• CPO price movement for the rest of the year is expected to be muted – trading c. RM2,100/MT-RM2,300/MT versus RM2,423/MT average for 1H18.

• Inventory is anticipated to stay above 2.0m tonnes as production is expected to increase steadily whilst demand remains sluggish.

• In-line with the fall in CPO price, plantation players are expected to register weaker qoq and yoy 2Q 2018 results announced in August.

• Earnings upside for FY18 is limited by high operational costs and lower profit margin - upstream players would be affected more than the rest.

• Our average CPO price projection of RM2,380/MT for 2018 remains unchanged. Maintain Neutral.

CPO price has been under pressure

The price of CPO (local delivery) started 2018 on a strong note at RM2,468/MT, but the trend was relatively short-lived as it started to fall below RM2,400/MT in the middle of April after hitting its highest level on 1st March 2018 at RM2,555/MT. Since then CPO price has traded within a range of RM2,200/MT to RM2,400/MT up to June 2018.

Local CPO price began falling below RM2,200/MT after 11th July 2018, a week after China imposed a 25% tariff on soybean as a retaliation against US levies on USD34bn worth of Chinese imports. In addition, MPOB’s weak June data which pointed to a higher PO stock level and subdued demand, added downward pressure to CPO price.

Taking cue from the weakening in CPO prices, plantation stocks declined to their respective lows in 1H18 with THP recording the biggest share price decline YTD June 2018, down by a hefty 43%. We foresee that any further decline in CPO price may induce a knee-jerk reaction on plantation stocks - as CPO price is one of the main drivers on plantation companies’ earnings. Currently, some of the plantation stocks under our coverage are trading near their 1-year lows price.

Lower average CPO price for 2H2018

We believe the decline in CPO price is a reflection of the anticipated higher palm oil (PO) production and stockpiles; and compounded by sluggish export demand, pick-up in demand in other oil seed substitutes, and bearish soybean (SB) and soybean oil (SBO) prices. We forecast CPO price for the remaining months of 2018 to trade lower, i.e. within a range of RM2,100/MT and RM2,300/MT versus RM2,231/MT and RM2,556/MT in 1H2018. However, we believe the downside for CPO price is limited, i.e. CPO is likely to stay above RM2,000/MT given:

• Crude oil price is currently above USD70/barrel – boosting biodiesel intake

• SBO price to trade above USD600/MT (USD28 cents/lb)

• China switches its import share from SBO to PO in order to meet its market demand

We strongly believe that the major catalyst of CPO price movement is SBO price direction. In recent months, the CPO price movement and SBO price differentials fell to a low of c. USD80/T, falling from its peak in 2008 of USD423/T. The current gap between CPO and SBO ranges from USD80/T to USD97/T. As YTD June 2018, SBO price in US, Brazil, Argentina and Rotterdam fell -12.2%, -9.0%, - 10.3% and -9.2% respectively to USD624/MT, USD685/MT, USD680/MT and USD786/MT. In-line with the fall in SBO prices, CPO price (local delivery) declined by 7% to RM2,295.50/MT at end-June 2018. We maintain our average CPO price forecast for 2018 at RM2,380/MT and RM2,450/MT for 2019.

We believe the possible negative factors for CPO price are:

• Ample supply of soybean and stockpiles – decline in SBO price will increase its competitiveness

• Slower economic growth and consumptions of edible oils

• Lower-than-expected biodiesel take-off

• Strengthening of ringgit against USD; and

• Higher demand from India and China fails to materialize whilst supply of CPO is stronger than expected.

Stock level is expected to continue above 2.0m tonnes

Stock level for the remaining months is expected to maintain above the psychological level of 2.0m tonnes as export growth is anticipated to be moderate. Simultaneously, production is expected to gradually increase up to its peak month of September/October. Furthermore, demand is likely to be sluggish as increase in competition will come not only from Indonesia but also from close substitute SBO. We also expect ample CPO supply and high stock level from Indonesia, due to large area of young estates attaining maturity and high age bracket.

As at May 2018, ending stocks at Indonesia stood at 4.76m tonnes (+19.6% mom), more than 100% increase from the same period last year of 621k tonnes whilst production for the period Jan-May 2018 rose by 24% yoy (+14% mom;+27% yoy) to 18.37m tonnes. For the same period, Malaysia recorded a 5.3% increase in production of 7.59m tonnes with stock level remaining at 2.17m tonnes. Malaysia’s total production for the period of Jan-June 2018 improved 2.3% yoy to 8.92m tonnes – making up 44% of our full year forecast of 20.05m tonnes.

Improvement in demand for palm oil is unlikely

We are of the view that PO demand for the remaining months is expected to be moderate, which is likely to be affected by 1) ample supply and high stock level of soybean especially from Brazil and Argentina; and 2) increased competition from Indonesia.

According to USDA’s report released in July 12, 2018, global soybean supply for 2018/19 is forecast to be higher by 22m tons to 609.9m tons primarily due to larger soybean crops in Brazil and Argentina. Importantly, Brazil’s SB production is forecast at a record 120.5m MT, up by 2.5m MT or 2% from last month and 1% yoy. Additionally, the USDA report highlighted Brazilian producers is anticipated to plant more SB to capitalise on the trade advantage over the US in response to China’s imposition of retaliatory duties.

The ample supply of soybean will translate into a narrower discount gap of PO price to soybean oil price and this can already be seen from the current gap that has fallen from its peak in 2008 of USD423/T to a current gap ranging from USD80/T to USD97/T.

Although Malaysia’s PO demand from major importing countries is higher yoy (table 5), we reckon that it is still losing market share to Indonesia. The continued discount of c. 10%-15% of Indonesia PO product prices against Malaysia’s price, is likely to impact Malaysia’s demand growth moving forward. As of YTD May 2018, palm oil and palm kernel oil intake by China, India, EU, USA and Pakistan from Indonesia is about 1.49m tonnes, 2.04m tonnes, 1.94m tonnes, 531k tonnes and 911k tonnes respectively. Whereas Malaysia exports about 754k tonnes, 1.28m tonnes, 1.01m tonnes, 262k tonnes and 531k tonnes respectively to China, India, EU, USA and Pakistan (Table 6).

Potential increase demand from China

The major driver of production is demand. In order to attract demand, CPO price must be attractive. Given PO is the closest edible oil substitutes in China, PO is seen to have competitive advantage interm of pricing, relative to SBO. We believe that in short to medium term, the higher tariff imposed on USA soybean will drive domestic soybean price in China higher. As a result, there is likely to be less crushing by China refinery. A lesser crushing means there will be less supply of SB meal and SBO, hence demand needs to be filled by other vegetable imports i.e. palm oil. Off note, soybean oil accounts for nearly half of the total edible oil consumption in China – as per USDA’s report in July 12, 2018, China edible oil consumption for 2018/19 is estimated at 38.53m MT, of which 18.45m MT is SBO.

Weak 2Q2018 results expected

The 2Q18 corporate earnings season has begun in earnest. We expect companies under our coverage to register weaker qoq and yoy 2Q results due to weaker ASP realised and lower production. Production in the 2Q is expected to be lower qoq except for companies with bigger estates in Sarawak, i.e. SOP, Sarawak Plantation and THP. We expect to see further margins squeeze in 2Q18 as ASP realized of palm products is expected to be in a range of RM2,230/MT–RM2,470/MT, as opposed to 1Q18’s range of RM2,380/MT-RM2,556/MT. We anticipate that upstream companies would be affected more than the rest. We expect IOI and KLK to suffer the least decline, as its earnings are more diversified.

Lower margins expected in 2H18 – revising earnings forecast downward

With limited positive catalyst, plantation companies are likely to continue to be vulnerable to negative news especially with regards to global trade tension, anti-palm oil campaign, new Pakatan Harapan-government policy on wages, to name few. Earnings upside is limited by high operational costs and suppressed profit margin on weaker ASP for palm products realise and lower-than-expected sales volume. Potential increase in minimum wages that will be announced soon is earnings-negative for plantation companies and hence, further earnings deterioration is likely moving forward. Based on our sensitivity analysis, every RM100 increase in minimum wage will reduce the bottom-line for companies under our coverage by 3% to 12%. Sarawak Plantation and SOP are likely to be most impacted by the new minimum wage, estimated at 12%, followed by HAPL (-10%), FGV (-9%), IOI (-9%), THP (-8%), GENP (-7%), KLK (-6%), TSH (-4%) and IJMP by -3%.

After fine-tuning our forecast, our FY18 and FY19 net profit forecast for the sector is reduced by 18% and 11% respectively (refer Table 10). The reduction in net profit is due to our revised CPO price, costs and downstream margins due to stronger-than-expected competition in value-add products, i.e. oleo-chemical and speciality oil & fats. As we have revised our sector average CPO price assumption for 2018 and 2019 to RM2,380/MT and RM2,450/MT respectively in previous sector report (refer report dated 11 July 2018), we lower our PO products assumption for companies under our coverage by 6%-10% from earlier forecast of RM2,550/MT to RM2,650/MT for 2018 and RM2,550/MT for 2019. We have yet to factor-in the potential increase in minimum wages in our earnings revision, however. As such, earnings growth is expected to be negative in 2018, averaging a decline of c. 17.7%.

Maintain NEUTRAL

We retain our Neutral recommendation on the plantation Sector as most of the companies under our coverage are fully valued, in our view. On revised earnings, our stocks universe currently trades at 21.6x 12-months forward PE, which is below its -2SD 3-years average forward PE of 21.9x (Chart 2). We believe that this might imply a good entry point for stock with a BUY recommendation in our stock universe and/or stocks with solid fundamental such as KLK or IOI (buy on weakness). Maintain Buy calls on SOP (TP: RM3.49) and GENP (TP: RM10.99) while Hold on HAPL (TP: RM2.20), KLK (TP: RM25.50), Batu Kawan (TP: RM19.04), IOIC (TP: RM4.55), TSH (TP: RM1.19), FGV (TP: RM1.66) and Sarawak Plantation (TP: RM1.52). We have Sell on IJMP (TP: RM1.70) and Non-rated on THP.

Source: BIMB Securities Research - 9 Aug 2018