Headwinds for the sector remain such as (i) rising inventory levels continuously applying pressure on CPO prices, while (ii) ESG concerns should continue to weigh on sentiment. That said, valuations of planters under our coverage and KLPLN index (-1.0SD to -1.5SD from mean) seem to have priced in the negatives. For now, the wide SBO-CPO premium (though temporary, in our opinion) offers a slight reprieve from further CPO price downside. Weather improvements and higher planted acreage in the coming months could however, further spur the selldown in SBO. From an earnings front, planters will enjoy a peak in 2QCY21, but beyond that, there is little excitement. Indonesia’s biodiesel policies are to be watched closely – the recent revision to lower its biodiesel levy structure will make the shift to B40 tougher. Its B40 plans are expected to be delayed beyond end-2022, but a speedier rollout will be a positive for the sector. Stay NEUTRAL on the plantation sector. Our integrated pick with defensive overall margin against the CPO price variability is KLK (OP; RM24.00). We also like SIMEPLT (OP; RM4.95) as earnings are relatively shielded by forward sales in a volatile CPO price environment. Additional share price catalyst which will have a spillover effect on the sector is the potential resolution of the WRO by U.S. CBP.

Review of CPO and KLPLN Index. As anticipated, crude palm oil (CPO) peaked in 2QCY21 (refer to Exhibit 1) after climbing (+17%) from c.RM4,100/MT (at the start of April) to an all-time high of c.RM4,800/MT in May. During this period, KLPLN slipped 1% instead and the correlation between CPO price-KLPLN was merely 30%, which we attribute to: (i) ESG concerns, and (ii) views that the elevated CPO price levels were unsustainable. Since its peak, CPO price has declined (-23%) to c.RM3,700/MT, while KLPLN index fell (-7%). Correlation during this period normalised to 84%.

What is the direction for CPO price? Drawing hints from the CPO forward curve (Exhibit 2) in backwardation, the direction continues to head south with near-term price range of c.RM3,500-3,700/MT. We concur with the direction, especially as rising inventory in 2H 2021 should continue to weigh on CPO prices.

Inventory still set to be on an upward trajectory. As of May 2021, Peninsular Malaysia’s production growth has slowed as trees rest, while East Malaysia continued to improve. For June, Peninsular should continue taking a breather and production growth should be driven by East Malaysia. Moving into 3QCY21, the production growth from Peninsular Malaysia should kick in, which will drive inventory higher and pressure CPO prices. As of May 2021, inventory level was at 1.57m MT, while stock-to-usage (STU) ratio was at 8% (Exhibit 4). We expect an average STU ratio of 8-9% in 2021. Based on Exhibit 5, the implied CPO price is RM2,916-3,099/MT, close to our CY21 forecast of RM3,000/MT.

Wide SBO-CPO premium offers a slight reprieve for now. The wide SBO-CPO premium (Exhibit 6) of c.USD480/MT (vs. 3-year average of c.USD111/MT) should provide some support for CPO price for the moment. However, there are some headwinds that remain. The U.S. could be in for a bumper harvest as farmers are more incentivized to increase soybean planting area due to better prices, and as the weather improves (especially in the Midwest).

Biodiesel mandate developments remain uncertain. According to GAPKI, Indonesia’s B40 plans could be delayed beyond end-2022, while Malaysia’s B20 plans in Sabah and Peninsular Malaysia have been delayed indefinitely. Additionally, Indonesia has recently revised its biodiesel levy structure lower, which could further derail its B40 plan. Based on the new biodiesel structure (Exhibit 9 & 10), we estimate that the shift to B40 is only sustainable if CPO price is around RM4,000/MT. Zooming onto the planters, the lower biodiesel levy structure is beneficial to Indonesian upstream planters, which could see c.RM200-300/MT increase in realised CPO price (Exhibit 11).

3QCY21 earnings unlikely to excite. CPO price has peaked in 2QCY21 at c.RM4,800/MT, while the QTD-2Q average is at c.RM4,200/MT. As of late June, CPO price is 12% lower at c.RM3,700/MT. This means that earnings for most planters will likely peak in 2QCY21. The silver lining lies in the fact that production growth could offset the decline in CPO price.

Valuations have suffered on ESG concerns after the U.S. CBP Withhold Release Order (WRO) on FGV and bellwether SIMEPLT. Fwd. PER valuations for KLPLN Index (Exhibit 7) which have remained >20x PER since 2013, are now at c.18.8x. Similarly, PBV valuations have also been trending lower. In an environment where earnings and net assets are growing, this suggests that ESG concerns have resulted in value destruction and this valuation derating could be here to stay.

Who is next into the hot soup? Despite earnings growth, KLPLN Index sentiment will remain lacklustre due to ESG concerns. The recent acknowledgement from U.S. CBP on a petition submitted by migrant worker rights specialist Andy Hall on alleged forced labour and new alleged forced labour report by Finnwatch at IOICORP will continue to dampen the sector’s sentiment. The question at the back of every investors’ mind will be – who is next into the hot soup? Accordingly, we have derated further valuations of large-cap planters – SIMEPLT, IOICORP, KLK, and GENP (Exhibit 12 & 13).

Stay NEUTRAL on the plantation sector. While headwinds like: (i) lower CPO price, and (ii) ESG concerns continue to weigh on the sector, we think valuations of planters under our coverage and KLPLN index (-1.0SD to -1.5SD from mean) seem to have priced in the negatives, making an UNDERWEIGHT sector call unfitting, in our opinion. Our integrated pick with defensive overall margin against the CPO price variability is KLK (OP; RM24.00). We also like SIMEPLT (OP; RM4.95) as its earnings are relatively shielded by forward sales. Additional share price catalyst is the potential resolution of the WRO by U.S. CBP.

Source: Kenanga Research - 2 Jul 2021