Investment Highlights

• Turning positive on the sector. We believe that CPO prices have bottomed. CPO price has fallen by 31.7% from a high of RM3,278/tonne on 24 January 2017 to RM2,240/tonne on 3 September 2018. We reckon that the decline in CPO price has priced in the negative impact of China’s tariff on US soybeans and expectations of rising palm production in 2H2018. In spite of our positive view, we are neutral on the sector as the total market capitalisation of companies with HOLD recommendations is higher than those with BUY recommendations. We have raised the PE assumptions of the plantation companies in arriving at their new fair values as we believe that valuations would be re-rated when CPO prices recover.
  We believe that industry CPO production would soften from 2Q2019 onwards after peaking in either 4Q2018or 1Q2019. This coupled with the factors below are expected to support the recovery in CPO prices in 2Q2019. To be conservative, we have kept our average CPO price assumption of RM2,500/tonne in 2019F (2018E: RM2,450/tonne). This implies a trading range of RM2,300/tonne to RM2,700/tonne in 2019F.
  Immediate beneficiaries of a rebound in CPO price are pure planters with high growth of FFB production. Hence, we recommend to BUY Genting Plantations (fair value: RM11.20), IJM Plantations (fair value: RM3.00) and TSH Resources (fair value: RM1.48). Among the big-caps, our preferred exposure is IOI Corporation (fair value: RM5.05) as its cash dividend yield is forecast to be more than 3% in FY19F.
• Positive factors:

1. Higher biodiesel take-up in Indonesia in 2019F. We estimate biodiesel demand in Indonesia to grow by 20% to 3.72mil kiloliters (KL) or 3.2mil tonnes in 2019F. This is expected to be underpinned by demand from the mining and power plant industries. The total consumption of 3.2mil tonnes would be about 8.2% of Indonesia’s CPO production of 38.8mil tonnes in 2018E.
   The mining and power plant industries have started using the B20 biodiesel in September 2018 following a presidential decree. Pertamina estimates an additional biodiesel demand of 878,776 KL or 765,484 tonnes per year from the two sectors. This would help absorb the rise in palm oil supply in Indonesia. The volume of 765,484 tonnes would be about 2% of Indonesia’s CPO production of 38.8mil tonnes for 2018F.
   Indonesia’s biodiesel consumption is estimated to be between 3.0mil (2.6mil tonnes) and 3.2mil KL (2.79mil tonnes) in 2018F vs. 2.54mil KL (2.21mil tonnes) in 2017. Although government officials have forecast biodiesel consumption to be 6mil to 6.2mil KL (5.2mil to 5.4mil tonnes) in 2019F, we believe that this would be difficult to achieve without B30.
   Long-term upside to biodiesel usage may come from the implementation of B30 in year 2020F. It is estimated that with B30, Indonesia’s biodiesel consumption may reach 8.8mil KL (7.7mil tonnes) per year. Currently, Indonesia implements the B20 biodiesel policy. We believe that the implementation of B30 would take time as vehicle road tests may take almost a year.
2. We believe that US soybean prices have bottomed. US soybean price has plunged by 19.9% from a high of US$10.53/bushel on 12 April 2018 to US$8.43/bushel on 31 August 2018. In comparison, China’s tariff on US soybeans is 25%. We believe that the 19.9% fall in US soybean price has priced in the negative impact of China’s 25% tariff and expectations of a higher global soybean inventory.
   Although new customers may not replace China’s purchases of US soybeans completely, we reckon that the new markets would at least help cushion any fall in Chinese demand. Hence, the impact may not be as severe as expected. The European Union (EU), Brazil and Pakistan have stepped in to buy US soybeans in the past months due to the sharp fall in US soybean price. China was the largest buyer of US soybeans, accounting for 57.9% of exports in 2017.
   In terms of demand and supply, the USDA (US Department of Agriculture) has forecast global soybean inventory to increase by 10.8% from 95.6mil tonnes in 2017/2018E to 105.9mil tonnes in 2018E/2019F. US soybean inventory is estimated to rise by 82.6% from 11.69mil tonnes in 2017/2018E to 21.35mil tonnes in 2018E/2019F. This is due to a 2.4% slide in soybean exports and 4.4% rise in soybean production. Global soybean production is anticipated to climb by 9% to 367.1mil tonnes in 2018E/2019F on the back of a 54.1% recovery in output in Argentina. Argentina’s soybean production was affected by drought this year.
3. Slowing industry palm production from 2Q2019 onwards? CPO production growth in Malaysia and Indonesia may soften from 2Q2019 onwards after hitting a peak in 4Q2018 or 1Q2019. As such, weaker palm supply may support CPO prices from 2Q2019 onwards. So far, a few plantation companies in Malaysia have guided that their CPO output growth would be lower in 2019F vs. 2018E. We attribute the lower growth rate to replanting of ageing oil palm trees in Sabah and tree stress.
   e think that Malaysia’s CPO production may be below market expectations of 20.5mil tonnes in 2018E (2017: 19.92mil tonnes). Industry CPO production in Malaysia has not been as robust as forecast as FFB yields were weak in Sabah from May to July 2018.
   In Indonesia, we reckon that the decline in new plantings of oil palm since year 2010 would affect CPO production growth in 2019F. We believe that CPO output in Indonesia may increase by less than 2018E’s 5.4% rise, in 2019F. This would imply a CPO production of less than 41mil tonnes for Indonesia in 2019F vs. 38.8mil tonnes estimated for 2018E. We estimate that new plantings of oil palm by the major listed plantation companies in Singapore plunged by 91.7% from year 2010 to 2017 due to strict environmental guidelines.

• Risks:

1. Fall in crude oil price would reduce biodiesel demand. If crude oil price falls, this would reduce the incentive for additional biodiesel consumption. Indonesia would not be compelled to implement B30. Based on the prices of RM2,222/tonne for CPO and US$689/tonne for gasoil, CPO is cheaper than gasoil by US$150/tonne or RM620/tonne currently. In comparison, CPO was more expensive than gasoil by US$144/tonne or RM612/tonne a year ago.
   According to news reports, Malaysia is expected to implement B10 in 2019F pending feedback on engine warranties from automobile manufacturers. Presently, B7 absorbs about 358,000 tonnes of palm oil in Malaysia. This is about 1.7% of Malaysia’s CPO production of 20.5mil tonnes in 2018E.
2. Short-term weakness in demand from India. Inventory of edible oils in India stood at 2.475mil tonnes as at 1 August 2018 vs. 2.473mil tonnes as at 1 August 2017. The lowest level of inventory was 2.1mil tonnes in the past year while the highest was 2.66mil tonnes. We believe that India’s demand will not pick up until inventory drops to 2.1mil to 2.2mil tonnes. In the long term, we believe that India’s demand for palm oil would be resilient, underpinned by a rising population. Palm oil is used to make vanaspati (vegetable shortening), which is part of the staple diet in India.
   We believe that China’s long-term demand for palm oil would be unexciting as rising affluence prompts a switch to vegetable oils, which are perceived to be healthier. Also, China’s demand for palm oil may be affected by a drop in the consumption of instant noodles. About 20% to 25% of palm oil are used to fry instant noodles in China. According to the World Instant Noodles Association, demand for instant noodles in China fell by 15.7% from 46.22bil packets in 2013 to 38.97bil packets in 2017. According to a BBC article in December 2017, the decline in the sales of instant noodles in China was partly due to changing consumption patterns as consumers can now order better quality food using their smartphones.
3. Valuations of plantation companies are at a premium to the KLCI. Hence, there is risk of a PE de-rating if the KLCI falls. We attribute the sector’s premium valuation to the cash-flow generative nature of the business and the industry’s low political risk. Excluding FGV, the large plantation companies such as Kuala Lumpur Kepong, IOI Corporation, Genting Plantations and Sime Darby Plantation are currently trading at FY19F basic PEs of 21x to 27x compared with the KLCI’s PE of 16.9x. The smaller companies like TSH Resources, IJM Plantations and TH Plantations are presently trading at FY19F PEs of 18xto 21x.

Source: AmInvest Research - 7 Sept 2018