Investment Highlights

• Synergistic benefits from downstream operations. In this report, we analyse the downstream operations of integrated plantation companies. We find that: (1) downstream earnings follow the trend of CPO prices most of the time; and (2) although this implies that downstream earnings would fall when CPO prices decline, they are still strong enough to sustain companies during periods of downturn.

• Exception to the downstream earnings and CPO price trend was the 2017 to 2019 period. Even though CPO prices fell from 2017 to 2019, downstream earnings increased for the 3 big planters. We reckon that global demand for oleochemicals was robust during this period, driven by growth in the cosmetics and personal healthcare industry. In fact, downstream earnings were so strong that they overtook upstream profits when CPO prices languished in FY19. For instance, downstream activities accounted for 70% of Sime Darby Plantation’s (SDP) operating profit in FY19.

• Downstream earnings go up when CPO prices increase. Looking at historical earnings, we find that most of the time, downstream operations of the integrated companies performed better when palm products’ prices increased. We attribute this to companies passing down the higher costs of raw materials to customers in the form of higher selling prices. As such, revenue and EBIT margins expand when feedstock costs increase.

• The opposite is true when palm products fall. This would affect selling prices and demand. Downstream companies would reduce selling prices to reflect the lower costs of raw material costs. However at the same time, consumer companies may defer their purchases in anticipation of weaker selling prices in the future. When CPO prices were in the doldrums from 2013 to 2015, downstream EBIT of Kuala Lumpur Kepong (KLK), IOI Corporation and SDP declined by 32% collectively. Combined EBIT margin of the 3 planters fell to 2.8% in FY15 from 4.5% in FY13.

• How much can companies pass on the higher costs of raw materials? The issue here is whether demand would be affected by higher selling prices. We believe that at a certain price level, consumer companies would re-formulate their products and use less fatty acids or fatty alcohols in the production process. Also at a certain price point, we reckon that consumers would buy cheaper shampoos and washing detergents or make them last longer by using less.

• Margins declined in 1Q2022 but recovered in 2Q2022. We think that the margin recovery in 2Q2022 was largely due to paper trading on CPO futures. The downstream revenue of KLK, IOI and Sime Plant fell by 1% to 15% in 1Q2022 vs. 4Q2021 even as EBIT margins were sustained. However, the combined revenue of the 3 companies recovered by 11% QoQ in 2Q2022 as EBIT margin improved to 5.2% from 4.2%. The recovery was mainly led by IOI. After being affected by margin squeeze since 2Q2021, IOI’s manufacturing EBIT margin rebounded in 2Q2022.

• Demand for high value-added oleochemical products is more stable. During periods of downturn, we believe that demand for high value-added oleochemical products sold to pharmaceutical industries is more resilient than personal care or surfactant industries. However, the exposure of integrated companies to high value-added industries for oleochemicals is still small, at less than 15% of total sales volume.

• Slower growth for oleochemicals. As prices of palm products are envisaged to be weak going forward, we believe that the EBIT margins and downstream earnings of integrated companies would soften. We think that downstream EBIT margins would normalise to 4% to 6% vs. the highs of 5% to 8% currently. We also reckon that revenue would decline as selling prices fall. Overall, we forecast the FY23F net profit of KLK, IOI and SDP to drop by more than 20%. The decline in profitability is not only due to weaker CPO prices but also weaker oleochemical earnings. Downstream or manufacturing accounts for about 20% to 30% of the companies’ group EBIT. We maintain UNDERWEIGHT on the plantation sector.

Source: AmInvest Research - 20 Sept 2022