We maintain our OVERWEIGHT rating on the rubber gloves sector. After a stellar run last year mainly boosted by the weakening of the Ringgit against the US Dollar, rubber glove stocks under our coverage have performed poorly YTD, led by KOSSAN (-36%), TOPGLV (-36%), HARTALEGA (-20%) and SUPERMX (-20%), hit by the reversing USD/MYR exchange rate and competitive pressure. Consequently, due to the retracement, valuations of rubber glove players under our coverage currently appear compelling and undemanding, trading at mean valuations supported by solid demand and new capacities expansion to more than offset the less favourable USD/MYR exchange rate. We are not perturbed and believe current valuations present a buying opportunity and expect their share prices to recover in subsequent quarters. Our investment case is based on: (i) earnings growth underpinned by new capacity expansions matched and fueled by pent-up demand for rubber gloves, especially nitrile gloves and (ii) stable raw material prices. In tandem with the strengthening of the Ringgit against the US Dollar, the sector is now trading at undemanding historical forward average PER valuation. Correspondingly, we revise down our target PER valuations for the sector from +2.0SD to +1.0SD. Correspondingly, we trim our TP for stocks under our coverage by an average 12%. Our TOP PICK is KOSSAN with an OUTPERFORM rating. Our target price is RM8.00 based on 19x FY17E EPS (previously 22x FY17 EPS). We like Kossan for: (i) its undemanding valuations at 16x FY17 EPS or 30% discount compared to closest nitrile-centric peer, Hartalega, which is trading at 22x FY17E EPS; (ii) its net profit growth averaging 14.2% each in FY16E and FY17E, (iii) it is gradually raising its dividend payout ratio (Kossan recently declared a final 6.5 sen tax-exempt dividend. This brings its total full-year FY15 DPS to 12.0 sen, implying a 38% payout ratio – well ahead of its <20% payout ratios in the past five years), and (iv) the unprecedented earnings growth over the next two years underpinned by rapid capacity expansion.

Solid results for gloves makers in the recently concluded 4QCY15. Glove makers reported a decent 4QCY15. Results of the gloves makers from the recently concluded 4QCY15 results season were mainly within expectations. The good set of results for Kossan, Hartalega, Top Glove and Supermax were underpinned by both volume growth from new capacity expansion and favourable USD/MYR exchange rate. Sales volume grew strongly for Kossan (+33% YoY, +12% QoQ), Hartalega (+32% YoY, +7% QoQ) and Top Glove (+16% YoY, -3% QoQ).

Neutral impact from the weakening of USD vs. MYR over the longer term. We expect gloves players’ earnings to sustain over the next few quarters despite the weakening of the USD against the MYR due largely to the higher volume sales emanating from sustained demand, YTD 2016, the MYR has strengthened by an average of 9% against the USD. Ceteris paribus, a 1% appreciation of MYR against USD will lead to an average 1%-2% decrease in the net profit of rubber glove players. However, a 1% increase in volume sales will boost bottomline by the same 1-2%. However, we believe the impact from currency movements (MYR vs USD) to glove players’ earnings is neutral over the longterm. This is because glove players typically hedge the currency on a consistent basis, hence in theory, any negative or positive impact will be neutralised over time.

USD FDA’s ban on latex to further fuel demand for nitrile gloves. The U.S. Food and Drug Administration (FDA) announced a proposal to ban most powdered gloves in the United States. According to the FDA, the proposed ban applies to powdered surgeon’s gloves, powdered patient examination gloves and absorbable powder for lubricating a surgeon’s glove. We expect this latest move by FDA to accelerate the switching from latex based to nitrile gloves of which the latter are already widely used in the US. We view this latest development by US FDA positively as: (i) nitrile generally offers better margins compared to latex gloves, and (ii) more importantly it alleviate the fears of oversupply in the nitrile market segment.

Lowering valuations marginally due to strengthening of Ringgit against the US Dollar. We believe share prices of rubber glove stocks have overshot on the upside following the sustained weakening of the Ringgit over the last four to five quarters coupled with record quarterly earnings. In view of the strengthening of the Ringgit against the US Dollar, we marginally downgrade our target PER valuation for rubber gloves stocks to between +1.0 to +1.5 SD (compared to +2.0SD previously) above historical mean under our coverage. We believe rubber glove stocks are poised to continue showing strong quarterly earnings over the next subsequent quarters due to the strong demand. As an indication, industry demand is set to grow an average 8-10% to 212b pieces of gloves in 2016. Volume growth will more than offset any shortfall in earnings from the strengthening of the Ringgit. All in, we believe rubber glove stocks should trade above their mean PER valuations given that rubber glove players have constantly evolved over the past several years by virtue of: (i) Malaysia has consistently gained market share over the last few years at the expense of Thailand, Indonesia and China, (ii) automation of plants and production processes leading to better efficiency and productivity and potentially translating to better margins, and (iii) rubber gloves makers’ resilience and ability to transform and increasing product mix from purely latex-based gloves into the higher margin nitrile gloves.

Our TOP PICK is KOSSAN with an OUTPERFORM and TP of RM8.00. Our target price is RM8.00 based on revised 19x FY17E EPS ( previously 22x FY17 EPS). We like Kossan for: (i) its undemanding valuations at 14.5x FY17E EPS compared to its closest nitrile-centric peer, Hartalega, which is trading at 22x FY17E EPS, (ii) its net profit growth averaging 14.2% each in FY16E and FY17E, and (iii) its gradual dividend payout ratio increase (Kossan recently declared a final 6.5 sen tax-exempt dividend. This brings its total full-year FY15 DPS to 12.0 sen, implying a 38% payout ratio – well ahead of its <20% payout ratios in the past five years) and (iv) the unprecedented earnings growth over the next two years underpinned by rapid capacity expansion.\

Source: Kenanga Research - 5 Apr 2016