Hartalega Holdings Bhd
(Dec 2, RM6.75)
Upgrade to “buy” with a target price (TP) of RM 8.45. The first two new-generation complex (NGC) production lines will come online this month. Backed by incoming capacity (about nine billion pieces per annum) and the best operating structure in the sector — break even utilisation of only 42% — we expect Hartalega to be more aggressive on its pricing, once it has commissioned sufficient capacity at the NGC plants. It would help Hartalega to: i) grab market share from competitors; ii) maximise utilisation and profits and iii) derail competitors’ expansion plans by depressing future internal rate of return (IRRs).

An aggressive pricing strategy will reduce earnings before interest and tax per 1,000 pieces of gloves (Ebit/k); we have reflected this in our forecasts but this will be more than offset by the resulting higher sales volumes. Despite revising financial year 2015 and 2016 (FY15 and FY16) sales volumes up by 8% and 13%, our revised earnings are only 2% and 3% higher because we conservatively slashed Ebit/k gloves. There could be upside to our earnings forecasts.

Our RM8.45 TP is based on 22 times FY16 earnings per share (EPS) (50% premium to peers average), which we believe is justified by our expectations for 16% earnings compound annual growth rate in FY15 to FY17 forecasts (F). We expect valuation to rerate once Hartalega proves it can execute its expansion plan successfully. The key rerating catalysts for the stock will be the timely roll-out of the NGC production lines, successful deployment of the new capacity in an earnings-accretive manner, and further milestones in plant 3 and plant 4.

Hartalega maintains an edge over peers in terms of production efficiency and automation. The six NGC plants are expected to have an annual capacity of 27.2 billion gloves. This is expected to triple Hartalega’s installed annual capacity to 42.5 billion gloves.

We estimate Hartalega has a break-even utilisation level of 42%, while its competitors’ are 44% to 57%. This gives Hartalega strong leverage to weather a price war.

We upgrade Hartalega to “buy” with a RM8.45 TP, based on 22 times FY15F EPS. Our target valuation is at 50% premium to the industry average. Hartalega is facing rising competition as the other glovemakers are crowding into the nitrile gloves segment.The lucrative margins currently enjoyed by Hartalega may not be sustainable. — AllianceDBS Research. Dec 2

This article first appeared in The Edge Financial Daily, on December 3, 2014.