This article first appeared in The Edge Financial Daily on July 17, 2019

Rubber products sector
Maintain neutral
Earlier expectations of an oversupply situation driven by robust capacity expansion has been somewhat neutered on the back of better managed and staggered expansion. We understand that the majors have collectively pushed new capacity down by one to two quarters to alleviate the pressures on the average selling price. Overall, we expect total capacity to increase by 9.7% in calendar year 2019 versus our earlier expectations of 14.6% prior to the rationalisation exercise by the sector.

The trajectory of the US dollar/ringgit is a mixed bag in the second half of 2019 (2H19). It has picked up to US dollar/RM4.11 on the back of weakening dollar due to the market pricing in a rate cut by the US Federal Reserve in July. However, major catalysts for ringgit depreciation in 2H19 including: i) Norway sovereign wealth fund exit from emerging market bonds; and ii) Malaysian Government Securities (MGS) exclusion from the World Government Bond Index, augurs well for the sector in maintaining its cost competitiveness against its regional peers. Our economics team has an average exchange rate projection of US dollar/RM4.05 to RM4.15 for the rest of the year which is within our forecast range. Within our coverage, Top Glove Corp Bhd is the main beneficiary of a weaker ringgit (stronger dollar) as it has the highest exposure to natural rubber (NR) latex gloves.

We expect the price of nitrile and natural rubber to parallel that of global commodities on the back of dampening sentiments driven by trade war tensions. Year to date (YTD), the price of butadiene (a core component in nitrile manufacturing) has declined by 8.5% but has since exhibited an upward trend since May, we expect price nitrile-butadiene rubber (NBR) to be flattish in 2H19. In June, Top Glove reported weaker-than-expected results on the back of a sharp incline in NR prices due to: 1) wintering season; and 2) support for prices in Thailand due to the general election. We expect the price of NR to normalise to its seasonal trend in 2H19 (YTD average: RM4.61/kg; 2018 average: RM4.30/kg) assuming no supply disruptions.

Gas Malaysia Bhd recently announced a tariff revision of about +5.3% for second half of 2019 (2H19) [from RM32.92 per million British thermal units (MMBtu)  to RM34.46/MMBtu]. We understand that this increase will result in an increase in glove prices by less than 1% and should be passed through in one to two months. We expect this lag will have an immaterial impact on margins especially to Top Glove given that it has recently raised average selling prices (ASPs) (NR: +8.8%; nitrile: +1.3%) in June. We understand that the more nitrile-skewed players have also raised prices within the 2% to 3% range to pass through the increase in nitrile prices recently. This should help to contain the higher operating costs and buffer against further margin compression in the coming quarters.

Valuations for the sector is palatable with the sector trading at 25.7 times or just above its three-year historical mean. We note that further downside would be limited given the sectors YTD mean reversion. However, we believe that upside risk remains at a distance given that the sector, in our opinion, is still on the road to recovery and would take at least one to two more quarters before ASP, supply and demand favour the producers.

Maintain “neutral”. While valuations are cheaper at this juncture, the protracted softer dollar would weigh on sentiments in the near term. With regard to managed and staggered capacity, we are of the opinion that these measures are still at infancy. Our preferred stock for the sector is Top Glove (target price: RM5.31; buy). — Hong Leong Investment Bank Research, July 16