Sunway-TES Student Research This report is published for educational purposes only by students competing in the CFA Institute Research Challenge.

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1 Sunway-TES Student Research This report is published for educational purposes only by students competing in the CFA Institute Research Challenge. Rubber Gloves Top Glove Corporation Ticker: TOPG MK / TPGC KL Recommendation SELL Price: RM 5.00 Price Target RM 4.02 Market Profile Issued Shares (num.) 618, 513, week range (High) RM week range (Low) RM Week Range RM Volume 1,708,900 Average Volume (30-day) 872,443 1-Yr Return % Float (M) Beta 0.96 Share Price Performance (%) 1M 3M 12M Relative Absolute Major Shareholders Holdings (%) Tan Sri Lim Wee Chai 34.2 and family Top Glove Holding SB 5.2 Matthews International 5.2 Kumpulan Wang Persaraan 5.0 Financial Highlights Source: Bloomberg FYE 31 Aug (RM m) F 2013F Revenue 2,079 2, Cost of Sale -1,641-1,819-1,902-2,068 Gross Profit GP Margin (%) Profit Before Tax Profit for the Year Free Cash Flow BEPS (cents) BEPS growth (%) DPS (cents) Dividend Yield (%) PE Ratio (x) NA/Share(RM) ROE (%) Gearing (%) Source: Company Earnings/Share M HIGHLIGHTS We We initiate initiate our our SELL SELL rating rating at at RM4.02 RM4.02 per per share share for for Top Top Glove Glove Corporation. Corporation. Based Based on on our our review review of of Top Top Glove Glove through through various various valuation valuation metrics, metrics, we we conclude conclude that that Top Top Glove s Glove s current current share share price price is is overvalued overvalued beyond beyond what what its its fundamentals fundamentals would would Valuation justify. Using single-stage discounted cashflow we arrive at a target price of RM4.02, an estimated downside potential of 19.6% on the current share price at its current share price of RM5.00. Top Glove s implied growth rate, based on its Q1FY12 free cashflow is 3.02%. This is higher than Hartalega s and Supermax s implied growth rates (which were below 2%) despite posting poorer performance in the recent financial year ended. We estimate Top Glove s implied growth rate to be lower. Dividend Yield Despite boosting dividend payout ratio from 40% in 2010 to 60% on the back of declining profits, Top Glove s FY11 dividend yield was 2.26%, trailing behind the glove industry average of 2.81%. Even though we expect the dividend yield to reach 2.7% in FY14, we think that the scope for further upside surprises is limited given its capital expenditure commitment going forward. Risk in Margins Top Glove s gross margin is undergoing a downtrend, posting a 3-year negative CAGR of -13.2%. Going forward, we expect margins to dip below FY11 s 11.4%, barely having any room for cost escalation. This leaves Top Glove s profit margins highly susceptible to being diminished entirely by the predicted rise in latex, gas and crude oil prices. Natural Gas Price Increase Given the rock-bottom subsidised natural gas prices (NG) in Malaysia, we believe the government will hike up NG tariffs in FY12 to relieve the subsidy financial burden. Our analysis shows that for every 10% rise in NG prices, gross margin will fall by an average 0.57 percentage points. Current Valuation too Expensive At the current share price of RM5.00, Top Glove is trading at a PE ratio of 28.7 times, double the glovemaking industry average of 13 times. Given Top Glove s highly volatile earnings growth, we conclude that the shares are immensely overpriced beyond its fundamentals. Volatility in Revenue and PBT Top Glove s FY09-11 revenue and PBT patterns were very volatile compared to Hartalega and Supermax, whose more stable uptrend in revenue and PBT is highly preferred. This shows that Top Glove s expensive share price is again unjustified given the risk in earnings fluctuation. 1

2 Figure 1: Top Glove s Geographical Market Segmentation, 1QFY12 BUSINESS DESCRIPTION Founded in 1991, Top Glove Corporation Berhad is the world's largest rubber glove manufacturer. It was listed on Bursa Malaysia in Rapidly growing over the years, Top Glove currently commands 24% of the global market share, with a total production capacity of 36.75bil pieces p.a. Top Glove s main listed competitors are Supermax, Kossan, Hartalega, Latexx Partners and Adventa. We estimate their market shares are 10%, 8%, 4% and 4% respectively on a revenue basis. Source: Company Figure 2: Porter s 5 forces Using Porter s 5 Forces model, we analysed the key forces which affect the business strategy of Top Glove. Threat of New or Potential Entrants. The current downward trend in latex prices provides easier entry barrier for new glovemakers as they can offer competitive prices without the economies of scale. Threat of Substitutes. Gloves are a global necessity especially in medical and food industry, since there are no other products which can substitute the function of gloves as a protection barrier. Bargaining Power of Buyers. The buyers could exercise its bargaining power by switching to other glove manufacturers. Further, the cost of switching is minimal, which makes it easier to change suppliers. Source: Investopedia Figure 3: Malaysian Glove Exports Bargaining Power of Suppliers. Latex suppliers could form a coalition to reduce the supply in order to boost the latex price back to its peak level of RM Intensity of Rivalry. Most glove manufacturers are located in South East Asia, with approximately 108 of them in Malaysia, intensifying competition. This is worsened by the overcapacity situation in global glove market. INDUSTRY REVIEW & COMPETITIVE POSITIONING Source: MREPC Figure 4: Healthcare spending as % of GDP, DEMAND Resilient Demand The glove industry is considered recession-proof as glove demand is measured by health awareness, not economic conditions. When the global financial crisis occurred in 2008 and 2009, Malaysian glove exports experienced slower growth (Figure 3). The y-o-y increase was 4% in 2008 and 1% in 2009, reflecting the recession. The positive growth in 2009 supports the statement that the industry is recession-proof. Increasing Health Spending Globally, healthcare expenditure continues to rise faster than economic growth in most countries. World health spending reached 9.5% of Gross Domestic Product (GDP) on average in 2009, up from 8.8% in The two most dominant consumers in the glove market, Europe and US saw their proportion of healthcare spending over GDP grew by 8.54% and 10% respectively from 2005 to Source: Kaiser Family Foundation Figure 5: Cost of Production-Natural Rubber versus Nitrile (US $ per 1,000 gloves) Emerging Markets Other countries have been steadily consuming a larger share of the glove market, from 24% in 2000 to 32% in Among them, China and India promise very attractive demand prospects due to their solid economic and healthcare spending growth. From 2000 to 2009, China s total healthcare expenditure grew by a CAGR of 14.49% per annum and India 12.10%, in tandem with their respective GDP growth of 14.68% and 12.83%. We believe exports to these other countries will continue to grow as their glove demand increases. Return of Bird Flu The recent December 2011 avian influenza outbreak in China and Hong Kong has been upgraded to a serious level following the death of a man. A further worsening of the outbreak will bring a huge surge in demand as customers hold as long as 6 months worth of inventory. In 2003 and 2009, there was a spike in Malaysian glove exports, which coincided with the outbreak of avian influenza in 2003 and influenza A (H1N1) in Source: Bloomberg 2

3 Glove Demand Growth and Mix The global glove demand is expected to increase at a steady rate of 8% to 10% per annum. Demand for nitrile gloves is forecast to grow at a robust pace, taking market share away from natural latex gloves. This trend will continue on as more healthcare providers in developed countries switch from natural rubber (NR) to nitrile gloves due to allergy reasons. Market Drivers. The global glove demand is driven by: Figure 5: Population Aged 65 & Above in Europe, Better hygiene and health awareness. The robust development of health and hygiene consciousness will translate into higher healthcare spending, especially in emerging countries like China and India. Fear of diseases. Glove players make exceptional gains from pandemic outbreaks, as last seen in H1N1 in 2009 which brought an average PBT growth of 54.3% in 2010 for the top 5 Malaysian glove players. Aging population. People grow more susceptible to health problems as they age, requiring more medical care. In Europe, the population aged 65 years and above rose from 15.6% of total population in 2000 to 17.2% in 2009, an increase met by a 17% growth in glove consumption. Source: IDESCAT Figure 6: Latex Price Movements, Source: MRB Figure 7: Glove Exports by Country Added regulatory requirements. Introduction of healthcare regulations which require glove usage will boost demand. Further, stricter regulations such will see the bigger players gaining larger market share due to ability to meet requirements. Smaller companies will be threatened by higher compliance costs. SUPPLY Nitrile Price Derived from crude oil but not traded as a commodity, nitrile prices are vulnerable to the political instability in the oil-producing Middle East. We expect nitrile price to increase in 2012 in line with crude oil. Latex Costs Volatility in latex prices constantly impacts the industry s performance. Prices reached an all-time high in FY11, prompting most glove players to post poorer performance. Some glovemakers are planning to embark on upstream rubber-tree planting (backward integrate) to create own internal latex source. Labour Shortage Glove players rely heavily on manual labour in manufacturing like glove stripping, quality control and packing. As foreign labour forms minimum 40% of the workforce, the industry is susceptible to labour shortage risk which results in production delays. This is worsened by increasingly stringent regulations imposed by authorities over foreign labour hire. To mitigate this, some manufacturers have begun equipping new plants with higher levels of automation. Limited Natural Gas Supply The current shortage of natural gas (NG) in Malaysia imposes a power constraint on local glove manufacturers capacity expansion projects. The gas shortfall also threatens to increase electricity costs. Source: MREPC COMPETITIVE POSITIONING Malaysia Leading the Global Glove Industry Malaysia dominates 60% of the world market share, followed by Thailand (18%) and Indonesia (10%). Malaysian glove manufacturers have the advantage in terms of superior infrastructure, service reliability and efficiency, better cost structures. Additionally, they also benefit from extensive R&D activities and support from Government agencies (e.g. Malaysian Rubber Export Promotion Council). Market Share. The Group is currently the world s No. 1 glove manufacturer with 24% global market share, dominating the position ever since overtaking Kimberly Clark in Market Capitalisation. Top Glove commands 36% of the sector market capitalisation, followed by Hartalega s 27% (the world s largest nitrile glove producer) and Supermax s 15%, Top Glove s direct competitor and 2 nd largest glove manufacturer. 3

4 Figure 8: Total Market Capitalisation of Glove Manufacturers, 26% 5% 3% Top Glove 12% 16% 38% Source: Companies Supermax Hartalega Kossan Latexx Partners Adventa The glove industry can be split into 2 segments: NR glove segment. Top Glove undoubtedly leads this segment with a NR glove production capacity of 29bil gloves p.a (79% of total capacity), which alone is already larger than Supermax s 19.85bil total capacity. Nitrile glove segment. This has lately seen exponential growth. Glovemakers who capitalised early on this segment performed much better in FY11, such as Hartalega (holding a 90% stake in the nitrile market share) who enjoyed PBT growth of 36.6% as others saw their earnings tumbled. Top Glove currently lags behind in this segment with 5.88bil gloves p.a. capacity. In light of the rapid demand shift to nitrile gloves, Top Glove aims to strike a balance between NR and nitrile glove production. As latex and gas prices rise, Top Glove will need to readjust its low-cost model to stay competitive. Strategies include capacity expansion, downstream glove distribution and upstream rubber tree-planting to secure latex supply. Other factors which will affect Top Glove s competitiveness: Consolidation of Industry. The Malaysian glove industry is being consolidated as bigger players engage in mergers and acquisitions, filling up vacancies left by smaller manufacturers who quit due to rising costs. With fewer but larger glove players, the higher economies of scale and bargaining power will intensify competition. Conversely, the current downtrend in latex prices could also catalyse the emergence of small glovemakers, heightening rivalry. Competition from China. Although labour and energy costs have increased in China, the Malaysian glove industry could still face potential competition from Chinese glove players. China is reportedly giving rebates to their local glove manufacturers to undercut glove prices. Figure 9: Top Glove share price vs Latex price, Source: Bloomberg, Company Figure 10: Top Glove s Operating Cost Source: Company INVESTMENT SUMMARY Volatility of Latex Prices Top Glove s earnings are vulnerable to fluctuations in latex prices. In FY11, volatile latex prices reached a record high of RM10.99/kg, eroding margins as costs soared. While prices have now fallen to RM6.37/kg, we believe the current downtrend will soon reverse into an uptrend in FY12 due to lower production during the February wintering season, shoring up of rubber prices by Thailand, Indonesia and Malaysia (which together account for 70% of the world's rubber production), the impending monsoon season and subsequent demand pickup in China s and India s automobile industry. Sensitivity analysis showed that 1% rise in latex price could slash Top Glove s gross profit by 5.5%. Latex prices also have an inverse correlation with Top Glove s share prices. The Thai government announced an intervention plan to increase rubber price to RM11.84, translating to a support price for latex of RM 7.10 (11% increase). Gas Tariff Increase Top Glove currently consumes piped gas and electricity as inputs into the manufacturing process. Natural gas (NG) is currently fiscally subsidised by more than 70%, but the government will increase RM3.00 per mmbtu every 6 months to reach market price. Owing to political reasons, we expect the government not to increase NG tariffs before the upcoming election, but will accelerate the tariff increase right after the election to cut down on subsidies. If the government fully withdraws the subsidy on NG, the current price of NG in Malaysia will boost from RM13.70 to RM62.00, the current market price in Asia. Fuel accounts for 7% of its operating costs, and with the increase of 353% in NG price, we assume the reported cost of sale will increase from RM1,819mil to RM2,268mil which will turn its reported gross profit of RM235mil into a staggering loss of RM213mil. Due to the nuclear crisis in Japan, it has raised interests in switching from the nuclear energy to safer energy, such as NG. We expect the world demand for NG to boost, and its price to rise accordingly. In May 2011, electricity tariffs were increased by 7.12% from kwh to kwh, increasing energy costs. With Tenaga Nasional Berhad (TNB), Malaysia s primary electricity provider, currently facing gas shortage in its power generation, it plans to import gas at market price after August 2012 once Petronas regasification terminal in Melaka is ready. The government may not fully absorb the huge difference between market and subsidised price, hence we expect a raise in electricity tariffs in the near future. 4

5 The increase in gas and electricity power price will result in increase in the inflation rate which further increases packaging, overhead and labour costs of Top Glove. The withdrawal of subsidy on petrol price will also push up transportation costs. Figure 11: MYR vs USD (from 13 July 2011 to 8 January 2012) 40% 35% 30% 25% 20% 15% 10% 5% 0% Figure MYR vs. USD (from 13 July 2011 to 8 January 2012) Source: Figure 12: Gross Profit Margin Figure 6: Production Capacity (bil/pa) Top Glove 9 12 Supermax Hartalega 9.6 Kossan Source: Company Latexx Figure 13 : IRSG s 2011 rubber supply forecast ( 000 mt) Source: Company, Bloomberg, CEIC Foreign Exchange Risk 90% of Top Glove s sales are exported, mostly in USD and AUD, posing high susceptibility to foreign exchange risk. After reaping RM18.5m foreign exchange gain in FY11 on the back of an appreciating USD, we expect the ringgit to strengthen to RM 2.90 against the USD in the first half of FY12. Top Glove will experience huge foreign exchange losses, although mitigated by hedging its foreign currency transactions. The Group has already reported RM13.3m foreign exchange loss for the first quarter of Sensitivity analysis shows that for every movement of 5% in the USD/RM exchange rate, Top Glove s post-tax moves inversely by RM1.5m. Shift to Nitrile Gloves The rapid demand shift to nitrile gloves has shrunk Top Glove s market share in USA. Top Glove will continue to lose market share in the developed countries given how illequipped in capturing the nitrile glove demand (nitrile glove forms only 20% of production mix). Although the Group targets capacity mix flexibility of 50% NR and 50% nitrile gloves, this balance will not be achieved until 3 years. Further, we predict a potential price war in the nitrile glove segment as many nitrile glovemakers are expected to reduce prices to gain market share. Slim Profit Margin The gross margin reported in FY11 was 11%, competitively lower than Supermax s 24%, Hartalega s 36%, Kossan s 24% and Adventa s 19%. The Group s thin margins are further subject to volatility in latex gas and crude oil. While price undercutting is Top Glove s competitive advantage, the slightest cost overrun can translate into huge losses, which could be prolonged up to 6 months due to time lag in passing costs to consumers will see Top Glove further cutting NR glove margin from 20% to 15% and nitrile glove margin from 30% to 20% to regain market share. We also expect 2012 to be a challenging year due to rising commodity prices, hence a flattish profit growth is predicted. Overcapacity The glove industry is facing an overcapacity situation. The world annual demand was 150bil pieces in Malaysia, possessing 60% of market share, would have produced 90bil pieces, easily exceeded by the approximate total production capacity of the top 6 Malaysian glovemakers (92.5b) alone, excluding those of smaller glove players. Bulk of the capacity (61%) is from Top Glove and Supermax. The active expansion programmes of glovemakers also worsen the overcapacity situation. Availability of supply The recent late-december 2011 floods in Southern Thailand adversely affected latex supply stability, given that the area supplies 80% of Top Glove s latex. Previously, supplies have also been threatened by severe drought and unusually heavy rainfall in Thailand, prolonged wintering season, rubber tree bark disease in Vietnam and higherthan-expected rubber tree replanting activities in major latex-producing countries. The break in supply chain will thwart the fulfilment of customer orders. Upstream Expansion To meet its latex needs, Top Glove is acquiring land in Cambodia and Malaysia for rubber plantation. This reduces reliance on latex suppliers and improves cost control, which leads to lower selling price. However, the Group is still securing land approval, a process taking longer than expected. There will also be no latex yields until 2018, hence earnings will not improve immediately, but instead will suffer from the substantial initial costs incurred for land development, plantation workers and legal procedures. Top Glove would also be exposed to upstream risks such as natural disasters and diseases. Downstream Distribution Top Glove plans to venture downstream into the distribution of its gloves, a move which complements the OBM approach. With its own distribution channel, the Group aims to penetrate emerging countries such as Turkey, Argentina and other Latin America countries to achieve its target 30% market share. However, with Top Glove still being new to distribution, we expect the venture to take time before earnings improve as the Group has to first develop its branding, marketing and customer relationship management. Top Glove may even be detracted from its core manufacturing business. 5

6 Q1FY10 Q2FY10 Q3FY10 Q4FY10 Q1FY11 Q2FY11 Q3FY11 Q4FY11 Q1FY12 EPS (sen) Groos Profit margin (%) Figure 14 : Top Glove Corporation Share Price against FBM KLCI Index Figure 15: Analysis of key financial data 80.00% 60.00% 40.00% 20.00% 0.00% % % % Source: Star Biz F 2013F 2014F Sales growth COS growth GP Margin PBT Growth Net Profit Growth OEM Being an OEM, Top Glove supplies gloves under their customers' brands instead of their own when penetrating new markets. Although this reduces the need for branding, marketing and advertising, relying too much on the OEM market may not be sustainable in the long term, as this is a marketing weakness which leads to the invisibility of the Top Glove brand in the global market. Top Glove should start venturing into the Original Brand Manufacturer (OBM) approach to cultivate its own brand, which will enable the Group to take advantage of situations of high demand like the ongoing A(H5N1) flu scare in Hong Kong by charging higher premiums. Cost of Compliance To secure exports, Top Glove must comply with local regulations on glove specifications and production sites, especially in developed nations such as USA, UK and EU. When Brazil introduced new standards in January 2009, Top Glove secured exports to Brazil through immediate compliance, taking the top spot in market share. Adherence to stringent quality control in line with ISO 9001, ASTM and EN455 are crucial for addressing increasing allergic reactions to NR gloves. Tougher healthcare regulations, such as the upgrade of US FDA inspection criteria from AQL4.0 to AQL2.5 in December 2009, will increase compliance cost. Failure to comply will attract penalties. FINANCIAL ANALYSIS Sales Growth is driven by an increase in sales volume and higher selling prices. In 1QFY12, Top Glove posted a 12.9% increase compared to 1QFY11, due to 2% q-o-q growth in sales volume and higher selling prices. The volume growth arose from the expected glove demand growth of 8-10% per annum, with higher demand for nitrile gloves of 30% p.a. The increase in selling price was attributable to the hike in prices of latex, oil, energy and labour Figure 16: Quarter 1 Revenue Quarter 1 Revenue We anticipate the latex price increase and the ringgit strengthening to RM2.90 vs USD in the first half of FY12 to result in Top Glove raising selling prices to maintain margins within acceptable level. Overall, a sales growth of 2.86% is foreseen in 2012, a considerable improvement in comparison to the fall in Gross Profit Margins Top Glove s gross profit margin has fallen from 21% to 11% in 2011 and is expected to fall continuously by 1-2% over the next 3 years. This downtrend arises from rising commodity prices, intensifying competition and inability to pass on additional costs to customers Figure 17: Gross Profit Margin During the AH1N1 outbreak in FY09-10, Top Glove reaped lower gross margins than Supermax (24.4% vs 23.7%). This is due to Supermax being an OBM which allowed Supermax to take advantage of the demand surplus by charging higher premiums for their brand. Top Glove being an OEM, saw their gross margin fell due to their products being undifferentiated Year Top Glove Hartalega Supermax Figure 18: EPS Quarter Source: Company Top Glove Hartalega From FY09-11, Top Glove s gross margins were polar opposites with Hartalega s, also a glove OEM. The huge disparity is due to Hartalega making higher margins in the nitrile glove demand surplus situation as Top Glove grappled with intensifying competition. Despite Hartalega s lower volume of production capacity and lower market share, it has achieved higher EPS than Top Glove due to its higher and less volatile gross margin. Volatility in Revenue, PBT and PBT Margin Analysing the PBT of Top Glove, Supermax and Hartalega on a 3-year quarterly basis, it is obvious that Top Glove s revenue is more volatile compared to its peers. Top Glove had a continuous fall in revenue index (Appendix 11) from 2QFY10, which drastically reversed 2 quarters later in 4QFY10. In contrast, Hartalega's index increased consistently q-o-q. Top Glove s PBT has been volatile similarly, contrasting with Hartalega and Supermax who maintained a high index of 175 and 145 respectively in Q4FY11. In spite of quarterly revenue being 3 times of Hartalega's, Top Glove's average 14% PBT margin (FY09-11) was depressing compared to Hartalega's 31%. Given the dismal PBT margins over its substantial revenue size, Top Glove underperformed compared to Hartalega and Supermax. 6

7 Inverse Gross Margin and PBT Movements Our FY12-14 estimates reveal a progressive fall in gross margin met by a growing PBT at a 19% CAGR. This is because going forward, we expect PBT to bounce back on lower foreign exchange losses as the USA economy recovers and the FY09-11 downtrend in administrative costs to continue as greater administrative efficiency is achieved through Top Glove s cost-effectiveness programme. Figure 19: Cash Position of Top Glove, Supermax and Kossan Top Glove Return on Equity (ROE) Top Glove evidenced an enormous fall in ROE figure from 22.4% in FY10 to 10.1% in FY11. We forecast ROE to pick up from FY12 onwards. We estimate an increasing growth for ROE for FY ROE will grow by 1% in FY12 and 1.3% in FY13, caused by declining capital expenditure (RM100, 000 in FY12 and RM 80,000 in FY13). The lower capital investments lead to a lower equity base, pushing ROE upwards. EBITDA EBITDA figures have fallen by 43.2% in 2011, along with a 2% y-o-y drop and a contracted margin of 1.6%, leaving only RM 58.2mil point into Q1FY12. These are the consequences of higher operating cost of RM million, shooting up 15% y-o-y in Q1FY12 backed by escalating average latex price by 16% and higher nitrile price by 46.4%. Supermax Strong Cash Position Top Glove has a healthy cash position of RM149 million (13% of net assets) in FY11, but this is lower than in FY10 (RM263 mil) and in FY09 (RM186 mil). This is mainly due to new subsidiary and PPE acquisition, which will generate higher future returns. However, its substantial cash balance compared to that of Supermax (RM97mil) and Kossan (RM91mil) both in 2010 shows a conservative approach to cash management. The large cash reserves enable internal capital funding and speculation purpose such as takeover of other businesses. Kossan Expansion Projects Top Glove has announced expansion plans worth RM100 mil for FY12. We expect the expansion to be funded internally as the Group prefers this financing method and has sufficient cashflows. Following the upgrading and expansion of factories in Sadao, Thailand, Top Glove targets a production capacity increase from 36.75bil in 2011 to 41.55bil gloves p.a. by May Further, an allocation worth RM160mil would be spread over a 6-year period for land acquisition in Cambodia in pursuit of the Group s upstream rubber plantation venture. This is to secure latex supply and reduce the impact of volatile latex prices. Source: Bloomberg WACC Assumptions D/E Ratio 0.25% Cost of debt 2.44% Tax Rate 25% Risk-free rate 2.98% Beta 0.96 Market Premium 9.2% Going forward, we believe Top Glove will focus more on nitrile glove production as the segment is fast-expanding and commands better margins. The Group had invested in new manufacturing facilities which are interchangeable between NR and nitrile production to achieve a 50:50 NR and nitrile mix in 3 years. Low Gearing Top Glove maintained a low gearing of 0.25% in 2011, and we expect it to reach 0.28% for FY12 due to the slight increase in loans worth RM146,000 in Q1FY12. Although the lower interest cost should benefit shareholders in terms of better dividends due to higher profits, dividend yields have not been above industry average. Assuming a WACC of 8.94%, the current financing is much costlier than the 3.25% interest on the Group s loans. Top Glove should take up more debt finance to invest its retained earnings in higher-return securities instead. VALUATION We derive our target price RM4.02 through single-stage DCF method, using Top Glove s enterprise value and Supermax s implied cashflow growth rate of 1.37%. Cost of Equity (COE) We derive our COE of 8.95% from CAPM based on the following assumptions: 2.98% yield on 1-year Malaysian Treasury Bill as the risk-free rate 10-year KLCI compounded growth of 9.2% as the market return Top Glove s beta is

8 DCF Our DCF analysis is based on forecast FY12E cashflows which are projected from the results posted in 1QFY12 ended 30 November By equating Top Glove s enterprise value with free cashflow yield, the implied growth rate is calculated. This single-stage basis is applied for Top Glove s main competitors for comparison. Implied Terminal Growth Rate (ITGR) With an implied growth rate of 3.02%, Top Glove ranks below Hartalega and Supermax, both of which are less than 2%. What this means is that the market attaches a more conservative growth assumption for Hartalega and Supermax relative to Top Glove, despite Hartalega s and Supermax s revenue growth having overpowered Top Glove over the last 3 years. FORMULAS Top Glove FCF (Cash Flow from operating activities tax paid purchase of PPE) NCF Cash Balance-Long & Short term benefits R Risk free rate of return +(Market 8.95% rate risk free rate of return)beta g R-[FCF/(Market capitalisation 3.02% NCF)] Market Capitalisation Share Price *No of Shares *the same formula applies to its competitors as well. For our methodology, we use Supermax s implied growth rate of 1.37% because it is Top Glove s closest competitor in terms of size and market share, being the 2nd world market leader in the glove sector. Single-Stage DCF Due to the 3-year volatility in Top Glove s earnings, we apply the single-stage DCF method as its short consideration period allows our valuation to be based on more certain short-term cashflows. We believe a longer-term approach to DCF is unsuitable given the major uncertainties in cashflow projection after more than 3 years. P/E Ratio Share price of RM 3.41 is arrived at by compounding our target P/E ratio of 16.25x with FY12E EPS RM The target P/E ratio is derived from adding a 25% premium to the rubber glove industry average PE ratio (13x) to account for Top Glove s position as the global market leader (36% market capitalization) and economies of scale. P/E ratio is used as it reflects the Group s growth prospects (16.67% EPS growth in FY12E) and low-risk earnings. As Top Glove has a negligible level of leverage, the P/E ratio would not be affected by its capital structure. Price/Earnings Growth Although PEG ratio is usually used alongside P/E ratio as a crude measure for earnings growth, in Top Glove s case it is unsuitable due to the negative EPS growth in Share Price (RM) TTM Earnings (cents) P/E Ratio (times) Top Glove Supermax Hartalega Adventa Kossan Latexx Figure 19: Sector Comparison as at 31/12/2011 Dividend Growth Model (DGM) Given a very volatile dividend growth, DGM is not suitable for valuing Top Glove. Assuming a cost of equity of 8.95% and a historical CAGR of 5.72%, each share is valued at RM3.60. It reflects the Group s lacklustre dividend yield, which we forecast will continue to stay unimpressive for FY Price to Book Value (P/BV) Our target price of RM4.02 represents a P/BV multiple of 1.7 times to book value of Top Glove s book value of RM2.62 in 2011 and RM2.25 for our FY12 estimates. PRICE RELATIVE ESTIMATES Trading at a premium to peers It is well above than Supermax, Hartalega, Adventa, Kossan and Latexx s P/E ratio of 11.8, 10.5, 9.8, 10.2 and 9.3 times respectively which makes Top Glove less attractive than other stocks. Trading at a higher price despite its low EPS gives less room for Top Glove s shares to reach a higher peak value. VALUATION RISK A weakness in the P/E ratio method is its heavy reliance on EPS, which is subject to a wide range of factors that can vary the figure and thus, our valuation. Example: Latex, gas and crude oil price fluctuations which depart from forecast prices. Volatility in foreign exchange rates, since USD-denominated exports form the bulk of revenue. Price wars which can spur Top Glove to further slash margins lower than our forecasts. 8

9 Figure 20: Sector Comparison as at 31/12/2011 Source: WHO Figure 21: Impairment Loss on Acquisition of APL (in red) INVESTMENT RISK The risks to our SELL recommendation are as follows: BUSINESS RISK Recession-Proof Demand Due to gloves being a healthcare necessity, the glove demand is considered recessionproof. As such, Top Glove s economy-resilient business profile which translates to defensive stocks could be seen as attractive in a bearish market, given the possible rippling effects from the economic uncertainties in Europe and the United States. However, given that Malaysian glove export growth fell by 3 percentage points from 2008 to 2009 (Figure 3), the notion of recession-proof demand is questionable. Bird Flu Re-Emergence The recent Hong Kong avian influenza scare in December 2011 could see a surge in global demand for gloves in With 24%, leading market share, Top Glove stands to gain the most from the demand surge due to available excess capacity (30% unutilised) compared to its competitors who are now operating close to optimum capacity. The PBT growth of 37.4% in 2010 attributable to 2009 s H1N1 could repeat depending on the outbreak severity. However, we stress that such outbreaks are only seasonal and the share price will plummet as demand normalises, evident in FY11 s stale performance. We also do not foresee the recent outbreak to escalate to pandemic proportions, given that most previous outbreaks have been minor. Merger and Acquisition (M&A) The Group is on the lookout to acquire other glove manufacturers to achieve its targeted 30% market share, possibly preferring smaller nitrile glove players. The announcement of a potential M&A could drive the Group s share price upwards as synergy arising from the move could favour Top Glove s earnings. However, we belief M&A is not foreseeable for Top Glove in 2012 due to their primary focus in acquiring land in Cambodia for their upstream plans. Further, Supermax proved that acquisition may not necessarily equal growth after suffering RM16.7m impairment loss upon acquiring APL Industries Bhd. Source: The Star Future Growth The growing health awareness in China and India is expected to stimulate the demand for NR gloves. This reduces the overcapacity situation, allowing Top Glove to operate at higher utilisation rates (currently 70%). Although higher economies of scale will reduce production costs, margins will unlikely widen as NR gloves selling price will be slashed to compete with Chinese rivals. Rise in Price of Nitrile Gloves As nitrile gloves increase in price, more cost-conscious customers will switch back to NR gloves, especially the emerging countries. The demand switch will be absorbed by Top Glove mostly since NR forms the bulk of its production capacity (79%). The less lucrative margins of NR gloves, however, do not fully compensate the Group s lag in the nitrile glove market. OPERATIONAL RISK Volatility in Latex Price Latex price has been on a sustained downtrend, falling 26% from RM8.66 on 31 st August 2011 to RM6.45 as at 30 th December The price drop is due to the shrinking latex demand caused by the slowdown in China s and India s automobile industry as well as the higher latex supply following the end of the wintering season. If the price falls further or stabilises, NR glove margins will widen. However, we believe the downtrend will be short-lived. Continued Subsidisation of Natural Gas Fuel accounts for 7% of Top Glove s production costs. Due to political reasons, the Government may decide to maintain the current LNG tariff which is discounted 70% off market price. This, coupled with the shift towards biomass fuel, could see reduction in energy costs. However, we foresee gas tariffs to rise in the second half of FINANCIAL RISK Foreign Exchange Risk The predicted weakening of the USD against the Ringgit may reverse in the second half of 2012 as the United States recover and Europe stabilises. A stronger USD will boost revenue and give a more robust translation of the Group s foreign assets. However, we do not expect a strong USD appreciation for 2012 given the grim global outlook. 9

10 Years Revenue (RM' mil) 1,529 2,079 2,054 Revenue growth (%) GP Margin (%) PBT Growth (%) Profit for the year (RM' mil) PAT Margin (%) BEPS (cents) BEPS growth (%) ROE (%) Free Cash Flow (RM' mil) P/E Ratio (x) Years 2012F 2013F 2014F CORPORATE CITIZENSHIP CORPORATE GOVERNANCE (CG) Top Glove is ranked 91 in The Top 100 Companies in 2011 in MCG Index Awards 2011 for CG, the only listed glove manufacturer to be awarded such. However, its board consists of only 11% of female members which is far below the government s target of 30%. Its board is also not balanced as there are less than 50% of Independent Nonexecutive directors (INED) which will lead to domination of certain party in board decision making process. There were only 4 board meetings held during the year which seem to be inadequate and it is a family-owned business which will lead to certain governance weaknesses, such as absence of succession planning. There is also no meritocracy being practised in appointing new directors to form an effective board as most of them are appointed based on close family relationship. CORPORATE SOCIAL RESPONSIBILITY (CSR) A key environmental concern is the non-biodegradability of nitrile gloves. Given the aggressively growing nitrile glove usage and its wear-and-dispose nature (high disposal rate), the impact on the environment will be very damaging. This will give rise to the negative actions being brought by the green lobby groups to boycott its products which will have an impact on its sales volume and reputation. Revenue (RM' mil) Revenue growth (%) GP Margin (%) PBT Growth (%) Profit for the year (RM' mil) PAT Margin (%) BEPS (cents) BEPS growth (%) ROE (%) Free Cash Flow (RM' mil) P/E Ratio (x)

11 APPENDICES APPENDIX 1 Statement Of Comprehensive Income for the year ended 31 August F 2013F 2014F RM'000 RM'000 RM'000 RM'000 RM'000 RM'000 Revenue 1,529,077 2,079,432 2,053,916 2,112,600 2,273,052 2,338,462 Cost of Sale - 1,155,975-1,640,550-1,818,767-1,901,340-2,068,477-2,151,385 Gross Profit 373, , , , , ,077 PBT 221, , , , , ,351 TAX -53,922-54,550-30,338-33,101-39,721-46,870 Profit for the year 168, , , , , ,481 Total Dividend= DPS * num. of shares -16,706-98,906-68,036-68,036-74,222-80,407 RE for the year 151, ,494 47,096 64,366 84, ,074 Other Comprehensive Income Net loss on available-for-sale financial assets: -Loss on Fair Value Changes N/A N/A -1,057 N/A N/A N/A Foreign Currency Translation 3,917-14, N/A N/A N/A Total Comprehensive Income for the year 171, , ,939 N/A N/A N/A Profit attributable to: Owners of parent 169, , , , , ,418 NCI -1,063 5,180 2, ,022 1, , , , , , ,481 TCI attributable to: Owners of parent N/A 235, ,009 N/A N/A N/A NCI N/A 485 1,930 N/A N/A N/A 171, , ,939 N/A N/A N/A (Source: Company) 11

12 Appendix 2 ASSETS Extract of Statement Financial Position as at 31 August Non-current assets F 2013F 2014F RM'000 RM'000 RM'000 RM'000 RM'000 RM'000 PPE 564, , , , , ,419 Land use rights 14,200 21,741 19,608 22,708 25,708 28,642 Investment securities 12, Current assets Inventories 119, , , , , ,237 Trade and other 198, , , , , ,117 receivables Investment securities N/A 40, , , , ,277 Derivative assets N/A N/A 2,954 2,954 N/A N/A Cash and cash equivalents 185, , , , , ,796 EQUITY AND LIABILITIES Share Capital 151, , , , , ,256 Share Premium 243, , , , , ,780 Other reserves -16,463 13,451 14,831 14,831 14,831 14,831 Retained earnings 445, , , , , ,036 Equity attributable to owners of parent 824,513 1,092,502 1,121,803 1,186,169 1,270,829 1,377,903 NCI 21,464 23,864 24,570 25,553 26,575 27,638 Total Equity 845,977 1,116,366 1,146,373 1,211,722 1,297,404 1,405,541 Non-current liabilities Loans and borrowings 8,960 3,025 2,851 3,308 3,235 3,465 Current liabilities Loans and borrowings 11, (Source: Company) 12

13 APPENDIX 3 Statement of Cash Flow for the year ended 31 August F 2013F 2014F Profit before tax 221, , , , , ,351 Non-Cash flow items 87,103 82,135 54,263 62,891 75,469 89,053 OP CF BEFORE WC CHANGES 309, , , , , ,404 Working Capital Changes 70,124-99, ,106-31,607-15,214 PROFIT FROM OPERATION 379, , , , , ,190 Interest Paid -8, N/A N/A N/A Tax Paid -38,851-73,797-28,418-36,411-43,693-51,557 Net Cash Flow from Operating Activities 331, , , , , ,633 Purchase of PPE -67,229-88, , ,000-70,000-80,000 Other cash outflow from investing activities Net Cash Flow from/(used in) Investing Activities -9,530-28,889-55,654-52,463-59,632-76,990-76, , , , ,133 29,7972 NCF from Financing Activities -186,403-13,215-87,524 N/A N/A N/A Net Cash Flow during the year 68,676 82, , , , ,605 Cash & Cash Equivalents in the beginning of the year Effects of Forex Rate changes Cash & Cash Equivalents at end of the year 120, , , , , , nil nil nil nil nil 185, , , , , ,834 (Source: Company) 13

14 APPENDIX 4 FINANCIAL ANALYSIS Years F 2013F 2014F Sales growth 10.97% 36.00% -1.23% 2.86% 7.60% 2.88% COS growth 11.00% 42.00% 10.90% 4.50% 8.80% 4.00% GP Margin 24.40% 21.00% 11.40% 10.00% 9.00% 8.00% PAT Margin 11.00% 12.00% 5.60% 6.30% 7.00% 8.00% PBT Growth 64.89% 37.37% 52.30% 13.77% 20.00% 18.00% Net Profit Growth 55.47% 49.00% 54.00% 15.00% 20.00% 18.00% No. of shares('000) Dividend 66,827 98,906 68,936 68,036 74,222 80,407 (RM'000) Dividend/ Share (RM) Dividend yield= DPS/MP per share 3.17% 2.68% 2.26% 2.74% 2.56% 2.71% PE Ratio (x) Gearing=LTD/Eq. 1.06% 0.28% 0.25% 0.28% 0.25% 0.25% Total SH Return 76.60% % % -7.00% 8.33% 5.21% Net Asset per share (RM) ROE 20.50% 22.40% 10.10% 11.10% 12.40% 13.50% Effective tax rate 24.30% 17.90% 20.90% 20% 20% 20% (Source: Company) 14

15 APPENDIX 5 DUPONT Analysis 2010 RM m Adventa Hartalega Kossan Latexx Supermax Top Glove Average Revenue PAIT Total Assets Equity Equity Multiplier Profit Margin 10% 25% 11% 13% 16% 12% 15% Asset Turnover (x) ROE 16% 40% 26% 28% 23% 22% 26% Source: Company APPENDIX 6 Rubber Industry Structure APPENDIX 7 Sector Comparison Company P/BV Dividend Dividend Market Cap No of Shares ROE (%) (times) (sen) Yield (RM 000) (000) Top Glove % % Supermax % % Hartalega % % Kossan % % Adventa % ,786 Latexx Partners % % Average % % - - (Source: Company) 15

16 APPENDIX 8 Total Healthcare Expenditure in China and India from 2000 to Total Expenditure on Health China India Expon. (China) Expon. (India) (Source: OECD) APPENDIX 9 Gross Domestic Product CHINA INDIA Expon. (CHINA) Expon. (INDIA) Years DP in China and India from 2000 to 2009 (Source: OECD) 16

17 APPENDIX 10 Acceptable Quality Level (AQL) for gloves inspection Criteria Inspection Level AQL 1000ml Water Tight Test G Visual Inspection G Visual Inspection G Dimension S Physical Properties S (Source: Company) APPENDIX 11 Quarterly Revenue Index of Top Glove, Hartalega and Supermax from Mar Jun Sep- 09 REVENUE INDEX 31-Dec Mar Jun Sep Dec Mar Jun Sep- 11 Top Glove Hartalega Supermax (Source: Company) 17

18 APPENDIX 12 Quarterly PBT Index of Top Glove, Hartalega and Supermax from PROFIT BEFORE TAX INDEX 31-Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep-11 Top Glove HARTALEGA SUPEMAX (Source: Company) 18

19 APPENDIX 13 Quarterly Profit Before Tax (PBT) Margin Index of Top Glove,Hartalega and Supermax from Mar Jun-09 PBT MARGIN INDEX 30- Sep Dec Mar Jun Sep Dec Mar Jun-11 Top Glove Hartalega Supermax Sep- 11 (Source: Company) 19

20 APPENDIX 14 Top Glove s Corporate Structure (Source: Company) 20

21 Disclosure: Ownership and material conflicts of interest: The author(s), or a member of their household, of this report does not hold a financial interest in the securities of this company. The author(s), or a member of their household, of this report does not know] of the existence of any conflicts of interest that might bias the content or publication of this report. Receipt of compensation: Compensation of the author(s) of this report is not based on investment banking revenue. Position as an officer or director: The author(s), or a member of their household, does not serves as an officer, director or advisory board member of the subject company. Market making: The author(s) does [not] act as a market maker in the subject company s securities. Ratings guide: Banks rate companies as either a BUY, HOLD or SELL.A BUY rating is given when the security is expected to deliver absolute returns of 15% or greater over the next twelve month period, and recommends that investors take a position above the security s weight in the S&P500, or any other relevant index. A SELL rating is given when the security is expected to deliver negative returns over the next twelve months, while a HOLD rating implies flat returns over the next twelve months. Investment Research Challenge and Global Investment Research Challenge Acknowledgement: [SocietyName] Investment Research Challenge as part of the CFA Institute Global Investment Research Challenge is based on the Investment Research Challenge originally developed by the New York Society of Security Analysts. Disclaimer: The information set forth herein has been obtained or derived from sources generally available to the public and believed by the author(s) to be reliable, but the author(s) does not make any representation or warranty, express or implied, as to its accuracy or completeness. The information is not intended to be used as the basis of any investment decisions by any person or entity. This information does not constitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security. This report should not be considered to be a recommendation by any individual affiliated with [SocietyName], CFA Institute or the Global Investment Research Challenge with regard to this company s stock. 21