In 1Q17, we continue to be NEUTRAL on the Plantation sector due to a likely 2H17 CPO price reversal, but with a POSITIVE short-term outlook as planters' valuations have yet to catch up with very high CPO prices - which should trade consistently at RM2,800-3,200/MT in 1Q17. Our FY17E CPO price is upgraded to RM2,550/MT (from RM2,400/MT) on higher crude oil, soybean oil (SBO) and USD/MYR assumptions, as well as slightly lower closing stocks. Production-wise, we expect 4Q16-1Q17 output to soften QoQ due to low production season resulting in lower stocks, which should support prices. However, normalizing production and unsustainable SBO-CPO premium are key risks heading into 2H17. Supportive factors include higher USD/MYR and recovering crude oil prices, while demand should improve in 2H17 as well. We upgrade IJMPLNT to OUTPERFORM with higher TP of RM3.92 (from MP; TP: RM3.60) on updated CPO price assumptions. Our TOP PICK is TAANN (OP; TP: RM5.00) as a double beneficiary of higher CPO prices and stronger USD benefiting its Timber segment earnings. Earrnings and TPs are generally increased across the board on higher CPO prices, though other calls are maintained, namely OUTPERFORM on IOICORP (TP: RM5.15), HSPLANT (TP: RM3.00) and UMCCA (TP: RM7.11) ; MARKET PERFORM on SIME (TP: RM8.60), KLK (TP: RM26.00), PPB (TP: RM16.75), FGV (TP: RM1.72), TSH (TP: RM2.12), and CBIP (TP: RM2.10); and UNDERPERFORM on GENP (TP: RM10.90)

Some improvement in 3Q16. Of our 11 stock coverage as of 3QCY16, we saw slight quarterly improvement as 8 stocks came in within/broadly within market expectations while 3 beat our forecasts (GENP, PPB, and TAANN). Meanwhile, 3 stocks came in below both our and consensus forecasts, namely CBIP, FGV, and UMCCA on slower-than-average production recovery. Nevertheless, this improved on consensus with 1 above, 2 within and 8 below expectations in 2QCY16. While Quarter-on-Quarter (QoQ) FFB continued to improve, Year-on-Year (YoY) average production actually worsened to -12% from -5% in 2QCY16- YTD on continued drought weakness, though price improvements (+15%, from +6%) largely offset the drop. We note that TAANN was the only counter that saw growth in both production (+8%) and prices (+12%) due to its Sarawak concentration and young tree age profile.

CPO price jump not yet reflected in share prices. 2016 was a relatively lacklustre year for planters, with stocks under our coverage recording YTD performance of -9.4% up to 5.4%. The top three share price performers in our sector were: HSPLANT (+5.4%), KLK (+4.9%) and SIME (+4.5%) while the bottom three were TSH (-5.1%), TAANN (-5.6%), and FGV (-9.4%). The KLPLN was only slightly up YoY at +1.7%. This was despite a sharp CPO price appreciation of 45.6%. With share prices yet to reflect the 4Q16 CPO price jump, we are optimistic in the short-term as we think planters are undervalued against current CPO prices.

4Q16-1Q17 production to moderate… due to the annual production down-season. We expect 4Q16 production to soften by 6% QoQ to 4.71m MT, less than 4Q15 QoQ decline of 13% (historical average: -4%). Meanwhile, we think 1Q17 production, while likely to weaken in line with historical trends, should decline less than 1Q16 QoQ 33% drop (against the historical average of -26%). The low production season should be positive for short-term CPO prices as it limits closing stock increase up towards 2Q17. We expect 2016 stocks to close at 1.62m MT, a substantial 62% decline from 2015 and the lowest closing level since 2010. With the weak short-term production, this should have a positive effect on CPO prices in the immediate term.

… while prices were very supportive, with QTD CPO prices rising 11% QoQ and 35% YoY to average at RM2,914/MT. CPO prices have strengthened remarkably in response to tighter supplies over the course of 2016, averaging RM2,649/MT or +22% YoY. We expect the price strength to benefit planters' earnings in 4Q16 and 1Q17, though prices may soften from 2Q17 onwards as we will highlight below.

But expect downside as SBO-CPO premium expands. Compared to its closest competitor soybean oil (SBO), CPO prices have jumped 46% YTD to close at RM3,204/MT, while SBO prices are up 13% to USD¢34.6/lbs. Price appreciation was largely led by tight supply for palm oil, while SBO appreciation was limited by continued new production highs. We note that for local CPO prices, the SBO-CPO premium briefly equalised in Aug 2016 but expanded to currently trade at c.USD50/MT. However, CPO prices CIF Rotterdam has traded on par with SBO prices since Apr 2016 and indeed traded at a premium to SBO since mid-December. We think this is unsustainable as the narrowed premiums are largely production-led and is very likely to normalize alongside the annual production uptrend which typically begins after February.

Production expected to normalize by 2H17. We expect FY16E production to come in at c.17.3m MT, or -13% YoY and -1% below the 5-year average (1.75m MT) after seeing new 5-year lows in 6 months of the full year. However, with a two-year impact cycle, we expect regional recovery from mid-2015 droughts in mid-2017 with younger areas, such as in Kalimantan and Sarawak seeing stronger recovery in conjunction with the normal production jump as the trees mature. Even if production comes in at 5-year low levels in 1H17 and average levels in 2H17, we expect YoY Malaysia production to jump at least 10%, and consequently reverse the production-led price appreciation that was seen through 2H16

But stronger USD to continue supporting CPO prices. The recent pick-up in USD has helped to support local prices, as we note that the local CPO price increase of 46% YoY slightly outperformed the USD-based Rotterdam price appreciation of 43%, with the impact more apparent QoQ at +17% local prices and +10% for Rotterdam prices compared to end-3Q16. The stronger rate of local price appreciation is positive as it resulted in higher value receipts to Malaysian planters. However, this is partially offset by higher fertiliser cost as fertiliser prices are largely USD-based. Nevertheless, we think the net margin impact of a rising USD should be net positive to planters as fertiliser cost usually makes up 15- 30% of operating costs with remaining costs denominated in local currencies. Note that this has been priced into our models alongside our CPO price upgrade as discussed below.

Crude oil prices a potential catalyst. Crude oil prices performed well in 2016, doubling from a low of USD28/barrel (bbl) of Brent to a peak of nearly USD57/bbl as of end-Dec. The production curtailment by OPEC appears to be seeing encouraging results, though a key risk to the recent appreciation could be further expansion of US production leading to further build-up in stocks. However, we view a sustained appreciation of crude oil prices as a potential catalyst for CPO prices in 2H17 as it could revive biodiesel demand and as an offsetting measure against a production rebound later in the year. At the current level, CPO prices are trading at c.USD200/MT premium to gasoil prices. In our view, CPO prices will be strongly supported at parity with gasoil, which implies a CPO-crude oil premium of c.USD100/MT. Nevertheless, continued enforcement of the Indonesian biodiesel mandate will be key, as high CPO prices will cause biodiesel production to be cost-prohibitive without subsidies. We note that the Indonesian government’s biodiesel contract volumes for Nov 2016 to Apr 2017 totalled 1.72m kiloliters (Kl) or 1.51m MT, which is 12% higher than the May-Oct 2016 volume of 1.53m Kl (1.35m MT) but 8% lower than the Nov 2015 to Apr 2016 contracted volume of 1.87m Kl (1.65m MT).

Unremarkable demand. With CPO prices currently trading on par with SBO prices, we expect demand to remain lacklustre in the short-term. 2016 demand was on the weak side, regularly coming in near 8-year monthly lows on Chinese de-stocking in 1H16 and high CPO prices turning off buyers in 2H16. Only Aug 2016 exports made a new high thanks to pre-festival demand in India and some re-stocking activity in China, although the rally was not sustained in later months. In the short run, Dec 2016 exports are not encouraging either, with cargo surveyors reporting 1-25 Dec exports to be 6-8% lower MoM. In our view, until CPO prices correct meaningfully below SBO prices, we are unlikely to see strong demand catalyst in 1H17 beyond the necessary level to maintain buyers’ stock levels. In 2H17, we think demand should pick up in view of depleted international stocks and higher frequency of festival seasons, particularly in key buyer India.

Upgrade FY17E CPO price forecast to RM2,550/MT (from RM2,400/MT). As noted in our previous reports, we have updated our FY17E CPO price forecast to RM2,550/MT as we increase our expectations for crude oil, soybean oil prices and USD/MYR, while slightly lowering our year-end closing stock level by 7% to 1.94m MT base as we think uptake may improve in 2H17 on higher biodiesel interest. Our crude oil assumption is increased 11% to USD54/MT (from USD49/MT) in line with our latest in-house view, on better-than-expected market effect of OPEC and non-OPEC production cuts. We up our SBO assumption by 16% to USD¢36/lbs. reflecting the average of the latest Dec 2016 USDA forecast of USD¢34.5-37.5/lbs. on higher EPA Renewable Fuel Standards (RFS) requirements for 2017. This implies a SBO-CPO premium of USD190/MT, close to +0.5SD on the historical average – we think this is fair given our outlook of strong CPO production recovery. We also up our USD/MYR expectation by 7% to 4.25 reflecting our latest in-house expecations. With the higher CPO price forecast, we upgrade most planters earnings and correspondingly increase TPs by up to 9% (please refer to pages 19-20 for latest valuation table). Our Monte Carlo CPO forecast model suggests a 38% probability of CPO prices of between RM2,200-2,500/MT, a 44% probability between RM2,501-2,800/MT, a 14% probability over RM2,801/MT and a 5% probability under RM2,200/MT. Taking the average forecast, we thus upgrade our FY17E CPO price estimate to RM2,550/MT (from RM2,400/MT)

Seeing upside on KLPLN. The KLPLN is currently trading close to the FBM KLCI as the KLPLN’s 2-year total return of -12.4% against the KLCI’s -11.9% represents a 0.5% discount, or +0.1SD against the historical average discount. However, with the strong near-term earnings upside for planters due to high CPO/PK prices and strong USD, we think the KLPLN could outperform the KLCI in the short run. Looking ahead, we see more upside for the KLPLN at 3.2% compared to downside of 1.5%, based on a KLPLN-KLCI standard deviation between +0.5SD and +1.5SD. Accordingly, we expect the KLPLN to trade between 7,620 to 8,000pts in the near term (upside: 3.2%; downside: 1.5%)

Expect another strong quarter in 4Q16. QoQ, we expect flat-to-higher earnings driven by the 11% increase in CPO price, which should offset a 6% production decline againt 3Q16. YoY results could be mixed on production setbacks seen in 1H16, though the 22% price increase should well offset the 13% production drop in Malaysia. Overall, we think

4Q16 results should largely come in within expectations, with potential upside from better CPO and PK prices received, and risks largely company specific (ie: higher write-offs).

Model PER for 2017 high/low CPO price environments. As we expect CPO prices to begin easing around 2Q17, below are our CPO price-based PER model results for CPO prices between RM2,400-3,200/MT:

Upgrade IJMPLNT to OUTPERFORM with higher TP of RM3.92 (from MP; TP: RM3.60) as we upgrade FY17-18E earnings by 5-8% on higher CPO price assumptions. We like IJMPLNT for its above-average FFB growth prospect at 6- 12% against the sector’s CY16-17E forecast of -2% and +10%. Note that we expect FY17E CNP to see a sharp recovery of 2.7x thanks to supportive CPO and PK prices, as well as production improvement on the back of maturing Kalimantan area.

Top Pick: TAANN (OP; TP: RM5.00) (from OP; TP: RM4.60) as we upgrade our CPO price assumptions. We expect TAANN to be a double beneficiary of higher CPO prices and stronger USD, which increases Timber sales & bottomline. Upside is supported by above-average FFB production and a solid 4.1% dividend yield (sector average 2.4%).

Maintain NEUTRAL; short-term POSITIVE. We maintain our long-term NEUTRAL outlook on the sector in view of likely 2H17 price declines in tandem with production recovery. However, we are POSITIVE in the near-term as planters’ valuations have yet to catch up with higher CPO prices. We expect 1Q17 CPO prices to remain consistent within a range of RM2,800-3,200/MT. While further CPO upside catalysts are limited on soft demand, we see little immediate downside on a strong dollar, higher crude oil prices and decent SBO outlook. Our preference remains with efficient planters with low average tree age, as we expect these counters to reap benefits from both high CPO prices and above-average rate of production recovery

Source: Kenanga Research - 5 Jan 2017