We maintain our NEUTRAL view on the plantation sector with no change to our average FY16E CPO price at RM2,400/MT. Nevertheless, we are short-term positive on CPO prices with a 3-month expected peak of RM2,850/MT premised on: (i) stocks to remain low <2.0m metric tons (MT) for at least 4-5 months due to drought impact, (ii) slow but supportive biodiesel policies, (iii) delay in US rate hike benefiting commodities, and (iv) narrowing soybean oil (SBO)-CPO premium. We also note that downstream players have a slight advantage on the return of export duties. Our recent study quantifying potential PER premiums during high CPO prices indicates that our Top Pick KLK (MP; TP: RM25.25) has good trading potential as a downstream player and lower downside risk as a bigcap stock. We also have as Top Pick CBIP (OP; TP: RM2.49) for its less-volatile orderbook-based earnings and likely better demand for its mill engineering services on high CPO prices. However, we downgrade IOICORP to UNDERPERFORM with lower TP of RM4.66 due to earnings uncertainty and potential long-term risks from its RSPO suspension. Other calls and recommendations aremaintained, i.e. OUTPERFORM on UMCCA (TP: RM7.42), MARKET PERFORM on PPB (TP: RM16.92), IJMPLNT (TP: RM3.71), TSH (TP: RM2.38), and TAANN (TP: RM5.88), UNDERPERFORM on SIME (TP: RM7.15), FGV (TP: RM1.32), and GENP (TP: RM11.30).

4QCY15 sees improvement. Of the 11 stocks under our coverage, 3 came in above consensus (CBIP, KLK and TSH) while 4 were within (GENP, IOICORP, PPB and TAANN). The remaining 4 namely FGV, IJMPLNT, SIME and UMCCA were below expectations. This is an improvement over 3QCY15 where only 1 was above, 5 within, and 5 below expectations. Planters in Indonesia (GENP, IJMPLNT, SIME) were adversely impacted by the USD50/MT CPO levy which resulted in Indonesian CPO price discounts of between 10-15% against Malaysian CPO prices. This worsened the mid-year drought impact which lowered FFB production.

Feeling the heat. Regionally, the severe droughts in East Malaysia and Kalimantan seen in mid-2014 and 2H15 are currently affecting FFB production. On a recent working trip to Central Kalimantan, we noted signs of dryness-induced tree stress, including poor bunch formation, lower development of FFB and higher proportion of male flowers (examples on page 5). These events usually take place about 6 months, one year and two years after the droughts event. Based on our study of historical drought impact, tree stress could result in 1-5% lower FFB production in the year following the drought. Overall, the worst drought effect is likely to hit in 2016, as a combination from mid-2014 (2-year impact) and 2H15 (1-year and 6-month impact) droughts. However, we expect to start seeing production improvement in 2017 once the effects of the 2014 dryness are left behind.

Local production should pick up…In line with previous years’ trends, we expect rising production from March onwards, with a likely peak between Aug-Oct.With 1Q16E production at 3.36m metric tons (MT) or -11% YoY, assuming an average YoY production decline of 3%, this implies the next 9 months’ production should only average -1% vs. FY15. Thus, despite the droughts, we believe production will continue to pick up seasonally, with potential for some months to see very strong double-digit growth in 2Q16-3Q16.

…but expect stocks to stay below 2.0m MT in the mid-term. Despite our expectation of strong rising stocks, we believe monthly inventories are likely to remain below the psychological 2.0m MT mark for at least 4-5 months. Based on historical production and export trends, we believe stocks are likely to continue trending downwards up to May/Jun-16.After After this period, we believe the production uptick will lead to supply overtaking demand, and hence a rising inventory trend in 2H16. 

Source: Kenanga Research - 5 Apr 2016