Reiterate NEUTRAL with unchanged 2018 CPO price estimate of RM2,400/metric ton (MT). 2Q18 CPO price of RM2,374/MT came within 1% of our RM2,400/MT estimate. We expect a downtrend to RM2,250/MT in 3Q18 on quarterly production pickup, though downside is limited by supportive crude oil prices. Higher production should ease planters’ cost issues, although the degree of margin improvement depends on the degree of CPO price decline. Meanwhile, CPO price risk could be seen from waning soybean prices due to China tariffs on US soy, potential further tariffs on US crude oil, and inventory build-up in Indonesia. However, demand should improve from China, and from India on narrowing edible oil tariffs. Short-term biofuel demand should be stronger on supportive crude oil prices. We widen our. 3Q18 CPO trading range to RM2,150-2,450/MT (from RM2,290-2,450/MT) reflecting downward volatility. Expect a lacklustre 2Q18 given soft CPO prices and modest palm oil production performance. We continue to prefer stable large-cap integrated producers (SIMEPLT, KLK, IOICORP), or stocks with lower CPO correlation (PPB, CBIP). Bolder short-term investors could consider switching opportunities in the large-cap space (PPB to FGV/IOICORP), playing the volatility in 2H. We upgrade our call on FGV to OUTPERFORM (TP: RM1.75 maintained) on stable operations and attractive valuation at below book value. We also update TPs for IOICORP (RM5.00 from RM5.15; OP unchanged), KLK (RM25.20 from RM25.75; MP unchanged), TAANN (RM2.85 from RM3.05; OP unchanged) and CBIP (RM1.50 from RM1.80; OP unchanged). Other calls/TPs are unchanged, namely: SIMEPLT (MP; TP: RM5.60), (PPB (OP; TP: RM22.30), GENP (OP; TP: RM10.75), IJMPLNT (UP; TP: RM2.00),TSH (UP; TP: RM1.10), HSPLANT (MP; TP: RM2.15) UMCCA (MP; TP: RM6.20), and SAB (MP; TP: RM3.95).

1QCY18: from bad to worse. 1QCY18 recorded the weakest quarter since 2QCY14, as no companies within our coverage exceeded expectations; and just over half of them missed both consensus and our forecasts (FGV, HSPLANT, PPB, SIMEPLT, TAANN, TSH and UMCCA). This is weaker than the already poor 4QCY17 where only 2 companies exceeded expectations, 4 within, and 7 below estimates. On average, CPO selling prices declined 13% YoY to RM2,526/MT, outweighing an average FFB production increase of 7.8%. However, higher cost structure and changes in accounting standards led to narrower net margins. Given the broad earnings setback, we cut FY18-19E earnings by an average of 13-9%, FGV (-44-18%) and TSH (-24-22%). Among our coverage, we upgraded GENP and IOICORP to OP given better-than-expected cost management and better downstream outlook. Otherwise, we largely cut our calls and TPs to reflect the high number of earnings downgrades.

2Q18 CPO price within expectations. In 2Q18, CPO prices trended down overall, despite a declining inventory pattern which is ordinarily supportive of prices, as export growth was relatively lackluster after the suspension of palm oil export tax was lifted in May 2018. Towards end-June, a series of US-China tariff events led to a sharp drop in soy prices (-6% to 29.2US¢/bushel Month-on-Month), and CPO prices likewise tracked downwards. Nevertheless, CPO prices in 2Q18 averaged at RM2,374/MT, which was well within 1% of our 2Q18 expectation of RM2,400/MT. For 3Q18, we expect continued price downtrend on quarterly production pick-up, although we believe that downside is limited by supportive crude oil price. As such, our 3Q18 average CPO price forecast is RM2,250/MT, and we expect this quarter to see the lowest CPO prices for the year before picking up in 4Q18 as production and inventories tighten up after peak production month (Sep-Nov).

Production pickup to ease cost woes. We believe that 3Q18 should see solid double-digit production growth (vs. 2Q18) as workers return from the extended festivities and holidays that led to a slow 2Q18 production (up by only 3% against 1Q18). This should lead to lower unit cost structure, especially in pure upstream planters that have been hit by various production setbacks since end-2017. Planters with younger average age are particularly sensitive to weaker yields given the high fixed cost factor and lower yields in young mature tree area. As such, we expect to see margin improvement in companies with younger estates such as IJMPLNT, TSH and UMCCA – although this would still hinge on the strength of decline in CPO prices over 3Q18.

Risk of lingering soy weakness. International trade spats ratcheted up in 2Q18 between the US and the rest of the world, and notably between US and China in June. As talks broke down, China retaliated to US tariffs with a 25% tariff on US soybeans slated to begin on 6-July. In line with our previously outlined expectation, Brazil has emerged as the big winner as buyers shifted demand from US to South America. As an aside, recall that Argentina, with its production curtailed by severe droughts, is much less likely to benefit against Brazil, which is seeing bumper crops this year. Accordingly, US soybean oil (SBO) prices have declined by 12% year-to-date (YTD) to USD¢29.1/pound (lbs) by end-2Q18. Despite the possibility of higher palm oil demand from China to supplement likely lower soy purchases, we view this development more as a short-term price risk as soy prices decline may lead to a lower price cap for palm oil prices.

Expect better near-term demand from India. Exports to India plunged in May as Malaysia reinstated its export duty after being fully exempted since the start of the year. This was compounded by the end of pre-Ramadan festival purchases and lower number of working days in May. While June may see only modest improvement due to similar factors as May, we expect Indian demand to pick up in 2H18 as the country has now equalised tariffs for all edible oils, including refined soybean oil, sunflower oil and rapeseed oil to between 35-45% (from 25-35% previously) in mid-June. This brings the Indian edible oils tariff gap closer from the abrupt hike in Indian crude and refined palm oil duty hikes in early March from 30-40% to 44-54%, respectively. As markets adjust to the new tariff environment, we expect to see better Indian demand, particularly in end-3Q leading up to Diwali in November.

Crude oil strength limits short-term downside, with a caveat. Crude oil price has staged a solid recovery YTD, appreciating 19% to hit USD79/barrel (bbl) by end-2Q. Given lackluster CPO price performance, this resulted in a consistent narrowing of the CPO premium to crude oil prices, which fell from c.USD140/MT in the start of the year to c.USD30/MT by end-June. We believe that crude oil prices will serve as a very strong price floor for CPO prices, given that CPO is an alternative fuel option which also fulfils (current) biofuel quota requirements, especially in the EU. While the proposed EU “phase out” of palm oil for biofuel is still very much on the debate floor, we do not expect this proposal to affect current demand, given that the “phase out” is only slated to begin from 2030 (with quotas to be frozen after 2019). One key risk, however, is once again the US-China trade spat, where China has threatened to impose tariffs on US crude oil imports. Based on the example of soybean prices, this could well result in a drop in crude oil prices overall, which would then lower the price floor for CPO prices, which is currently at USD2,150/MT.

Potential price & demand risk as Indonesian supply builds up. Another factor to watch for Malaysian palm oil prices is the status of Indonesian palm oil stock, which have been building up steadily from Feb 2018 to Apr 2018, the latest available information. As of Apr 2018, Indonesian recorded stocks of 3.98m MT, only slightly below its 2017-end stock level of 4.02m MT (-1%). In contrast, Malaysian stocks were pared down substantially in the same period to 2.17m MT (Apr 2018) from an end-2017 level of 2.73m MT (-20%). Although this may be reflective of the success of Malaysia’s export tax suspension during that time period, recall that the export tax has now been reinstated, making Indonesian palm oil more competitive – and potentially more attractively priced for foreign buyers given the ample supply in the country. Thus, continued Indonesian inventory buildup would not bode well to CPO price as a whole.

Broadening CPO price spread to RM2,150-2,450/MT (from RM2,290-2,450/MT). We update our CPO trading price floor for 3Q18 to RM2,150/MT (from RM2,290/MT) as we lower our crude oil premium to zero from USD30/MT to reflect the ongoing price risks and high downside pressure arising from international trade volatility. Our price cap is unchanged at RM2,450/MT based on a narrower SBO discount of USD40/MT (from USD60/MT) as we think CPO demand improvement (and weaker US soybean demand) may bring the price gap closer between the two oils. As such our expected CPO trading range in 3Q18 is widened to RM2,150-2,450/MT (from RM2,290-2,450/MT). Our full-year CPO price forecast is unchanged at RM2,400/MT.

Switching opportunities in big-cap space? In our review of potential pair trading options within the plantation sector, we observed that large-cap integrated planters and small-mid cap planters have a tendency to trade as a block; meaning that sub-sector rallies and declines tended to occur together. Within the space, we observed several opportune trade pairs that could signal trading opportunities for switching within the sector, as presented in the below charts.

• PPB-FGV: the model indicates an entry point where PPB is RM19.80 and FGV is RM1.55, where the investor is short PPB and long FGV at a ratio of 2.5 (FGV shares) to 1 (PPB share).

• PPB-IOICORP: the model indicates an entry point where PPB is RM20.00 and IOICORP is RM4.70, where the investor is short PPB and long IOICORP at the ratio of 1.7 (IOICORP shares) to 1 (PPB share).

2Q18 could be flat QoQ, YoY, as QoQ expected production should improve only slightly (+3% to 4.62m MT) counteracted by lower prices (-3% to RM2,374/MT). YoY, 2Q18 earnings could be flat-to-weaker against 2Q17, as production was marginally less (-2%) while prices were much lower (-13%). We expect few stocks to outperform in the next earnings release, but stability could be found in integrated producers (SIMEPLT, IOICORP, KLK, PPB, GENP) as lower CPO price impact is offset by lower raw materials price in the downstream segment.

KLPLN: safe haven in the market? With a base year of 2015, the KLPLN is trading close to par with the FBMKLCI with a 3-year return of -3.5% vs. the FBMKLCI’s -3.2%, far above the lowest differential of -7.6% in May 2015. We observe that since the Malaysian elections in May, the KLPLN has reversed its downtrend in the start of the year against the FBMKLCI and is now seeing positive performance compared to the market. We think the plantation sector has turned into a safe haven, as the election’s aftermath introduced substantial volatility among several key sectors. Currently, the KLPLN-FBMKLCI discount of - 0.3% implies -0.1SD against the historical average premium of 0.9%. At a range of -0.5SD to mean valuation against the FBMKLCI, we think that the KLPLN would likely trade at 7,460 to 7,610 pts in the near term. At this level, downside of 1.0% is relatively close to upside at 0.9%, indicative that sector valuations should remain stable going into a high production season.

Upgrade FGV to OUTPERFORM on unchanged TP of RM1.75. We believe that the recent share price weakness has been overdone given FGV’s stable operations and management situation. Downside is limited as share price is currently trading below book value (RM1.59/share); close to -1.0SD levels. Management had previously indicated better earnings in 2H18 on lower costs and stronger production at +14% for the full year, which provides upside possibility against our +8% FFB growth forecast. Thus, we upgrade our call on FGV to OUTPERFORM, with unchanged TP of RM1.75 based on 1.1x Fwd. PBV applied to average FY18-19E BVPS of RM1.59, implying mean valuation basis.

Lower TP on IOICORP, KLK, TAANN & CBIP on updated PER. We update our TP for IOICORP (RM5.00 from RM5.15; OP unchanged), KLK (RM25.20 from RM25.75; MP unchanged), TAANN (RM2.85 from RM3.05; OP unchanged) and CBIP (RM1.50 from RM1.80; OP unchanged) with valuation basis unchanged except for CBIP. We have sharply cut CBIP’s valuation basis from -0.5SD down to -2.0SD following the derating of small cap companies this year, resulting in much lower applied Fwd. PER of 8.5x (from 10.1x). Even at rock bottom valuations, the stock still offers decent upside of 14% and we believe the downside risk is limited at this stage, as share price is at its lowest point since 2010. With CPO prices on a downtrend, we think CBIP could provide a good hedge given its limited correlation to CPO prices and low downside. Thus, we reiterate our OUTPERFORM call on the stock.

Maintain NEUTRAL, outlook mixed. We continue to maintain our neutral outlook on the sector as lower CPO prices should be offset in 3Q18 by a solid production boost, which should improve planters’ cost structure. We expect international policymaking to have an outsize impact on price movements this year, and volatility will unfortunately continue. Our preference remains with stable large-cap integrated producers (SIMEPLT, KLK, IOICORP), while investors may find security in indirectly related counters (PPB, CBIP) which have lower direct correlation with CPO prices. Bolder short-term investors could find interesting switching opportunities among large-caps, should they wish to play the expected volatility going into the second half.

Source: Kenanga Research - 5 Jul 2018