• Pandemic has resulted in spot prices for gloves ballooning 5-fold. Order lead times have been stretched from one month to a year. Supply shortfall to continue until 2021.
• With its own branded gloves and distribution network, UG Healthcare should be able to monetize a larger share of supply-chain profits, starting from manufacturing to distribution
• Initiate coverage with BUY recommendation and target price of S$2.70. Valued at 15x FY21e PE, a 40% historical discount to peer on account of its smaller scale and size.

Company Background

Established in 1989 and listed on the SGX in 2014, UG is a disposable-glove manufacturer with two factories in Malaysia. It makes and distributes gloves under its proprietary “Unigloves” brand to more than 2,000 customers in 50 countries, including the UK, Germany, US, China, Brazil and Nigeria. Around 55% of its gloves are latex and the balance nitrile. Industries served include healthcare, food and beverage, electronics, beauty, etc. Annual production capacity is 2.9bn gloves, with plans to expand to at least 3.2bn by FY21e.

Investment Merits

1. A surge in demand. Covid-19 has resulted in a sharp spike in demand, precipitating severe industry shortages. Industry order lead times have multiplied from one month before Covid to 12 months. Ex-factory spot prices for nitrile gloves have skyrocketed from US$25 to US$120 per 1,000 pieces. The three levers of demand: a) quantum jumps in the number of hospital patients, frequency of use and typically low inventories, which have led to a scramble for gloves; b) hospitals, governments and NGOs have started to build buffers or strategic stocks to prepare for future spikes in demand; and c) the new normal of hygiene practices has necessitated the use of gloves by consumers and non-healthcare industries such as airlines, airports and restaurants.

2. Capturing the entire supply chain margins. Since listing, UG has been investing aggressively in its brands, logistics, warehouses and end-customer network. Sales from its Unigloves brand have leapt from around 50% of the total in 2015 to 85%. Own-brand products offer higher customer stickiness and selling prices. UG can also capture distribution margins. With a network that reaches out to end-customers directly, UG can benefit from higher end-selling prices of gloves and enjoy both manufacturing and distribution margins for its premium branded gloves

3. Shortage should persist till 2021. Demand for gloves worldwide was already growing at a CAGR of 10.6% before Covid. We believe the current shortage will persist into 2021. Firstly, glove penetration in emerging markets such as China and Brazil is only 10 and 24 pieces per capita respectively. This compares with 100 and 150 for Europe and the US. UG can benefit from growth in both countries, as it has been entrenching its brand and distribution networks in China and Brazil since 2002 and 2014 respectively. Secondly, industry supply is not expected to meet demand growth even in 2021. Demand was growing by around 30bn a year before Covid. This year, it is expected to grow by 60bn and another 33bn in 2021, as the pandemic has created new growth drivers. This surge of almost 93bn in two years is above expected increases in planned glove capacity of around 74bn. If we assume a 90% utilization rate for the industry, actual supply addition will only be around 67bn pieces.

We initiate UG Healthcare with a BUY rating. Our target price is S$2.70. This is based on 15x PE FY21e. The average discount to peers for UG since listing has been around 40%.

REVENUE
Revenue for UG can be split into two large product types, latex (55% of sales) and nitrile (45%)*. Nitrile gloves are predominantly used in healthcare industries in developed countries due to regulations. Meanwhile, latex is used more in emerging markets due to the lower price, comfort and higher sensitivity of such gloves. UG produces many types of gloves that can be differentiated by their weight, raw material, thickness, colour, scent, barcode, etc. Another source of revenue is the sale of ancillary products such as surgical, vinyl and cleanroom gloves, face masks, and other medical disposables. By geography, the major markets for UG are the UK, Germany, Brazil, China and Nigeria. Revenue for UG has been growing around 13% CAGR from FY15 to FY19 as the company expanded production capacity (Figure 2). In FY20 and 21, we expect revenue to surge due to the spike in selling prices. Nitrile gloves are expected to grow faster than latex (Figure 3).

*Latex gloves are made from natural rubber and can be classified into powdered and powder-free. In the past, latex gloves were powdered with cornstarch for easier donning and to prevent sticking. But this can cause a sensitive or allergic reaction to the skin when worn for long periods. Powder-free gloves undergo chlorination that provides a slippery effect on the glove surface to ease donning and removal of the glove without the need for powder. Nitrile gloves are made from petroleum-based synthetic rubber.

EXPENSES
The breakdown of manufacturing cost are raw materials (55-60%), labour cost (10-11%) and other overheads such as utilizes, depreciation (30-35%). The type of raw material for natural latex gloves is natural rubber latex. Meanwhile, nitrile gloves are made from synthetic rubber (i.e. nitrile latex). The feedstock in the production of nitrile is the petrochemical butadiene. The prices of butadiene have been stable in-line with the weaker crude oil price (Figure 4). Rubber prices similarly are at record lows (Figure 5).
Operating expenses include selling and distribution (3% of sales), administrative expenses (13%) and other operating expenses (2%). The last three years have seen a doubling in operating expense from S$8.1mn in FY16 to 16.8mn in FY19 (Figure 7). Marketing and administrative cost have risen the past two years as the distribution network expanded into new countries such as Brazil. UG had to invest fixed cost such as warehouse and new marketing and sales teams.

MARGINS
EBITDA margins for UG have 6% for the past three years. This is below larger peers such as Riverstone (22%), Top Glove (15%), Hartalega (25%) and Supermax (16%) – Figure 1 The lower margins is due to UG lower production capacity and economies of scale. Without the higher volume, fixed cost per unit will be higher. Besides, the utilization rate will be lower due to higher downtime and smaller batch production runs. Higher contribution from nitrile sales is another factor to margins. Both Hartalega and Riverstone sell only nitrile gloves.
The two years where margins were weakest was in FY17 and FY18. Margins were negatively impacted by higher material cost, gas tariff hike, foreign worker levy and higher depreciation from new product lines. The supply disruption in global butadiene supply caused nitrile latex prices to spike in early 2017. Whilst, difficult to quantify, the margins are higher than typical OEM manufacturer because of the distribution margins which UG can capture.

OTHER INCOME
There are two categories of other income

1. Other income: This item in the income statement records fair value gains or losses from derivatives and foreign exchange realized/unrealized gains or losses. Other income is a material item which is as large as the net income for the company. It was S$4mn in FY18 and S$1.8mn in FY19.
2. Associates: The key associate is 19.3% owned German distribution arm – Unigloves Germany. Contribution from associates has been rising S$534k in FY17 to S$711k in FY19.

BALANCE SHEET

Assets: Fixed assets of the company has doubled over the past four years (FY15-19) to S$32mn (Figure 8). The rise in assets is in tandem with capacity and revenue doubling over a similar period. Conversely, inventory tripled during these four years. Expanding the distribution network into new markets requires warehouse and inventory to become available to customers.

Liabilities: UG swung from net cash of S$1mn to net debt of S$27mn from FY15 to FY19. Debt was required to fund the growth in fixed assets (+S$17mn) and inventory (+$21mn).

CASH-FLOW
Cash-flow from operations has generally been negligible. Any cash generated has been used to fund inventories and receivables. Accumulated operating cash-flow from the past four years has been a negative S$2mn. Meanwhile, capex required was around S$7mn p.a. between FY16 to FY19, as the company doubled its production capacity from 1.4bn to 2.9bn.

INDUSTRY

The global rubber gloves industry is dominated by Malaysia exporters. In 2019, Malaysia accounts for 67% of global production followed by Thailand the 2nd largest at 19%, according to MARGMA*. Over the past three years, global demand for gloves has been rising at a CAGR of 12.5% or 29bn pieces a year (Figure 10). Pre-Covid 19, demand for gloves have been driven by increased spending in healthcare, ageing populations, rise in non-communicable diseases, increased regulation and improvement in hygiene, especially in developing countries.

When the Covid-19 pandemic struck, the first wave of demand came China. As the pandemic spread, demand from the healthcare sector soaked up large amounts of the supply. The second wave of demand will now come from non-traditional or healthcare sectors and resumption of economic activity as lockdown eases.

Our expectations are for glove demand to rise by 20% in 2020, or 60bn pieces, followed by a 33bn increase in 2021. Our assumptions around demand are:

1. 20% spike this year is supported by recent Malaysian export numbers. YTDMay20, glove exports from Malaysia is up 19.6% YoY to 391.8k MT (Figure 11).
2. For 2021, we use the 7-year pre-Covid 19 CAGR of 9.3% as our baseline growth estimate.

UG BUSINESS MODEL
Large glove manufacturers such as Top Glove and Hartalega are largely OEM manufacturers. OEMs manufacture gloves for under the brand of their customers such as large medical distributors (e.g. Medline, OneMed, Marbena, Cardinal Health, Microflex, Ansell, Kimberly Clark), government agencies (Defence or Health Ministries) and non-profit organizations (e.g. WHO, United Nations).

OEMs are not keen to build their own distribution network. Firstly, this is to avoid any conflict of interest. Secondly, managing warehouses and logistics in the destination markets is not their core expertise especially compared to the scale of their production. Another challenge in distribution is the huge variety of products to be stocked and sold, not just a single product – gloves.

The typical logistics or sales cycle is as follows: UG manufactures the gloves from its factory and ship to its warehouses in the UK, China, Brazil and Germany. UG services many end customers that may just order several cartons every week. UG needs to have sufficient stock to meet such consistent orders for next day delivery. For effective sales, UG needs a local sales team to promote the brand, speak to customers, engage in marketing activities and provide after-sales support.

For more than a decade UG has spent building a distribution network for its own branded gloves. It started with Germany and this has now grown to major emerging countries such as Brazil, Nigeria and China (Figure 14, Figure 17). Brazil is a notable country with high barriers to entry due to the need for every glove to be barcoded.

Investment Merits

1. A surge in demand. Covid-19 has resulted in a sharp spike in demand, precipitating severe industry shortages. Industry order lead times have multiplied from one month before Covid to 12 months. Ex-factory spot prices for nitrile gloves have skyrocketed from US$25 to US$120 per 1,000 pieces. The three levers of demand are: a) quantum jumps in the number of hospital patients, frequency of use and typically low inventories, which have led to a scramble for gloves; b) hospitals, governments and NGOs have started to build buffers or strategic stocks to prepare for future spikes in demand; and c) the new normal of hygiene practices has necessitated the use of gloves by consumers and non-healthcare industries such as airlines, airports and restaurants.

2. Capturing the entire supply chain margins. Since listing, UG has been investing aggressively in its brands, logistics, warehouses and end-customer network. Sales from its Unigloves brand have leapt from around 50% of the total in 2015 to 85%. Own-brand products offer higher customer stickiness and selling prices. UG can also capture distribution margins. With a network that reaches out to end-customers directly, UG can benefit from higher end-selling prices of gloves and enjoy both manufacturing and distribution margins for its premium branded gloves.

3. Shortage should persist till 2021. Demand for gloves worldwide was already growing at a CAGR of 10.6% before Covid. We believe the current shortage will persist into 2021. Firstly, glove penetration in emerging markets such as China and Brazil is only 10 and 24 pieces per capita respectively. This compares with 100 and 150 for Europe and the US. UG can benefit from growth in both countries, as it has been entrenching its brand and distribution networks in China and Brazil since 2002 and 2014 respectively. Secondly, industry supply is not expected to meet demand growth even in 2021. Demand was growing by around 30bn a year before Covid. This year, it is expected to grow by 60bn and another 33bn in 2021, as the pandemic has created new growth drivers (Figure 12). This surge of almost 93bn in two years is above expected increases in planned glove capacity of around 74bn (Figure 10). If we assume a 90% utilization rate for the industry, actual supply addition will only be around 67bn pieces.

Risks:
1. A decline in selling price. The largest impact to margins and earnings will be a drop in selling prices for gloves. The current shortfall in supply has triggered a spike in prices. We expect the demand-supply imbalance to continue into 2021. Our assumption for prices is still conservative considering the recent spike (Figure 27).

2. Import restrictions from the U.S. On 16 July 2020, Top Glove announced the U.S. Customs and Border Protection has placed a detention order on disposable gloves manufactured by two of the Company’s subsidiaries. The urgent need for gloves plus a shortage of supply, there will be pressure to ensure sufficient supply for hospitals and medical workers.

3. Additional taxes imposed by Malaysian authorities. In the past, notably palm oil, the Malaysia government has imposed windfall taxes on the palm oil industry due to the surge in palm oil prices. An windfall tax will have dire consequences to the equity markets in Malaysia where the combined market capitalization of rubber glove companies total around RM170bn.

Valuation
We initiate coverage on UG Healthcare with a BUY recommendation. We peg UG to a PE of 15x FY21e. It is a 40% discount to peer valuations of around 25x PE (Figure 19).

UG has always traded at a discount to its larger peers due to its lower scale, growth and liquidity. The discount has widened recently to 60% due to the weaker financial performance of UG, in our opinion. We believe this discount can shrink to back to at least the historical average since listing of around 40x PE as the financials start to turnaround for UG (Figure 20).