Rubber Products. Waiting for the right grip. Neutral (maintain) Sector Update

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1 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Waiting for the right grip 2Q16 was another watershed quarter for the glove sector as earnings declined qoq largely due to ASP pressure and margin contraction. However, sequential recovery could be nearing on ASP adjustments, suggesting a more reasonable competitive environment. Global glove demand trajectory remains intact on expanding glove usage and higher consumption but a short-term supply glut will likely keep unit profitability in check. Maintain NEUTRAL. Weaker yoy 2Q Glove manufacturers under our coverage reported sequentially weaker results in 2QCY16, which mostly came below our expectations despite our earlier projected margin declines on heightened competition and diminishing external tailwinds. Margin pressure was prevalent across the board but what truly surprised us was the yoy earnings declines for Hartalega (despite strong capacity growth) and Top Glove, dragged down by sharp contractions in margins on higher raw material prices and longerthan-expected time lags in cost pass-through. But sequential recovery likely in the offing Having said that, a sequential recovery could be nearing as there have been instances of U$ ASP adjustments upwards in 3Q to account for higher raw material prices, and cost hikes in utilities and labour. This could indicate an improving competitive environment, as it encourages manufacturers to preserve margins over market share via cost passthrough, and bodes well for the sector amid an accelerated capacity growth backdrop. Glove demand likely to grow between 6% and 8% annually Global glove demand is expected to grow between 6% and 8% annually, premised on increasing glove consumption per capita and the expanding use of gloves in non-medical industries. Demand growth should be underpinned by healthcare reforms in emerging markets and increasing hygiene standards among the growing population. Empirical evidence points to a strong correlation between rising levels of income in emerging markets and higher healthcare spending and, by extension, glove consumption given its importance in medical healthcare services. Supply glut a short-term issue The current supply glut is a function of step-up changes in capacity, brought forth by accelerated capacity expansion by major players. We expect the top 4 players to expand capacity by a 12% CAGR in CY16-19 but we are less perturbed by the excess capacity. Utilisation levels remain healthy at above 80% while excess supply as a percentage of total demand is well-contained at below 5%. Nevertheless, the short-term glut will tilt the bargaining power temporarily to the buyers, limiting the headroom for ASP adjustments and keeping unit profitability in check. Sector Update Rubber Products Neutral (maintain) Absolute Performance (%) 1M 3M 12M Hartalega Kossan Supermax Top Glove Relative Performance (%) Top Glove Supermax Hartalega Kossan Source: Affin Hwang, Bloomberg Coverage Summary Name Rating Price New TP Old TP (RM) (RM) (RM) Hartalega HOLD Kossan HOLD Supermax HOLD Top Glove BUY Source: Affin Hwang, Bloomberg Note: Closing prices as of 1 September 2016 Aaron Kee (603) aaron.kee@affinhwang.com Maintain NEUTRAL; no change to recommendations Sector valuations are fair at 18x rolling 12M PER relative to a 19x average past-3-year PER. We expect the sector to deliver 9% earnings growth for each of CY16/17, largely on capacity expansion and market share gains, as we expect unit profitability to normalise in the absence of external tailwinds and the rising capacity. All in, we maintain our NEUTRAL rating on the sector, as a reflection of the lacklustre profitability growth profile visà-vis the sector valuations. We still prefer players with a changing product mix and rising nitrile capacity like Top Glove (but with a lower TP) while we are neutral on nitrile-centric players like Hartalega and Kossan. We had earlier downgraded Supermax due to its tax uncertainties. Page 1 of 11

2 Fig 1: Peers comparison table: Company Ticker Rating Price TP Mkt Cap Core EPS growth (%) Core PE (x) Div Yield (%) ROE (%) (RM) (RM) (RMm) CY16E CY17E CY16E CY17E CY16E CY17E CY16E CY17E Hartalega HART MK HOLD , Kossan KRI MK HOLD , Supermax SUCB MK HOLD ,409.7 (18.8) Top Glove TOPG MK BUY , Sector NEUTRAL 18, (2.4) (2.6) Q results round-up Sector core earnings fell yoy The 2QCY16 results season was a watershed quarter for all the glove manufacturers under our coverage, driven by yet another round of intensifying competition. 2QCY16 s ASP across latex and nitrile gloves fell by a double-digit percentage yoy, although it was modestly better than in 1QCY16. Ongoing capacity expansion did little to alleviate ASP pressure while waning currency tailwinds and higher raw material prices crimped margins. Overall, sector core net earnings were below our expectations with a yoy decline. Among the companies under our coverage, only Kossan was in line, while Hartalega, Supermax and Top Glove were below expectations. Fig 2: Sector performance overview Below expectations In line Hartalega Kossan Supermax Top Glove Source: Affin Hwang Margins drag in 2Q The aftermath of the supply glut seen in 1Q is apparent, with glove manufacturers reporting up to double-digit ASP declines in 2QCY16 as margins suffered. While the companies have guided that ASPs have been increased by up to 5%, any recovery will only be meaningful in 3Q due to the time lag. The higher U$ ASPs are mostly to account for the higher raw material prices, higher utility costs due to the increase in natural gas prices and higher labour costs on the implementation of the minimum wage in July 2016, as part of the cost pass-through mechanism. Nevertheless, the ASP adjustments made are good indications of an easing competition backdrop, as manufacturers are now more inclined to pass on costs to preserve margins. Fig 3: Falling ASP but upward adjustments in 3Q (U$/1,000 gloves) NR gloves NBR gloves Fig 4: Manufacturing cost structure breakdown Packaging, 5% Labour, 9% Chemical, 10% Fuel, 13% Raw materials, 45% Q13 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 Source: Companies Source: Top Glove Overhead and others, 18% Page 2 of 11

3 Sustained U$ ASP recovery visible, in our view Having said that, a sustained U$ ASP recovery over a longer term could stem from a more controlled and discipline capacity management. We have observed a general consensus among glove manufacturers to slow capacity growth in an attempt to balance the supply-demand dynamics. While we do not expect an immediate recovery, we believe that a sustained and gradual ASP recovery remains visible over time. Outlook demand still on uptrend Demand likely to grow 6-8% The glove manufacturing sector has always been seen as recession-proof, and well-liked for its defensive qualities. Demand for rubber gloves is a function of healthcare, hygiene and population size. Global glove demand is expected to grow between 6% to 8% annually, premised on higher glove consumption per capita and the expanding use of gloves in non-medical industries. Emerging markets likely to be growth catalyst Growing awareness on latex allergy should drive demand for nitrile gloves, while the FDA ban on powdered-latex gloves is likely to accelerate nitrile adoption among developed nations. Meanwhile, healthcare reforms in emerging markets are expected to boost glove consumption, bolstered by increasing hygiene standards among the growing population. In addition, the growing non-traditional end-use industries for specialised gloves like cleanroom gloves and laboratory gloves could buoy further demand. Fig 5: Global glove demand (bn pog) Source: Companies Page 3 of 11

4 Gradual long-term growth prospect The US and the Europe continue to be the largest importers of gloves, especially nitrile gloves, and consume 2/3 of the total glove supply. Emerging markets demand should be the next growth catalyst for gloves demand, given their relatively lower glove consumption per capita. Healthcare services are underpenetrated in emerging markets and total healthcare spending remains well below the levels seen in developed markets. The emerging markets have the benefit of rapidly rising levels of income and sizeable population growth. Empirical evidence points to a strong correlation between rising levels of income and higher healthcare spending. However, demand growth can take time in emerging markets and it could be a long time before they bridge the gap with the likes of the US in terms of healthcare spending and, by extension, gloves as a medical consumable. However, this still provides a gradual long-term growth prospect for the sector. Nitrile glove exports overtook latex ones in 2015 Malaysia s exports of rubber gloves grew 16% yoy to 57bn pairs while the total exports value increased 12% to RM12bn in Nitrile glove exports overtook latex gloves for the first time in 2015, signalling the growing importance of nitrile gloves. Exports of nitrile gloves recorded double-digit growth yoy in both value and quantity terms to 33bn pairs and RM6.4bn respectively in 2015, according to the Malaysian Rubber Export Promotion Council. Exports of latex gloves decreased slightly to RM5.5bn in 2015 despite the marginal increase in quantity, likely due to the drop in ASP. Cumulatively, nitrile glove exports made up 54% of total rubber gloves exports in value terms in Malaysia likely to continue global dominance We expect Malaysia s exports of rubber gloves to outpace the global glove demand growth, largely on market share gains over rival countries like Thailand and Indonesia. Malaysia is the largest rubber gloves manufacturing country with more than a 63% market share of the global glove supply. The global dominance has its merits, as Malaysian manufacturers enjoy a competitive advantage in the form of lower energy costs due to state subsidies, while labour productivity remains favourable. The Malaysia Rubber Glove Manufacturers Association expects exports to achieve a global market share of 65% by 2020, not a tall order in our view. Fig 6: Glove demand and supply projection (bn pog) Total global supply Total global demand CY16E CY17E CY18E CY19E Source: Affin Hwang, Companies Page 4 of 11

5 Short-term supply glut not unusual We are less perturbed over excess capacity in the market. Our checks indicate healthy utilisation levels at above 80%, not too far from the bottleneck level of 90%. Excess supply as a percentage of total demand is also well-contained at below 5%, by our estimates. We expect the shortterm supply glut to tilt the bargaining power temporarily to the buyers, mainly due to the rising capacity that could drive down the ASP. We expect the 4 glove manufacturers under our coverage to grow their combined capacity by a 12% CAGR in the next few years. The capacity increase would be essential for longer-term growth, and to maintain the respective dominance and market share by putting pressure on smaller competitors. Step-up changes to capacity are only economically beneficial when done at scale, and hence a short-term supply glut is not unusual in the manufacturing industry per se. Declining unit profitability Volume growth aside, a falling unit profitability (measured using EBIT/total gloves manufactured) could be a cause for concern. Unit profitability has in recent quarters plateaued largely on margin erosion, driven by ongoing ASP pressure, cost increases, and a longer time lag for the cost passthrough. This was in part due to the short-term supply glut as mentioned above, which complicates the cost pass-through mechanism and creates a longer-than-expected time lag for the pricing adjustments to kick in. But stabilising on slowing capacity growth Having said that, we believe that unit profitability is stabilising on the slowing capacity growth while glove manufacturers are now more inclined to pass on structural cost increases like the higher natural gas prices and implementation of the minimum wage to customers via a higher ASP. This was evident in the U$ ASP adjustments in recent months, the first in many quarters, suggesting competition has eased and a more reasonable operating environment moving forward. Fig 7: Estimated product mix by companies Nitrile Latex 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Hartalega Kossan Supermax Top Glove Source: Affin Hwang, Companies Page 5 of 11

6 Aug-2013 Oct-2013 Dec-2013 Feb-2014 Apr-2014 Jun-2014 Aug-2014 Oct-2014 Dec-2014 Feb-2015 Apr-2015 Jun-2015 Aug-2015 Oct-2015 Dec-2015 Feb-2016 Apr-2016 Jun-2016 Volume growth driven In the near term, we are likely to see margins normalise at current levels, with earnings growth likely driven by sales volume increases. Efficient product mix management could boost margins, and we like companies with a growing nitrile glove contribution like Top Glove. Typically, nitrile gloves yield better profitability vis-à-vis latex gloves. Although the premium has narrowed greatly due to technological breakthroughs and economies of scale, nitrile gloves still yield at least 3-5 percentage points more than latex gloves at the gross profit margin level, by our estimates. On the other hand, we are neutral about names that already have a nitrilecentric product mix like Hartalega and Kossan. Valuations and recommendations Sector trading at mean Sector valuations are fair at 18x rolling 12M PER relative to a 19x average past-3-year PER, after a hefty correction in 1H16 which saw the total sector market capitalisation wiped out by nearly 24% from the peak. Sector valuations were mainly dragged down by de-ratings on a strengthening Ringgit and overcapacity issues which sparked concerns over margin contractions, the latter proving to be the major cause of earnings disappointments. Fig 8: Sector valuations slightly below mean Sector PE Avg +1SD -1SD 15 Neutral on the sector We expect the glove manufacturers under our coverage to deliver 9% earnings growth in each of CY16/17. The expected earnings growth will be largely-volume driven, as we expect unit profitability to normalise in the absence of external tailwinds and rising nitrile capacity which would limit the headroom for ASP adjustments. All in, we are retaining our NEUTRAL rating on the sector, as a reflection of the lacklustre profitability growth profile vis-à-vis valuations. Page 6 of 11

7 Aug-2013 Oct-2013 Dec-2013 Feb-2014 Apr-2014 Jun-2014 Aug-2014 Oct-2014 Dec-2014 Feb-2015 Apr-2015 Jun-2015 Aug-2015 Oct-2015 Dec-2015 Feb-2016 Apr-2016 Jun-2016 Hartalega We maintain our HOLD rating for Hartalega and make no changes to our TP of RM4.00. Our TP is based on a PER of 22x our CY17E EPS, which is 1SD below its past-3-year mean. Our below-mean valuation is premised on Hartalega s eroding premium margins vis-à-vis the sector, as its leadership in nitrile segment is rapidly declining due to the rising capacity. Fig 9: Hartalega s premium valuations unjustified Rolling PE Average +1SD -1SD 19 Hartalega s 2QCY16 results were weaker sequentially despite higher sales volumes, dragged down by lower margins on higher raw material costs and start-up losses at the Next Generation Complex (NGC). Lagging sales growth relative to its accelerated capacity expansion from the NGC also led to a below-average utilisation rate. Despite our expectation of a sequential recovery in 3Q, which is mostly volume-driven, there is little room for margin expansion in the near term on limited efficiency gains from the NGC and ongoing ASP pressure. Upside risk: stronger-thanexpected recovery in ASP; downside risk: further margin erosion. Page 7 of 11

8 Aug-2013 Oct-2013 Dec-2013 Feb-2014 Apr-2014 Jun-2014 Aug-2014 Oct-2014 Dec-2014 Feb-2015 Apr-2015 Jun-2015 Aug-2015 Oct-2015 Dec-2015 Feb-2016 Apr-2016 Jun-2016 Kossan We maintain our HOLD rating for Kossan and make no changes to our TP of RM6.40. Our TP is based on a PER of 17x our CY17E EPS, which is in line with its past-3-year mean. This implies a 23% discount to Hartalega s target PER of 22x. Fig 10: Kossan s valuations have priced in most positives Rolling PE Average +1SD -1SD Kossan s 2QCY16 results were weaker sequentially on the ASP decline and muted capacity expansion. EBITDA margin fell 3ppts, in line with other peers, on higher raw material prices, utility costs and labour costs. Kossan is expected to resume capacity expansion in CY17 after a brief hiatus in CY16, which will provide sequential growth momentum. While we are upbeat on Kossan s visible capacity growth, which will double its existing capacity by 2020, unit profitability improvements could be capped given its nitrile-centric product mix, limiting margin expansion in the near term. The stock is currently trading at 18x CY17E EPS and we believe that most of the positives have been priced in. Upside risk: stronger-thanexpected recovery in ASP; downside risk: a delay in its expansion plan. Page 8 of 11

9 Aug-2013 Oct-2013 Dec-2013 Feb-2014 Apr-2014 Jun-2014 Aug-2014 Oct-2014 Dec-2014 Feb-2015 Apr-2015 Jun-2015 Aug-2015 Oct-2015 Dec-2015 Feb-2016 Apr-2016 Jun-2016 Supermax We had downgraded Supermax to a HOLD with a TP of RM2.30 post its 2QCY16 results. Our TP is based on a PER of 13x our CY17E EPS, which is in line with its past-3-year mean. We had downgraded our target PER from +1SD to its mean PER mainly due to a lack of clarity in its expansion plan, and uncertainties over its tax status. Fig 11: Supermax s valuations are cheap for a reason Rolling PE Average +1SD -1SD 8 Supermax s 2QCY16 results were sequentially weaker on a high tax charge, mainly due to underpayments in previous tax assessment years and higher provisions for deferred tax liabilities. We are cautious on Supermax largely due to the heightened risk over tax uncertainties as we could not ascertain if the high tax charge will be a one-off event. The stock is currently trading at 12x against the sector average of 18x. The lack of a delivery track record will continue to dampen investors sentiment on the stock, thereby limiting any re-rating catalyst to narrow the discount. Upside risk: strong-than-expected recovery in ASP; downside risk: a delay in its expansion plan. Page 9 of 11

10 Aug-2013 Oct-2013 Dec-2013 Feb-2014 Apr-2014 Jun-2014 Aug-2014 Oct-2014 Dec-2014 Feb-2015 Apr-2015 Jun-2015 Aug-2015 Oct-2015 Dec-2015 Feb-2016 Apr-2016 Jun-2016 Top Glove We maintain our BUY rating for Top Glove, but lower our TP to RM5.40 after revising our target PER to 18x CY17E (from 21x), in line with 1SD above its past-3-year mean. Our above-mean valuation is premised on its expanding nitrile capacity and scope for margin improvement on its low nitrile base (32% of total product mix). Fig 12: Top Glove s valuations are in line with the mean Rolling PE Average +1SD -1SD 9 Top Glove s 2QCY16 results were weaker sequentially on a sharp contraction in the EBITDA margin, mainly dragged down by a stronger Ringgit, higher raw material prices and longer time lag for its cost passthrough. Incremental sales from new plants should sustain volume growth as Top Glove is expected to commission 3 additional plants with a combined capacity of 7.8bn pieces in the next 12 months, which represents a step-up in capacity of 17%. The capacity growth will largely cater for nitrile gloves production, in line with its commitment to grow nitrile contribution to 50% of its total product mix. Downside risk: steeper-thanexpected margin erosion. Page 10 of 11

11 Equity Rating Structure and Definitions BUY Total return is expected to exceed +10% over a 12-month period HOLD Total return is expected to be between -5% and +10% over a 12-month period SELL Total return is expected to be below -5% over a 12-month period NOT RATED Affin Hwang Investment Bank Berhad does not provide research coverage or rating for this company. Report is intended as information only and not as a recommendation The total expected return is defined as the percentage upside/downside to our target price plus the net dividend yield over the next 12 months. OVERWEIGHT Industry, as defined by the analyst s coverage universe, is expected to outperform the KLCI benchmark over the next 12 months NEUTRAL Industry, as defined by the analyst s coverage universe, is expected to perform inline with the KLCI benchmark over the next 12 months UNDERWEIGHT Industry, as defined by the analyst s coverage universe is expected to under-perform the KLCI benchmark over the next 12 months This report is intended for information purposes only and has been prepared by Affin Hwang Investment Bank Berhad (14389-U) (formerly known as HwangDBS Investment Bank Berhad) ( the Company ) based on sources believed to be reliable. However, such sources have not been independently verified by the Company, and as such the Company does not give any guarantee, representation or warranty (express or implied) as to the adequacy, accuracy, reliability or completeness of the information and/or opinion provided or rendered in this report. Facts, information, views and/or opinion presented in this report have not been reviewed by, may not reflect information known to, and may present a differing view expressed by other business units within the Company, including investment banking personnel. Reports issued by the Company, are prepared in accordance with the Company s policies for managing conflicts of interest arising as a result of publication and distribution of investment research reports. Under no circumstances shall the Company, its associates and/or any person related to it be liable in any manner whatsoever for any consequences (including but are not limited to any direct, indirect or consequential losses, loss of profit and damages) arising from the use of or reliance on the information and/or opinion provided or rendered in this report. Any opinions or estimates in this report are that of the Company, as of this date and subject to change without prior notice. Under no circumstances shall this report be construed as an offer to sell or a solicitation of an offer to buy any securities. The Company and/or any of its directors and/or employees may have an interest in the securities mentioned therein. The Company may also make investment decisions or take proprietary positions that are inconsistent with the recommendations or views in this report. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences and hence an independent evaluation is essential. Investors are advised to independently evaluate particular investments and strategies and to seek independent financial, legal and other advice on the information and/or opinion contained in this report before investing or participating in any of the securities or investment strategies or transactions discussed in this report. Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data. The Company s research, or any portion thereof may not be reprinted, sold or redistributed without the consent of the Company. The Company, is a participant of the Capital Market Development Fund-Bursa Research Scheme, and will receive compensation for the participation. This report is printed and published by: Affin Hwang Investment Bank Berhad (14389-U) (formerly known as HwangDBS Investment Bank Berhad) A Participating Organisation of Bursa Malaysia Securities Bhd Chulan Tower Branch, 3rd Floor, Chulan Tower, No 3, Jalan Conlay, Kuala Lumpur. research@affinhwang.com Tel : Fax : Page 11 of 11