KUALA LUMPUR (Jan 9): CLSA has downgraded the Malaysian glove sector to "neutral" and said after a decent 2018, a lack of supply moderators in tandem with continued expansion threaten to destabilise the supply-demand dynamics.

In a report Jan 7, CLSA's Shane Chan said given the absence of demand/supply moderators, such as China and Kossan Rubber Industries Bhd, in tandem with continued capacity additions, he sees supply will outpace demand by 8.2 billion in 2019.

"The ensuing heightened competition, in the nitrile segment specifically, threatens to diminish the cost pass-through mechanism, leading to earnings downside risk," said Chan.

He highlighted that the expectations of blunted earnings render valuations too pricey at this juncture, hence the firm's lower 2019 "neutral" stance on the sector from "overweight" in 2018.

Chan has also downgraded Top Glove Corp Bhd and Kossan to "sell" and Hartalega Holdings Bhd to "underperform".

The profitability of glovemakers is also exacerbated by the waning US dollar as the currency plays a big part in glovemakers' profitability as 100% of their revenues are denominated in US dollar while only a fraction of cost is US dollar-denominated, noted Chan, adding that a stronger US dollar also increases the purchasing power of glovemakers' customers.

Chan said CLSA's in-house economists forecast the ringgit to progressively appreciate against the US dollar in 2019, strengthening to 4.09 against the US dollar by third quarter of 2019 from 4.17 at end-2018.

"Our sensitivity analysis indicates every 1% change in the US$:RM results in a 2.7% to 4.2% change in earnings across the glove companies under our coverage," said Chan.

"Coupled with expected increases in a myriad of costs, we think there is prevalent downside risk to profitability," said Chan, adding that in isolation, the oversupply environment is manageable via continued efficiency improvements, but expected escalating operational costs could tip the scale.

Nonetheless, Chan noted that the biggest upside risk for glovemakers would be the outcome of the US-China trade war.

"The touted tariff hike to 25% (from 10%) for China gloves would render the above headwinds moot, more akin to the environment of 2017," he said.