Rubber Gloves - Accelerating capex cycle to capitalise on sustained demand growth OVERWEIGHT

- We re-initiate coverage on the rubber gloves sector with an OVERWEIGHT stance. From our company visits, we note that industry players are turning optimistic about a resurgence in demand with positive guidance on volume growth moving into 2013. Global glove consumption is set to grow by another 8%-10% in 2013, having stagnated in 2011 (-1%). With domestic manufacturers commanding 63% of world market share, this translates into an additional demand of 20 billion pieces per annum by end-2013.

- Volume recovery to be driven by lower ASPs. The recent trend of lower raw material prices has been fully reflected in the present average selling prices. Latex and nitrile prices have fallen 40%-47% since reaching their respective all-time highs of RM10.60/kg and USD2,200/tonne in 2011. Having anticipated the price correction, some customers had refrained from accumulating inventory. With higher uptake from sustained re-stocking activities, we expect larger sales volume going forward. Our channel checks reveal that currently,  most manufacturers are in an oversold position with lead times of between 40 days and 6 months, depending on glove types. 

- Margins to continue expanding in the next quarters. In view of the improved operating environment, we believe glove manufacturers will be able to filter down any increase in revenue to their bottom line. We expect margins to show improvement going forward.  This trend was evident in Top Glove’s recently released FY12 (Aug) results. Net profit jumped 79% YoY while its EBITDA margin expanded 3.3% to 13.4%, a tad below its historical average of 14% but still below its peak of 19%. We anticipate a similar set of strong results by Kossan Rubber Industries (Kossan) and Supermax Corp (Supermax) at the end of this month.

- Accelerating capex.  In line with this renewed optimism, the top four glove manufacturers have allocated capex of RM433mil (+80%) for 2012 and RM636mil (+47%) for 2013 to boost installed capacity by 21% (~17 billion pieces). While Top Glove and Kossan have indicated their intention of going upstream, Hartalega and Supermax are keen to enlarge their installed capacity by embarking on longer-term large-scale capacity expansion projects. We note that Hartalega’s Next Generation Integrated Glove Manufacturing Complex (NGC), which is set to begin construction in 2013, will see its capacity grow to 43 billion pieces per annum in FY22 (Mar) (10-yr CAGR of 16%). In a bid to reduce labour costs and improve operating efficiencies, glove makers have also been investing in the automation of their production lines.

- Healthy financial position. Rubber glove companies under our coverage have strong balance sheets, with three of them having net cash positions (Top Glove FY13F: RM114mil; Kossan FY12F: RM48mil and Hartalega FY13F: RM38mil). Supermax is the most leveraged, but even so, average net gearing ratio is only 0.14x for FY12F-FY14F.  The sound balance sheet and ability to generate strong cash flows enable the glove makers to fund their investments internally.

- Decent dividend yields. Rubber glove stocks have dividend yields of 2.7%-3.6% for 2012 to 2014, even after factoring in their expansion plans. For a defensive growth sector, these yields can be considered decent. Target payout ratios range from 30% (Kossan and Supermax) to 50% (Top Glove).

- BUY Top Glove and Kossan... Despite the strong performance of its share price (+14% YTD), we like Top Glove as it is the prime beneficiary of easing latex prices (NR gloves make up ~80% of their sales quantity), well-executed volume strategy and the largest liquid sector proxy. Also, operating leverage is high given its enlarged revenue base. Top Glove is currently trading at undemanding multiples of 15x to 16x FY13F and FY14F. This is midway of its 4-year historical PE band. In view of Top Glove’s improving core fundamentals, we have assumed a PE of 19x (0.5SD above its mean) to arrive at a fair value of RM6.50/share. At current  price, this represents a 17% upside. Our fair value for Kossan of RM4.60/share pegs the stock to a PE of 12.5x its FY13F earnings, slightly above its historical mean of 11x. 

- ...initiate coverage on Hartalega and Supermax with a HOLD. While we see value in Hartalega, we believe our hold rating is justified given the limited upside potential in the near term. The stock has seen a meteoric rise of 74% YTD, outperforming the FBM KLCI by 68ppts. Based on a PE of 14x FY13F EPS, our target price for Hartalega is RM5.10/share. We have a fair value of RM2.20/share for Supermax, which implies an FY13F PE of 10x. This is a deep 47% discount to industry leader Top Glove’s PE because of liquidity reasons. 

Source: AmeSecurities