We are upgrading SOP to a BUY, following a 13.5% retracement in its share price since we downgraded the stock 1'' months ago. The stock's valuation is now looking attractive again. We believe an earnings recovery is in store, especially in 2H2012, as SOP's refinery commences operation and FFB production rebounds from drought-induced weakness. As fertilizer application would also be lower y-oy in the upcoming quarters, costs will moderate. A lull in CPO price for the next quarter notwithstanding, we believe investors should start nibbling on SOP as its illiquidity necessitates time to accumulate. Upgrade to BUY, with FV of RM7.24, representing a 20.7% potential upside.
Falling short twice.SOP's earnings over the past 2 quarters have been poor as its CPO uptake from local refineries in Bintulu was sluggish amid refining capacity shortages in the state and tepid downstream margins following a downward revision in Indonesia's export tax structure in 2H2011. This led to some of the company's CPO production being sold but remaining unshipped at the end of each of the past 2 quarters. Compared to 1QFY11, fertilizer expenses were also higher y-o-y in 1QFY12, as SOP applied a larger proportion of its FY12 full-year fertilizer allocation in the first quarter. The heavy rains in 1QFY11 had skewed fertilizer application towards the latter 3 quarters of FY11, while the benign weather in 1QFY12 facilitated manuring.
Light at the end of the tunnel. We believe that earnings will recover in the subsequent quarters for three main reasons: (i) SOP's own refinery will come on stream in June, (ii) less fertilizer will be applied in the following quarters after 1QFY12's relatively heavier application, and (iii) FFB production should recover after the early-2010 drought effects fade. SOP's own refinery in Bintulu, which currently absorbs the company's entire CPO production, should resolve the delay faced in shipping all its CPO supply to a refinery. With the near-perfect weather experienced in SOP's producing regions over the past few months, FFB production should rebound in June after the tail-end effects of the early-2010 drought wear off.
Earnings forecast not out of reach. Although CPO prices have been softening since mid-April, the average price YTD still stands at a solid RM3,295 per tonne, 9.8% above our 2012 average CPO price assumption of RM3,000 per tonne. With this in mind, we think our revenue forecast will be easily met. Thus, higher-than-estimated cost and weaker-than-expected FFB production would be the main concerns moving forward. FFB production was 7.7% higher y-o-y in 1QFY12 and 0.9% lower YTD up to April, with the early-2010 drought anticipated to impact production from Feb-May 2012. We are keeping our expectations at FFB production growth of 16.1%.