The worst is over. We upgrade the plantation sector to OVERWEIGHT with a higher CY20 CPO price target of RM2,700/MT. We believe that the worst is over for the plantation sector as: (i) demand-supply dynamics for CPO is in favour for price upside due to tight supply (arising from production decline) as well as growing demand (from biodiesel), and (ii) planters are expected to register significant sequential earnings improvement on the back of higher CPO prices (QTD: +23%), after the recent 4QCY19 earnings disappointment.

Stockpiles to decline into 2020 on weak production. Dry weather impact on CPO production which typically lagged by 6-12 months (recall that Malaysia and Indonesia experienced dry weather from June to early October 2019) has already begun. Based on data from Malaysian Palm Oil Board (MPOB), we have started to see double-digit decline in November CPO production (- 14.4% MoM) while according to Malaysian Palm Oil Association (MPOA), CPO production from 1 Dec to 20 Dec 2019 fell 16.4% MoM (Peninsular: -20%, Sabah: -11%, Sarawak: -7%), steeper than our expectation (-8% MoM). Alongside lower application of fertiliser and a slowdown in new plantings to manage costs during the depressed CPO price environment in 2018 to mid-2019, we expect the production decline to to continue into 2020. On the other hand, data from cargo surveyors (AmSpec, Intertek and SGS) for December reveals better-than-expected palm oil exports registering a 5.8% MoM decline (vs. our expected -9.8% MoM). Furthermore, demand from India in the subsequent months is expected to pick up following its recent move to reduce import taxes on crude (from 40% to 37.5%) and refined palm oil (from 50% to 45%) from ASEAN countries. Overall, we continue to expect demand to outstrip supply in 1QCY20, leading to depleting stockpiles (likely reaching 1.8-2.1m MT level), which should sustain CPO prices.

Biodiesel mandates - the tipping point. Indonesia has recently launched its B30 biodiesel mandate which will be effective 1st Jan 2020. The mandate is expected to increase CPO consumption by an additional 3m MT to a total of 9m MT in 2020 (c.20% of Indonesia’s CPO output for 2020). Locally, the Malaysian government targets to implement B20/B10 for the transport/industrial sector by 2020 which is expected to absorb an additional c.0.6m MT to a total of 1.3m MT (c.7% of CPO production). Collectively, the biodiesel mandates (B30 Indonesia; B20/B10 Malaysia for transport/industrial) are estimated to increase global CPO consumption by an extra c.3.6m MT (+4.9% YoY from FY19E global consumption of 72.9m MT). This in essence convinces us that demand for palm oil will remain robust and with production already slowing down, it builds a case for demand growth to outpace supply growth.

1QCY20 to register significant sequential earnings improvement. After a disappointing 4QCY19 results season, we are banking on a significant sequential earnings improvement in 1QCY20 to continue buoying the plantation sector. Based on MPOB, 4QCY19 average CPO price increased (+23%) to RM2,480/MT (vs. RM2,018/MT in 3QCY19). From our checks, we gathered that most of the planters have done only minimal forward selling, allowing them to capitalize on the CPO price rally.

Planters deserve to trade at +1SD valuations due to CPO price rally. Planters under our coverage are currently (report’s cut off date on 20-Dec-2019) trading at -0.5SD to mean PER/PBV. Notwithstanding, we believe that the current low valuations are unwarranted as historically most planters were traded at +1.0SD levels in 4QCY17, when CPO was around RM2,700-2,900/MT (similar to the current situation). Additionally, the expected improvement in ROEs (see Exhibit 4) should justify higher valuations for planters. We also underscore that the KLPLN index has also lagged behind the CPO price rally. While YTD CPO price has surged 54%, the KLPLN index is up a mere 13%, suggesting that planters could play catch-up to CPO prices. We highlight that over the past 5 years, the KLPLN index and CPO price has a correlation of 72%.

Soybean oil price rally supports CPO price rally. On 13 December 2019, the U.S. and China announced an interim deal with a key factor being China’s commitment to increase U.S. agriculture purchases by USD32b over two years, implying an average USD40b annually (vs. pre-trade war level of USD24b in 2017), which augurs well for soybean oil. According to data from the General Administration of Customs, China’s soybean import surged (+54% YoY) to 8.3m MT in November 2019 and consequently, soybean oil rallied (+17%) to USD775/MT. The soybean oil-palm oil (SBO-CPO) spread is currently at c.USD48/MT (vs. MTD average of USD37/MT) and could widen further, lending support to CPO price rally.

Higher CY20 CPO target of RM2,700/MT. We are revising up our CY20 CPO price forecast (from RM2,400/MT) to RM2,700/MT. For 1HCY20, we believe CPO price should trade around the range of RM2,700-3,100/MT and average RM2,700/MT for CY20, supported by: (i) continuous CPO production decline, (ii) robust demand from biodiesel mandates, and (iii) widening soybean oil-crude palm oil (SBO-CPO) premium of USD48/MT (vs. MTD average of USD37/MT). Post-CPO price revision, we upgrade planters’ earnings on average for FY20 by 60% (coming from a low base). Consequently, our TPs are revised by average 28% higher with valuations generally pegged at +1.0SD to mean PER/PBV levels, except for CBIP (valued at mean given its plantation’s extremely young age profile of 2.9 years, rendering it unlikely to be able to fully capitalise on the CPO price rally), and UMCCA (also valued at mean reflecting its high production cost and loss-making status).

Upgrade the Plantation sector to OVERWEIGHT with a higher 2020 CPO price target of RM2,700/MT. All in, we believe that CPO price outlook remains robust given: (i) production decline is expected to continue into 2020 from the dry weather impact, lower fertilizer application as well as lower replanting, (ii) sturdy demand on top of the implementation of biodiesel mandates (B30 Indonesia; B20/B10 Malaysia for transport/industrial), and (iii) significant earnings improvement ahead from higher CPO prices. As such, we upgrade the plantation sector to OVERWEIGHT (from NEUTRAL) with a higher CY20 CPO price target of RM2,700/MT (from RM2,400/MT) and we now have 8 OUTPERFORM calls, and 5 MARKET PERFORM calls (refer to exhibit 5 for more details).

Our Top Picks are:

(i) GENP (OP; TP: RM12.10) – We like GENP for its upstream exposure (c.45%), making it one of the more CPO price sensitive big cap planters. At current price, GENP is only trading at CY20 PER of 25x (5% discount to peers) which we believe is unjustified given: (i) its highest FY20 FFB growth prospect of 4.4% (among big caps), allowing it to fully capitalize on the CPO price rally, (ii) lowest EV/planted Ha of RM62k amongst big cap peers (39% discount to peers; 10% discount to SIMEPLT), (iii) stable contribution from its premium outlets, and (iv) decent dividend yield of 2.2%.

(ii) KLK (OP; TP: RM32.90) – We like KLK as an integrated play (which is similar to IOICORP), providing more stable earnings outlook from both its upstream and downstream portfolio. Despite its integrated status, KLK is only trading at Fwd. PER of 23.9x (c.9% discount to peers), implying only -1.0SD valuations which we think is unwarranted given its: (i) above-average FFB growth of 4.3%, allowing it to capitalize on the CPO price rally, (ii) superior ROE of 10.4% (second only to IOICORP), and (iii) decent dividend yield of 2.0%. Given its integrated status and the merits mentioned above, KLK deserves to trade at a premium.

Source: Kenanga Research - 2 Jan 2020