should the glove sector not be exempted, the impact to 2022 earnings could be up to 10%. However, the glove producers already compensate its workers (basic + performance) beyond the minimum wage and would typically pass through costs. Given these buffers, we do not expect earnings to be significantly impacted.

Current ASPs are close to US$25/’000 pieces, declining 3.8% m-o-m. ASPs could remain above pre-pandemic levels given that input costs such as natural gas, labour and logistics are considerably higher. However in terms of margins, we expect it to potentially find a bottom in 2Q or 3Q22, with margins possibly dipping below pre-pandemic levels.
Buyers appear to be replenishing inventory now that ASPs are closer to pre-pandemic range. A pick-up of utilisation rates towards 80-90% followed by resumption of capacity expansion should signal the bottom for the industry. Sentiment is unlikely to improve until a bottom is found.

Existing sector valuation at 16.9x suggests there remains downside, as it is above the five-year P/E mean of 15.4x. The average has been distorted with a downward bias over the past two years with glove companies trading at 3-4x P/E. However, we believe pre-pandemic valuations are more reflective of sentiment and volatility of the glove sector, since the pandemic and its effects on the sector are a black swan. Hence, if sector valuations were to be compared to pre-pandemic conditions, 16.9x P/E is below the -2 standard deviation of its five-year mean of 17.7x.

Recent results have culminated in valuation declines across the sector. This comes as no surprise given the inertia to adjust earnings projections by consensus amid drastic sector developments. That said, we believe earnings downside is limited given that we have projected for softer than pre-pandemic margins for 2022.
Furthermore, current valuations are below -2 standard deviation of the 5-year pre-pandemic mean P/E, which suggests limited downside. This is balanced by a potential bottoming of sentiment in tandem with earnings over the next 1-2 quarters.
Given the temporal nature of bottoming of the sector, the reward-to-risk payoff now appears balanced with valuations trading below -2 standard deviation. Hence, we upgrade the sector to a MARKET WEIGHT from UNDERWEIGHT and advocate to investors to accumulate on potential upcoming weakness.

Philip Wong UOB Kay Hian Research | https://research.uobkayhian.com/ 2022-03-18

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