We came away from Top Glove’s analyst briefing feeling assured of the fundamental prospects of the company. Nevertheless, we believe that current price levels have reflected most of the positive news. We downgrade our call to NEUTRAL (from Buy), on valuation grounds, with an unchanged MYR13.84 TP (0% up/downside).

Record 1QFY16 results. Top Glove recorded earnings of MYR128.4m in 1QFY16 (Aug), the best quarterly results in company history. The stellar start to FY16 was primarily driven by two factors: i) operating efficiency improvements – where concerted effort in the automation and research and development (R&D) segments has increased production line speeds and glove quality. This led to higher PAT margins (1QFY16 margins: 16% vs 14.5% in 4QFY15), and ii) it held on to a majority of itsforex gains and lower raw material savings – despite a 10%/5% fall in latex/nitrile raw materials respectively and 11% appreciation in USD/MYR, ASP remained relatively unchanged. Still, we believe that PAT margins would rationalise to more comfortable levels of 14% as iteventually passes on the forex gains and raw material savings to its clients.

Prospects. It would add a 7.8bn glove capacity over the next 15 months,bringing total capacity to 52.4bn, where we forecast the nitrile/latex mix would improve to 39%/61% from the current 32%/68%. It has reiterated its commitment to the automation and R&D drive to further improve operating efficiency. Also, it is looking to conclude up to two M&A deals within the glove related industry in FY16 to help boost growth.

Downgrade to NEUTRAL. While we are assured of its fundamental prospects, we believe that the current price levels have reflected most of the positive news. Note that Top Glove has risen 207% since end-2014. We believe the potential upside for the stock would be capped as Top Glove’s PEG (Figure 2) has caught up to the sector’s average. Thus, we downgrade our call to NEUTRAL with an unchanged DCF-based TP of MYR13.84 (CoE: 8.3%, TG: 2%), which implies 20.2x FY16F P/E. We prefer Supermax (SUCB MK, BUY, TP: MYR3.84) for its exposure to the rubber gloves sector. Upside risks to our recommendation include the extended re-rating of the sector driven by liquidity due to the scarcity of earnings growth opportunities. Downside risks include capacity delays, a reversion in the USD/MYR trend and raw material prices.

In light of the current forex sensitivity, we have introduced a scenario a nalysis to summarise the impact of diverse views on the USD/MYR exchange rate. Based on Bloomberg’s consensus currency forecast, we assume the weakest 2016 forecast (USD/MYR=3.98) to be our worst case, while assuming the strongest forecast (USD/MYR=4.68) to be our best case.

Subsequently, we based our ‘Worst Case’ cost of equity assumptions on RHB’s historical assumptions during the last time the USD was trading at MYR3.98 (Aug 2015).

Our ‘Best Case’ scenario is based upon the assumption that the stronger USD (weaker MYR) would extend the sector re-rating, driven by liquidity, as investors seek refuge in the rubber glove sector that enjoys 90% of revenue proceeds denominated in USD. As such, we assumed a 30% fall in Top Glove’s beta to 0.4 (in line with the trend observed throughout 2015 during the weakening of MYR against USD). Additionally, there is a 130 bps hike in equity risk premium (the same quantum RHB revised its equity risk premium assumption in Sep 2015to reflect the higher expected risk of the equity m arkets).

In conclusion, our scenario analysis shows that FY16F earnings/TP would fall by 6%/12% respectively, should USD/MYR average 3.98 in our worst case. Earnings/TP would rise by 5%/19% respectively, should USD/MYR average4.68.

Source: RHB Research - 7 Jan 2016