Investment Highlights

• Average CPO price assumption of RM2,100/tonne in 2019E. We have reduced our average CPO price assumption for Malaysia to RM2,100/tonne from RM2,300/tonne in 2019E. As a result, core net earnings of the companies under our coverage are expected to fall by more than 30% YoY in 2019E. Average MPOB spot price was RM1,996/tonne in 1H2019 compared with RM2,424/tonne in 1H2018 (2018 MPOB spot price: RM2,235/tonne).

CPO prices have been lacklustre so far this year. Although palm stockpiles in Malaysia and Indonesia have fallen from record levels, they are still perceived to be high and more than sufficient to meet demand. GAPKI (Indonesia Palm Oil Association) estimates Indonesia’s palm stockpiles to be 3.55mil tonnes as at end-June 2019 vs. 4.85mil tonnes as at end-June 2018. Palm inventory in Malaysia stood at 2.42mil tonnes as at end-June 2019 against a record 3.22mil tonnes as at end-Dec 2018.

• Key is palm supply, which will affect the level of inventories. We would turn positive on the plantation sector if there are indications that industry palm production is expected to fall. The supply disruption can either be due to weather issues or biological tree stress.

• Unexciting outlook in 2H2019. We believe that CPO prices would remain weak in 2H2019 as palm inventories may increase on the back of rising production. A few plantation companies in our stock universe have indicated that CPO output in 2H would be larger than 1H. 2H is expected to account for 55% to 60% of their full-year production. This implies that it may be difficult for palm stockpiles in Malaysia to continue declining from the current level of 2.42mil tonnes. Average monthly palm inventory in Malaysia was 2.07mil tonnes in the past five years compared with 2.42mil tonnes as at end-June 2019.

• A recovery in FFB yields in Peninsular Malaysia and Sabah is expected to support Malaysia’s CPO production growth in 2H2019. Hence, we believe that Malaysia’s CPO production would improve YoY in 2H2019 after falling by 5.4% YoY in 2H2018. Recall that last year, FFB yields in Sabah were affected by lagged impact of El Nino, which took place in 2015.

We believe that Malaysia is on track towards meeting or surpassing Oil World’s CPO production forecast of 20.3mil tonnes for 2019E (2018: 19.52mil tonnes). According to the MPOB, FFB yield in Sabah rose by 4.0% to 9.01tonnes/ha in 1H2019 from 8.66 tonnes/ha in 1H2018. FFB yield in Peninsular Malaysia improved by 12.9% to 9.19 tonnes/ha in 1H2019 from 8.14 tonnes/ha in 1H2018. On the other hand, FFB yield in Sarawak edged down to 6.76 tonnes/ha in 1H2019 from 6.87 tonnes/ha in 1H2018.

• Indonesia’s CPO production growth to be positive in 2H2019 although at a slower rate of increase. The major Singapore-listed planters guided that their FFB production growth would be 4% to 15% in 2019E (2018: 6.8% to 27.6%). Their FFB output increased by -8% to 7.0% YoY in 1Q2019. Although FFB yields may only be flat or marginally higher, Indonesia’s FFB production growth in 2019E is expected to be underpinned by expansions in mature areas.

• The major Singapore-listed Indonesian planters recorded a -0.2% to 29.5% YoY increase in their FFB production in 4Q2018. After the blistering growth, we believe that FFB yields in Indonesia would soften in 2H2019.

Overall, Oil World forecasts that Indonesia’s CPO production would rise by 5.3% to 43.7mil tonnes in 2019E from 41.5mil tonnes in 2018. GAPKI forecasts Indonesia’s CPO output to be 47.3mil tonnes in 2019E vs. 43mil tonnes in 2018.

We do not expect Indonesia to face a shortage of barges and vessels in 2H2019. Recall that in 2H2018, Kalimantan faced a shortage of barges as the barges were used to transport biodiesel to the various collection points instead of CPO. Indonesia has reduced the number of biodiesel delivery points to only 10 in 2019F from 112 in 2018. Also, Indonesian companies have ordered more barges. According to an industry player, the number of vessels and barges in Indonesia is anticipated to increase to 48 by year-end from 32 last year.

• Negative structural changes in world demand for palm oil. Long-term demand for palm oil from the EU may decline due to the EU’s proposal to phase out palm-based biodiesel by year 2030. We reckon that even without the EU’s proposed ban on palm biodiesel, the biodiesel market in the EU is anticipated to contract as electric vehicles gradually replace diesel cars. In April 2018, Volvo said that by year 2025, half of its vehicles would be electric cars. In February 2019, Volkswagen said that it would be rolling out 20 electric vehicle models by year 2025. In March 2019, Honda said that it would only sell electric cars to Europe by year 2025.

• Global soybean production is falling but CPO prices are not rising as fast. Although soybean prices have been resilient underpinned by falling production, CPO prices have not risen in similar pace. This is because of concerns that CPO supply would increase. Due to this, the discount between the two commodities is large currently. Based on prices of RM2,037/tonne and US$0.2760/pound, the discount between soybean oil and CPO is 20.0% or US$122/tonne. Average price discount between the two commodities was 16.2% or US$155/tonne in the past five years.

The USDA (US Department of Agriculture) forecasts global inventory of soybean to fall to 104.53mil tonnes in 2019E/2020F vs. 112.98mil tonnes in 2018/2019E. Global production of soybean is anticipated to decline by 4.4% to 347.04mil tonnes in 2019E/2020F from 362.87mil tonnes in 2018/2019E due to a drop in output in the US. US soybean production is envisaged to fall by 15.4% to 104.645mil tonnes on the back lower yields and smaller planted areas. Planted areas of soybean in the US are anticipated to be 80.0mil acres in 2019E/2020F compared with 89.2mil acres in 2018/2019E.

• Silver lining – biodiesel consumption may increase in Indonesia. If vehicle tests are successful, Indonesia would be implementing the B30 biodiesel policy in year 2020F. This would lift the country’s biodiesel consumption to a range of 7mil to 9mil KL (6.1mil to 7.8mil tonnes) in 2020F from an estimated 6.2mil KL (5.4mil tonnes) in 2019E. The biodiesel consumption of 7.8mil tonnes in 2020F would be about 18.2% of Indonesia’s CPO production of 43mil tonnes in 2019E.

Risk is a decline in crude oil and gasoil prices. If crude oil and gasoil prices continue to fall, biodiesel may not be feasible. As such, the implementation of biodiesel in Indonesia would require subsidies. Hence, Indonesia would need to reimpose the export levy on CPO exports.

Previously, monies received from the export levy were used to subsidise biodiesel. The export levy was reduced to zero in November 2018 as CPO became cheaper than gasoil. Also, we believe that the Indonesian government wanted to encourage companies to export CPO to reduce the level of palm inventories in the country. Currently, biodiesel is just barely feasible as the difference between gasoil and CPO is small at US$70/tonne.

• Valuations of plantation companies are stretched. Large-cap plantation companies (KL Kepong, IOI Corporation, Sime Darby Plantation and Genting Plantations) are currently trading at PE multiples of 26x to 41x for FY20F. Their smaller peers i.e. TSH Resources and IJM Plantations are trading at PE ratios of 21x to 23x.

We do not have any BUY recommendation in the plantation sector currently. However, if investors would like exposure to the sector, we would recommend IOI Corporation. IOI has a resilient downstream business (mainly oleochemicals and refining), which would help cushion the downturn in plantation earnings. In addition, if IOI does not find any investment opportunities, the group is expected to pay higher dividends to its shareholders in FY21F. We have a fair value of RM4.40/share for IOI, which is based on a FY20F PE of 27x.

Source: AmInvest Research - 8 Aug 2019