This article first appeared in The Edge Financial Daily on August 1, 2019
Hartalega Holdings Bhd
(July 31, RM4.95)
Maintain neutral with a higher target price (TP) of RM4.77: To recall, Hartalega Holdings Bhd’s weak fourth quarter of financial year 2019 (4QFY19) earnings at RM91.4 million translate into a decline of 23.7% quarter-on-quarter (q-o-q) and 21.7% year-on-year (y-o-y). We are expecting 1QFY20 normalised earnings at between RM87 million and RM97 million — about 20% to 22% of our FY20 earnings forecast. On a comparable basis, we view 1QFY20 normalised earnings to remain stagnant q-o-q, also meaning that y-o-y, we are expecting an earnings reduction of more than 22%.
We are anticipating the group’s average selling price (ASP) to remain depressed in the near term, for example, below RM100 per thousand pieces versus RM96 per thousand pieces in 4QFY19. Despite the “cost pass-through” in the glove industry, we believe the group was unable to fully pass-through to its customers the higher cost of production during the last quarter arising from an upward revision of gas tariff and minimum wage. This was largely due to a supply surplus of nitrile gloves particularly in the first half of calendar year 2019 (1HCY19). Take note that we are estimating a 3% q-o-q increase in production cost which the group must absorb.
We gathered that 2HCY19 is expected to be better in the supply and demand dynamic driven by industry players’ effort to regulate expansion. Based on our channel checks, local glove manufacturers have delayed about six billion of planned capacity expansion in FY19 or about a -30% cut from the initial plan. Nonetheless, we believe Hartalega would be in a difficult position to meaningfully increase its selling price as its bigger peers are aggressively expanding its nitrile glove manufacturing capacity, inadvertently leading to a lower profit margin.
With the ASP remaining under pressure, Hartalega has been very conservative in its capacity expansion plan, particularly in CY19 relative to its bigger peers. Despite this, the group’s main focus is still on increasing its capacity and production efficiency to meet its medium- to long-term target of a lower production cost per unit.
The group has set aside capital expenditure (capex) for plant expansion and automation of RM630 million and RM115 million respectively for three years. The capex for plant expansion is allocated for constructing Plant 6 to produce 4.7 billion pieces and Plant 7 (2.6 billion pieces), targeted to start production in 1HCY20 or FY20 and 2HCY20 or FY21 respectively. These will increase its current capacity from approximately 34 billion to 42 billion pieces by FY22. The group is also looking to acquire suitable land for future expansion beyond Plant 7.
The group prides itself as a leader in technological innovation in the glove industry. Hartalega remains the best in productivity with an efficiency level at 3.3 workers per million pieces per month (WPM) compared with the industry average of 5.3. The greater efficiency is largely contributed by its Next Generation Integrated Glove Manufacturing Complex (NGC) plants supplying about 70% of its total capacity and achieving about 2.6 WPM. With an intensified investment into automation, the group targets to further reduce workers at the NGC to 2.3 WPM. Initiatives to reduce labour dependency include installing a robotic auto packing system, replacing the manual inserting a stack of gloves into a box.
We are revising our earnings forecasts for FY20 and FY21 downward by 15.1% and 6.2% respectively due to the downward pressure on ASP as higher production costs cannot be fully passed to customers. We are not expecting much space for the ASP to increase in the near to mid-term in view of an intensifying competition.
We revised our TP to RM4.77 per share from RM4.65 as we rolled forward our valuation base year to FY21. Our TP is derived via pegging our FY21 forecast earnings per share of 15.4 sen at price-earnings ratio (PER) of 31 times — -1 standard deviation below its three-year average historical PER. We prescribed a discount to Hartalega’s historical PER valuation in light of a diminishing differential between its profit margins and those of its peers.
We are still concerned about the declining ASP in view of the industry’s oversupply which has also affected the group’s profit margin. This is due to our expectation that 1QFY20 earnings growth will stagnate compared to that for 4QFY19. On a longer term, we opine that industry players’ effort to regulate their expansion, coupled with a resilient demand for rubber gloves globally, will restore the supply and demand dynamic.
We also applaud the group’s effort to continue being the leader in technological innovation in the glove industry, giving them an upper hand in managing production cost. In terms of valuation, the stock is currently trading close to its three-year historical average PER of 37.4 times. Therefore, we believe there is a limited upside for the stock. All in, we are maintaining our “neutral” recommendation on Hartalega. — MIDF Research, July 31