PublicInvest Research

Author: PublicInvest   |   Latest post: Thu, 21 Nov 2019, 11:24 AM


Plantations - Time to Turn Bullish

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We believe the worst is over for the plantation sector after suffering from the downcycle of almost 2 years. CPO prices should rebound gradually in anticipation of falling global palm oil inventories as we see few key catalysts from the supply and demand factors that could contribute to a lower stock level in Malaysia and Indonesia. Hence, We upgrade our sector call from Neutral to Overweight in anticipation of an upward trending CPO price. We raise our average CPO price assumption from RM2,200/mt to RM2,400/mt in 2020, which is a 15% increase from prevailing market prices. We expect CPO prices to start rising towards end-2019 after the peak production season is over. Our Top Picks are KLK, Genting Plantations, TSH and Ta Ann.

  • Lower global palm oil inventories next year. We are seeing a decline in global palm oil inventories in 2020 on the back of i) slower palm oil production growth ii) higher biodiesel consumption and iii) stronger demand from China and India. We project Malaysia’s palm oil inventories to fall to 2m mt by mid-2020. Meanwhile, inventories in Indonesia are likely expected to inch down to about 3m mt.
  •  Expecting higher palm oil demand from China. Exports to India and China markets, which made up about 40% of our total exports, saw an impressive growth this year thanks to the favourable import duty policy in India while China has been hard-hit by African swine flu, which has wiped out a third (38% as of Aug 2019) of China’s swine population or more than 100m, resulting in weaker demand for soy meal, which is the main feed for their farming industry. Consequently, it makes it less appealing to buy soybean for crushing purpose and palm oil would be the most suitable replacement for soybean oil. The number of sows has also shrunk by 37%, indicating fewer piglets will be born and the pig population will continue to shrink in the near-term. YTD, palm oil exports to India surged 118% YoY while demand from China grew 29% YoY.
  • Stronger appetite for biodiesel. To offset the impact of anti-subsidy duty from EU, Indonesia has been pushing to increase domestic consumption of palm oil with higher biodiesel mandate, B30 (up from B20), which is set to take off early next year. The shift to B30 can generate additional 2.5m palm oil demand, which forms 3.3% of global demand. Meanwhile, the imposition of anti subsidy duty on Indonesian biodiesel exports by EU allows Malaysia to take away some market share from its counterpart. Malaysian biodiesel exports registered an impressive 33% YoY growth to 414k. Domestic consumption under B10 mandate will be extended to heavy vehicles next year, bringing the total biodiesel demand to 1.6m mt from 1.3m mt.
  • Slowdown in global production growth. We foresee weakness in palm oil production next year on the back of i) drastic cut in fertilizer application by smallholder plantation ii) prolonged dry weather pattern during May-Sept 2019 period, iii) a slowdown in Indonesian production growth and more aggressive replanting activities by companies. Malaysian production in 2020 is projected to see a decline in 2020 from 20m mt while Indonesian production is expected to increase by only 1m mt or 2.3% YoY, the weakest production growth in a decade. After seeing a strong production growth over the last decade, we think Indonesian supply growth is softening and is likely to see a low single-digit growth next year. To recap, Indonesia started imposing a moratorium on forest-clearing under the Reducing Emissions From Deforestation And Forest Degradation (REDD+) agreement with Norway worth USD1bn in 2010 to protect their forest as a way of reducing greenhouse gas emissions. Last year, Indonesian President Joko Jokowi Widodo signed a moratorium on new oil palm plantation permits and ordered a review of existing permits. According to the ministry’s data, the area mapped out for the moratorium on new forest clearance for activities such as palm plantations or logging totalled 66.1m ha. Since then, the new planting activities have slowed down to 300k-500k p.a. or at an annual growth of 4%. The estimated new planting growth for 2019-2026 will reduce to 1-2% or about 200k ha p.a. Consequently, the Indonesian CPO production growth in the coming years will slow down from 8%-9% p.a. to 1-2% p.a .
  • Seeing downside risk in Malaysian FFB production. We see potential risk of weaker FFB production in Malaysia next year on the back of i) a cut in fertilizer application by small farmers and ii) aggressive replanting activities carried out by the plantation companies, namely, FGV Holdings, IOI Corp, KLK and Sime Darby Plantations. We suspect smallholder plantation, which made up of 17% of Malaysia and 40% of Indonesia  planted area, have cut down the fertilizer application over the last one year due to lacklustre CPO prices. The impact could pose a threat to the national production as it could cause a significant reduction in bunch weight and fruit abortion over the near-term. Ripening of fruit bunches should also slow down, making a longer period needed for harvesting. In addition, the prolonged dry weather period during May-Sept could affect the nutrient uptake and cause moisture stress in palms. Depending on the severity, the lagged effect on the production will be seen two years later.
  • A strong earnings recovery. Our sensitivity analysis suggests that a RM100/mt jump in CPO prices will see earnings recover by as much as 10%-20%. Upstream producers will be more sensitive to CPO prices as margins will at least double on the back of stronger sales as well as a sharp decline in CPO production cost. With the exception of IOI Corp and KLK, the rest of the plantation players under our coverage have more exposure in the upstream business.
  • Light at the end of the tunnel. It was challenging year for the plantation industry as CPO prices were trading below the psychological level of RM2,000/mt. We saw a growing number of plantation companies reporting losses in the second quarter results as average recorded CPO price was only RM1,941/mt. Historically, CPO prices rarely sustained below that psychological level. We think CPO prices have bottomed out after solidly staying above RM2,000/mt since early-Aug. In our view, We foresee that CPO prices could potentially inch up after the peak production season ends within these two months and it could surpass RM2,300/mt in the near term. At the point of writing, CPO futures stood at RM2,173/mt. We are looking at higher CPO price assumption of RM2,400/mt (up from RM2,200/mt) for 2020 while retaining RM2,200/mt for 2019. We opine that investors should position for an uptrend in CPO prices.
  • Trading at a steep discount to soybean oil price. Current spread of CPO soybean oil prices are standing at USD146/mt , the widest spread since June 2017. It is also trading at a 30% discount to the 5-year average of USD102/mt. The wide spread will attract more palm oil buying interest from the price sensitive buyers like Pakistan and India. In addition to that, the weakness in Malaysian Ringgit will also make palm oil a cheaper source for the major consuming countries. The wide spread between palm oil and soybean prices indicates there will be more room for the upside in CPO prices (about USD44/mt or RM185/mt).
  • Upgrading the sector to Overweight. In view of the positive CPO price outlook, we upgrade the sector from Neutral to Overweight. We revise up our PER valuations across the companies under our coverage by 2x to reflect the positive outlook. In addition, we also raise the respective company earnings by 15%-30% for FY20. We prefer upstream plantation companies given their earnings are more sensitive to the fluctuation in CPO movements. Consequently, we upgrade Genting Plantations (RM11.72), KLK (RM24.87) and TSH (RM1.16) to Outperform call as valuations look attractive at current level.
  • Key risks to our earnings forecasts. i) Weaker-than-expected CPO prices, ii) a new minimum wage policy, iii) lower-than-expected FFB production, iv) weather abnormalities, v) volatility of FX movements and vi) change of foreign trade policy.


Source: PublicInvest Research - 9 Oct 2019

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Labels: GENP, KLK, TSH

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