We discover that the CPO production recovery patterns were different in Indonesia and Malaysia in 2Q18 due to different rainfall patterns and age profiles. For 2Q18, Malaysia’s palm oil production was down, while Indonesia’s production is expected to grow. Thus, companies with Indonesian exposure are likely to outperform peers. Under our coverage, GENP’s strong production growth from Indonesia is likely to offset production weakness in Malaysia. Maintain MARKET WEIGHT.

WHAT’S NEW

• Different CPO production trends in Malaysia and Indonesia in 2Q18. From the data we gather, crude palm oil (CPO) production patterns in Malaysia and Indonesia were different in 2Q18. In Malaysia, CPO production experienced three consecutive months of mom declines in Mar-May 18, while in Indonesia, CPO production increased marginally in Apr 18, surged in May 18 and is expected to register a marginal decline in Jun 18 due to less harvesting days on the back of Hari Raya holidays. The different CPO production trends in 2Q18 could be due to the severity of 2015 El Nino, recent rainfall patterns in both countries and age profiles, leading to the different production recovery pace.
• Sabah CPO production dropped the most. According to MPOB, Sabah CPO production dropped the most in 2Q18 (-10.1% qoq, -12.7% yoy). We understand that the decline was due to the lack of crops from older oil palm trees and a labour shortage. The production recovery in Sabah was not as good as expected as older palm trees take a longer time to recover. Meanwhile, the hiring of foreign workers could get tougher under the new government. The labour shortage will result in the wastage of crops that cannot be harvested and are being left to rot.
• Key to outperformance in 2Q18:
• Exposure in Indonesia. Genting Plantations (GENP MK/HOLD/Target: RM10.15) has 58% of planted areas with young age profile in Indonesia. Indonesia’s production contribution is expected to offset the production weakness from its Malaysia operation. For 1H18, FFB production grew 12% yoy. On the other hand, despite IJM Plantations (IJMP MK/HOLD/Target: RM2.33) having 59% of planted areas in Indonesia, its FFB production merely increased 1.8% yoy in 1H18 as most of its estates in Indonesia are in East Kalimantan where production recovery will only come later.
• Exposure in Sarawak. Sarawak reported a qoq increase in CPO production in 2Q18. Sarawak Oil Palms (SOP MK/BUY/Target: RM4.15) and TH Plantations (THP MK/ SELL/Target: RM0.60) have higher exposure in Sarawak. For 2Q18, FFB production of SOP and THP grew 13.5% qoq and 14.1% qoq respectively.

ACTION

• Maintain MARKET WEIGHT. We see CPO prices could have bottomed and further downside is limited. However, it is still not time to buy plantation companies as there are no strong catalysts to lift CPO prices in the medium term. CPO prices are likely to trade sideways in the near term, while we await stronger re-rating catalysts, eg much stronger biodiesel demand or disappointing production.
• The plantation sector is more defensive and less affected by the high market volatility due to a change in the government in Malaysia. Among big caps, we like Genting Plantations (GENP) where its earnings growth is supported by FFB production growth from its Indonesia estates.
• Maintain BUY on Kim Loong and SOP, and SELL on Sime Darby Plantation and IOI Corporation.

ESSENTIALS

• Could review our FFB production forecasts. FY18 FFB production of Sime Darby Plantation (SDPL MK/SELL/Target: RM4.30) could come in slightly lower than our forecast. Meanwhile, SOP’s 1H18 FFB production accounted for 40% of our full-year forecast. We might look to revise down our FFB production forecasts after the 2Q18 results season. For other plantation companies under our coverage, FFB production is on track to meet out full-year forecasts.

ASSUMPTION CHANGES

• Maintain 2018 CPO price assumption. As of end-Jun 18, CPO ASP was RM2,421/tonne (-17.9% yoy). For 2018, we maintain our CPO price forecast at RM2,400/tonne as CPO prices could trend as low as RM2,250/tonne once production picks up in 2H18. We also maintain our 2019 CPO price assumption at RM2,500/tonne.
• CPO prices could trend sideways in the near term. CPO prices are negatively correlated to palm oil inventory levels. As inventory is expected to increase in 2H18, we forecast CPO prices at RM2,250-2,600/tonne in 2H18. CPO prices could trend even higher in end-4Q18 due to the low production season.

SECTOR CATALYSTS

• Stronger-than-expected discretionary biodiesel consumption.
• The development of El Nino. According to Australian Bureau of Meteorology, the likelihood of El Niño forming in 2018 is about 50%, or double the normal chance.

RISKS

• Backtracking of biodiesel mandate in Indonesia.

Source: UOB Kay Hian Research - 24 Jul 2018