We came away from a meeting with Kuala Lumpur Kepong’s (KLK) IR, Ms. Lim Poh Poh, feeling unenthused about the group’s immediate-term prospects. 3Q18 earnings could be soft amid CPO price weakness and extended Eid al-Fitr holidays. Earnings comeback expected in 4Q on production pickup. No change in FY18-19E CNP of RM1.15-1.22b. Maintain MARKET PERFORM with unchanged TP of RM25.20 based on Fwd. PER of 22.4x.

Expect soft patch in 3Q followed by a 4Q comeback. The average CPO price of RM2,374/MT (-3.8% Q/Q; -13.6% Y/Y) and KLK’s FFB output of 926k MT (-3.4% Q/Q; +0.5% Y/Y) portend soft earnings in 3Q18. The weak production came as estate workers were away for extended Eid al-Fitr holidays. Notwithstanding, 3Q18 is likely to be broadly within our expectations as we expect FFB production to pick up in 4Q18 when the workers return for harvesting.

Slower FFB growth cushioned by Oleo. Management has revised FY18E FFB growth guidance from 5-6% to 3%, which is below our forecast of 10% and the peer average of 5%. This is attributable to the dry weather in Kalimantan and Sumatra last year, which has adversely affected production yield. In light of this, we have trimmed our FY18E FFB growth to 3% from 10% accordingly. Nevertheless, the impact on our earnings is negligible (c.1%) thanks to higher earnings contribution from its oleochemical business on lower CPO prices.

CPO price to stay sideways but downside limited. Management expects CPO price to be uneventful in the immediate term as buyers take a wait-and-see approach amid multiple concerns such as further weakness in US soybean oil prices in the aftermath of China’s 25% tariff on US soybean, and a stronger-than-expected production pickup in 2H. Other feedbacks include that some buyers are either holding back purchases or seeking lower prices in anticipation of further CPO price weakness. On the other hand, we believe the current CPO price of RM2,155 is supported the Brent crude oil price of c.RM2,200/MT and smallholders’ production cost of RM1,800-RM2,000/MT.

Oleochemicals demand has been encouraging as crude oil prices trended up (Brent crude oil +13% YTD), which improves the competitiveness of the group’s Methyl Ester-based products (such as detergents). In addition, management has said that the RSPO certification status of KLK’s PO (c. 72% certified) and PK products (c.76%) helped sustain the demand from Europe. Unfortunately, the segment’s PBT margin is expected to normalise to 3-4% in 2H from 1H’s 5% as the margin boost from cheaper PKO input fizzled out. Overall, we expect the segment’s FY18E PBT to surge 154% Y/Y, although likely down by 5% on a H/H basis in 2H.

No change in FY18-FY19E CNP of RM1.15-1.22b as the revision in our FY18E FFB growth poses minimal impact to earnings (c.1%).

Maintain MARKET PERFORM with an unchanged TP of RM25.20 pegged to 22.4x average CY18-19E EPS of 112.6 sen. Our Fwd. PER of 22.4x is based on its 3-year historical average. We deem this fair as its FY19E FFB growth of 8% is in line with the peer average of 9%. While KLK is going to see tepid FFB growth in 2H18, they benefit from the cushioning effect of its oleochemical segment. KLK’s long-term prospects remain positive as management continues its hunt for M&A targets and its plan to establish a JV refinery in Indonesia.

Risks to our call are sustained weakness in CPO prices and a precipitous rise in minimum wage.

Source: Kenanga Research - 03 Aug 2018