Supermx ... Nov11

CIMB Research Report

Results highlights
• Upgrade from Hold to BUY. Lower costs should provide some bounce to Supermax’s earnings, which have already hit trough. We are upgrading the stock as its established brand and own distribution network will help it ride out the next 1-3 years of excess capacity better than its peers. At 72% of our FY11 forecast, 9M11 core net profit was in line with our expectations as well as that of the market. We fine-tune our EPS for a lower dividend payout. Our target price (9.8x forward P/E) rises from RM3.64 to RM4.38 as we roll it forward to end-2013. We upgrade Supermax from Hold to BUY.

• Higher sales and margins. 9M11 revenue increased 8.7% yoy to RM750.7m due to a full-quarter contribution from new lines commissioned in the final two weeks of 2Q. Another factor was the 9% pt rise in 3Q utilisation to 80% as Supermax overcame a labour shortage in 2Q by hiring replacements. Earnings were also given a boost by lower input costs. At RM8.63/kg, average natural rubber (NR) latex price was 11% lower in 3Q than 2Q. Average nitrile costs rose by 12% qoq to RM6.43/kg in 3Q. Even so, because 65% of the gloves that Supermax sells are made of NR, 3Q EBITDA margins increased by 6.6% qoq to 17.1%. The better operating performance was enough to offset a 4% pt qoq increase in Supermax’s effective tax rate, leading to a 16.0% qoq rise in 3Q core net profit.

• Lower latex prices. We agree with Supermax’s view that earnings will improve in the quarters ahead as NR latex prices stabilise. Supermax expects NR latex prices to fall to RM7/kg by end-2011 (current: RM7.96/kg) due to more latex supply from maturing plantations in Cambodia and Vietnam. Supermax is confident of achieving an FY11 net profit of RM100-120m, as guided in late Aug 2011. The company is
actively adjusting ASPs to mitigate the impact of volatile raw material prices and exchange rates.

Recommendation
Expanding capacity. Supermax is at an advanced stage of expanding its surgical glove capacity from 2.5m pairs per month to 28m pairs per month. The facility is expected to be completed by the end of 2011. The company indicated that the new capacity will add US$67.2m in revenue (implied ASP: US$0.2/pair) and US$10.1m in net profit to the group in FY12.

Over the next two years, Supermax intends to build two additional plants in Meru, Klang where it has 10 acres of land adjacent to its existing facilities. By building on an existing site, it will have no problem accessing gas. The two plants will add a total of 3.9bn gloves p.a. to the group’s capacity by the end of FY13. The company is also upgrading old lines to improve efficiency.

Stable costs will boost earnings. We believe that less volatile NR latex prices will lead to an earnings re-rating as a result of a) better margins and b) higher demand. Stable costs will enable Supermax to pass on a higher portion of its costs to customers, clawing back lost profits when raw material costs were on the uptrend.
Currently, Supermax is passing on 75% of the cost increase, higher than the 70% passed on in the 2Q. In normal conditions, Supermax is able to pass on 90% of the cost increase.

Also, we believe that less volatile raw material costs will entice distributors to restock their inventories. We gather that inventories are at an all-time low of 1-2 months due to the recent wild swings in rubber prices. This has prompted distributors to hold back their purchases and wait for NR prices to stabilise. With NR latex prices stabilising at around the RM8/kg level, we believe that distributors will be more comfortable about
taking aggressive inventory positions.

Defensive business model and strategy. With its own distribution network, established brand and focus on the dental market, we believe Supermax will ride out the next 1-3 years of excess capacity better than its peers. By owning the network and brand, Supermax controls both the manufacturing and distribution portions of the
value chain. Unlike Top Glove which is integrating vertically upwards by buying rubber plantation land, Supermax is investing downstream to enhance its marketing and distribution capabilities.

We are in favour of this strategy as it enables Supermax to bypass distributors and sell directly to the end-user. This means that unlike its larger rival, Supermax does not have to dance to the tune of distributors who may not have the customer’s long-term interests in mind. Note that Supermax sells nearly 70% of the gloves under its own brand, which can add up to 5% pts to the company’s profit margins.

Focused strategy shields Supermax from competition. Supermax will also be less affected by the industry’s overcapacity because of its focus on the US dental market where it has a 9.2% market share and is the 2nd largest player. This puts its ahead of its peers for several reasons a) Supermax has built a dominant position and reputation in this market, giving it first-mover advantage, b) when the company switches customers from NR to nitrile, Supermax will not cannibalise its own products and c) by focusing on a sub-segment of the examination glove industry, Supermax faces less competition by serving a niche market.

Cheaper entry than Top Glove. We believe Supermax provides a cheaper entry into the glove sector than Top Glove. The stock trades at just 8.7x FY12 P/E or more than half of Top Glove’s forward P/E of 19.0x. We do not believe that Top Glove’s premium is justified given the company’s lower ROEs and earnings growth. Supermax is also just as liquid as Top Glove, as both stocks have an average daily turnover of about
US$1m and a free float of c.50%.

EPS tweaked for lower dividend payout. While earnings met our expectations, dividends did not. Supermax declared a 3 sen dividend, which was lower than our 5 sen expectation. It also indicated that a 3 sen final dividend is likely, which is again below our 6 sen expectation. We now lower our FY11 DPS forecast from 11 sen to 6 sen. Also adjusted is our FY12-13 dividend payout from 30% to 20% (% of net profit),
as guided by Supermax. This leads to a 0.22-1% increase in our FY11-13 EPS forecasts due to a higher earnings retention ratio.