KUCHING: The weakening of the ringgit versus US dollar has been viewed by the research arm of Kenanga Investment Bank Bhd (Kenanga Research) as a boon to rubber glove players.
Kenanga Research expects gloves players’ margins to expand or at least sustain over the next few quarters due largely to the sustained/further weakening of the ringgit against the US dollar.
The research arm noted that quarter on quarter (q-o-q) in the fourth quarter of 2015 (4Q15), the ringgit has weakened by an average of nine per cent against the US dollar (year to date (YTD) down 19 per cent). Kenanga Research’s in-house economist forecasted an average of RM4.17 in 2016. The research arm’s average assumption is RM4.20 for financial year 2016 (FY16) earnings forecasts.
“Generally, a weakening ringgit is positive for glove makers,” it said.
According to Kenanga Research, since sales are US dollar denominated, theoretically, a depreciating ringgit against the dollar will lead to more revenue receipts for glove makers.
“Ceteris paribus, a one per cent depreciation of ringgit against US dollar will lead to an average two per cent-three per cent increase in the net profit of rubber glove players,” it said.
The research arm noted that Top Glove Corporation Bhd (Top Glove) is likely to benefit the most due to the group’s hedging policy of one to two months coupled with raw material latex purchased in ringgit.
It further noted that the others typically hedge between three to six months with the exception of Supermax Corporation Bhd (Supermax) who does not hedge.
On the average 17 per cent tariff hike for natural gas for non-power sectors, Kenanga Research noted that ceteris paribus, assuming “no-cost pass through”, this development is expected to marginally impact rubber gloves players’ earnings by three to five per cent.
However, the research arm was not overly concerned since rubber gloves players have generally been able to pass on the cost increase judging from past experiences, such as in May 2014, November 2014 and July 2015.
It noted that fuel accounts for an average of 10 per cent of production cost, of which natural gas accounts for an average of seven per cent of the production cost.
Based on Kenanga Research’s back-of-envelope calculations, players need to raise their average selling prices by 1-1.3 per cent.
“Generally, it takes approximately between one to three months to pass through the cost increase. However, the weakening of the ringgit against the US dollar makes it relatively easier for glove makers to pass cost through,” the research arm said.
Moving forward, Kenanga Research noted that based on historical valuation at peak earnings, rubber gloves stocks namely Kossan Rubber Industries Bhd (Kossan), Hartalega Holdings Bhd (Hartalega) and Top Glove are trading at between 19-fold to 28-fold price earnings ratio (PER) valuation or at +2 standard deviation (SD) above forward mean average.
The research arm believed rubber glove stocks are poised for a further re-rating and should trade at their previous peak PER valuations given that all players have evolved successfully.
It was also based on factors including automating of plants and production processes leading to better efficiency and productivity, potentially translating to better margins, resilience and hence ability to transform and increasing product mix from purely latex-based gloves to the higher margin nitrile-based gloves and expected to report solid and another record-peak quarterly earnings.
“Both Kossan and Top Glove announced their best quarterly earnings since 2001,” the research arm added.
Kenanga Research noted that Kossan and Hartalega are currently trading at between 19.7-fold and 25.4-fold financial year 2016 (FY16) PERs which are close to their current peak PER valuation of 19.8-fold and 28-fold, respectively.
It has however said that Top Glove which offers higher upside is meanwhile trading at 17.8-fold FY16E earnings per share EPS (lower than historical 5-year forward mean average of 18x) compared to its historical peak valuation averaging 23x-26.
“Given its dominant production capacity as well as large earnings base, Top Glove appears undervalued,” the research arm added.
All in, Kenanga Research’s top pick was Top Glove with an ‘outperform’ call. The research arm believed the PER expansion is justifiable considering that Top Glove has shown the best quarterly earnings growth and the biggest quarterly profit among its peers.
“Top Glove’s historical valuation at peak earnings averaged at between 23 to 27-fold PER,” it said.
It noted that PER valuation of Top Glove (19.5-fold FY17E PER) has lagged behind its peers and is trading at an average 25 per cent discount to Kossan (23-fold FY17E PER) and Hartalega (27-fold current year 2017 estimate (CY17E PER).
Kenanga Research considered the under-performance as unwarranted.
“The valuation gap should narrow when we consider that Top Glove has similar/higher total capacity and net profit level compared to Kossan and Hartalega,” it said.
The research arm liked Top Glove for the group’s ability to evolve from purely a dominant latex-based rubber gloves producer into a higher margin nitrile-based products producer and undemanding PER valuation at discount to peers.