Upgrade to overweight from neutral: Glove stocks outperformed the FBM KLCI in 2012, beating the index by 7.1%. We think Malaysia’s original equipment manufacturer (OEM) glovemakers can repeat in 2013 and we upgrade the sector to “overweight”. We believe glove stocks will be rerated this year by:
(i) their defensive qualities;
(ii) the start of LNG imports in the second half of the year;
(iii) stable demand for gloves; and
(iv) higher selling prices as costs are passed through. Our top pick remains Hartalega Holdings Bhd.
In terms of outlook, we are positive on the sector for its defensiveness. The cost of rubber (natural rubber and synthetics) makes up 50% to 60% of a glovemaker’s cost of production. Historically, wet and dry natural rubber prices are closely correlated but we believe they are beginning to decouple.
While the correlation between dry and wet natural rubber prices has been close to parity since 2007, this link decoupled in May 2012 to 0.7 times. The decoupling continued and by December 2012 the correlation turned negative. The trend will persist this year.
One reason for the decoupling could be the weak demand for wet latex because of the switch from natural rubber to synthetic gloves. Note that wet latex is used predominantly for dipped-goods (condoms and gloves) while dry latex is used by tyre manufacturers. The price of dry rubber had been on an uptrend recently due to the improved outlook in major auto markets such as China and the US.
This is positive as the increased earnings stability should reduce the market risk premium for glove stocks, which will in turn enhance valuations and earnings multiples.
We believe the glove sector is less dependent on the outcome of the general election as glovemakers’ revenue and costs depend more on external factors and less on domestic politics.
Glove demand is largely dependent on healthcare consumption in the US and Europe. Also, 60% of costs are linked to natural or synthetic rubber, which have very large and liquid markets and are difficult to control.
Thailand’s unsuccessful attempt last year to boost natural rubber prices by limiting exports and soaking up excess demand is testament to this.
Based on the average stock price performance after the 10th, 11th and 12th general elections, glove stocks appear defensive after elections. In 1999 and 2004, when the ruling Barisan Nasional (BN) won a high number of parliamentary seats, the average glove share price performance a week after the election results was in line with the KLCI.
In 2008, when BN won fewer seats than expected, glove stocks proved defensive, falling by a lower percentage than the KLCI. Combining the data from all three elections, it is clear that the share prices of glove stocks were not linked to the results.
While historical data may suggest little linkage between glove stocks and the election, we think 2013 may be different. Energy subsidies in Malaysia are unsustainable and subsidies could be rolled back after the election. Also, the Opposition has said that if it wins the next general election it will raise the minimum wage in Peninsular Malaysia to RM1,100 per month, 22% above the current level of RM900.
While this is negative for the sector, we believe glovemakers would be able to pass on the additional cost as Malaysian OEM glove manufacturers own 50% to 60% of the world’s glove manufacturing capacity.
This gives the sector significant pricing power, which can be used to offset the higher labour cost. For example, Top Glove Corp Bhd had told its customers that it would raise selling prices by up to 5% to accommodate the government’s new minimum wage policy.
We also believe that nitrile demand has come full circle. A decade ago, natural rubber accounted for more than 82% of the examination gloves imported into the US and nitrile made up only 18% of total glove imports. Today, the tables have turned, with nitrile playing a more significant role at more than 82% of total US examination glove imports.
US glove imports are used as a proxy for global demand because the country is the single largest consumer of gloves and sets consumption trends due to its sophisticated healthcare sector.
The reasons for the change are:
(i) a preference for synthetics due to natural rubber allergies;
(ii) improvements in technology which allow manufacturers to make thin synthetic gloves (30% lighter than NR); and
(iii) manufacturers’ preference for nitrile gloves due to cost and foreign exchange advantages.
We believe that this trend is positive for synthetic glovemakers. While the incremental change from NR to nitrile over the next few years may be slower, the data illustrate the importance of the nitrile market. Glovemakers can no longer ignore consumer demand for synthetics, and we have seen a change in sentiment among glovemakers. — CIMB Research, Jan 21
This article first appeared in The Edge Financial Daily, on Jan 23, 2013.