Investment Highlights

• ESG practices of the Big Three in Malaysia. In this report, we look at the ESG practices and policies of the three large palm oil companies in our coverage i.e. Kuala Lumpur Kepong (KLK), IOI Corporation and Sime Darby Plantation (SDP). We believe that in spite of the intense efforts in implementing sustainable practices, the palm oil industry would be a target of NGOs. Hence, there is no room for error as all it takes is for a small fire or disgruntled worker to set the wheels in motion.

• Optics are poor. Negative publicity from the US Customs and Border Protection’s (CBP) ban on Malaysian palm products from FGV Holdings and Sime Darby Plantation (SDP) has amplified the misperception that the palm oil industry in Malaysia is fraught with labour abuse. This, coupled with the EU’s ban on palm biodiesel from year 2030F onwards, are expected to exert pressure on the ESG ratings of the palm oil sector. As such, we only have a 3-star ESG rating for most of the palm oil companies in our coverage.

• Three weak ESG links. Overall, we believe that the palm industry’s weakest links within the ESG (Environment, Sustainability and Governance) framework are fire (under Environment), greenhouse gas (GHG) emissions (Environment) and labour practices (Sustainability).

• During dry weather, the issue is open fire burning. Haze resulting from fires in Indonesia triggers accusations of open fire burning. Although the plantation companies do not practise open fire burning to clear land, the risk is that neighbouring fires or fires started by smallholders would spread to the estates owned by the planters. This is prevalent during periods of drought e.g. in 3Q2019. In Indonesia, smallholders are allowed to use fire to clear the land. On average, smallholders in Indonesia own less than 2ha of land although government definition allows for ownership of up to 25ha of land.

• GHG emissions are mainly from palm operations and conversion of land into oil palm. According to a 2009 RSPO report, greenhouse gas (GHG) emissions from palm oil operations amount between 920 and 2,007kg of carbon equivalent emissions per tonne of CPO per year. Most of the GHG emissions from palm operations come from palm oil mills’ effluents. GHG emissions from the conversion of grass land or forests to oil palm estates are estimated to range from 425 to 7,813kg of carbon equivalent emissions per tonne of CPO per year. To reduce GHG emissions, the three large Malaysian planters have set up biogas power plants, methane capture plants and filter belt presses. IOI, SDP and KLK have also set targets to reduce GHG within a certain time period.

• Labour is also a hot spot. As for labour practices, we believe that the issue is more of a miscommunication. The three large planters in our coverage are now taking the effort to explain the calculation of wages to their workers. Hotlines have also been established for workers to voice their grievances anonymously. As it is difficult to monitor every oil palm estate, we believe that the onus is on the estate supervisor/manager to ensure fair treatment and enforcement of good practices.

• Labour practices may have to be constantly audited. We think that plantation companies would have to go above and beyond RSPO requirements in the long term. A few plantation companies in Malaysia have set up panels to engage with NGOs directly. Also in the future, the planters may have to engage independent third-party consultants to audit their labour practices periodically as checks and balances. We reckon that costs relating to ESG compliance would rise going forward.

• No impact on demand as trade flows are rerouted. On a positive note, we believe that as plantation companies become more vigilant and careful in their estate management and labour practices, ESG risks would ease. Also, we reckon that there would always be buyers for palm products as trade flows are rerouted to new markets from countries with bans on palm products such as Sri Lanka and Belgium. The downside is that sellers may have to forego premium markets such as the EU for lower end markets such as Africa.

• Fall in share prices of Malaysian planters. In the meantime, the ESG issues, coupled with negative news flow, have dented investors’ interest in plantation stocks in Malaysia. Although spot CPO prices have been hovering above RM4,000/tonne since the start of the year, share prices of KLK, IOI and SDP have fallen by 6% to 9% (up to 30 April 2021).

• Singapore planters are performing better than their Malaysian peers. The Singapore-listed plantation stocks have fared better than their Malaysian peers. From the start of the year to 30 April 2021, share prices of the major Singaporelisted but Indonesia-based planters have risen by -6.9% to 57.2% compared to the 6% to 9% fall in the big three planters in Malaysia.

• Wilmar was voted best in workers’ rights. So far, there has not been any negative publicity on the major Singaporelisted plantation companies with the exception of Indofood Agri Resources. In fact, in October 2020, Wilmar International was voted the top company in Asia for workers’ rights by KnowTheChain organisation (a US supply chain accountability initiative). In Indonesia, share prices of CPO proxies such as Astra Agro Lestari and London Sumatra have slid by 24.3% and 5.1% respectively since the beginning of the year.

• Foreign shareholding of Malaysian planters has been declining. KLK’s foreign shareholding stood at 12.84% as at end-March 2021 vs. the high of 19.17% as at end-April 2012. SDP’s foreign shareholding stood at 9.32% as at endMarch 2021 against the high of 21.25% as at end-March 2008. According to Bloomberg, IOI’s foreign shareholding stood at 7.01% as at end-March 2021 vs. the high of 16.71% as at end-March 2010.

• Silver lining – decent 1Q2021 results. We believe that earnings of the plantation companies would be sterling in 1Q2021 underpinned by high CPO prices. Average the MPOB, spot CPO price was RM3,895/tonne in Malaysia in 1Q2021, 44.1% higher than the RM2,703/tonne achieved in 1H2020. On the flip side, industry CPO production in Malaysia fell by 5.2% YoY in 1Q2021. We have assumed an average CPO price of RM3,000/tonne for the companies in our coverage in 2021F vs. RM2,765/tonne realised in 2020.

• Neutral. We believe that ESG concerns and expectations of a rise in industry palm production in 2H2021 would continue to exert downward pressure on share prices. Nonetheless for investors who seek exposure to the plantation sector in Malaysia, we recommend KLK for its young oil palm trees in Indonesia and acquisitive growth. We have a fair value of RM25.00 for KLK based on an FY22F PE of 25x.

Source: AmInvest Research - 17 May 2021