The plantation sector performed poorly in CY21 despite strong CPO prices and earnings upgrades following two strong quarters of earnings that surpassed expectations. Attributing this disconnect to the sector’s generally poor ESG credentials and the consensus view that CPO prices have peaked and likely to decline in 2HCY22, we maintain a NEUTRAL call on the sector. Accounting for 9.6% by weight in the FBM Shariah Index (and 9.4% in the FBMKLCI), investing in the sector is unavoidable for Shariah funds that are benchmarked against the Shariah Index. For outperformance, we recommend KLK as our top large cap pick for its integrated structure that lessens its sensitivity to CPO prices, and attractive PER that is 1.5SD below mean.

Review of CY21. The plantation sector did poorly in CY21 despite strong CPO prices. The oils & fats market started CY21 with palm oil inventory at near decade low and palm oil leads the global oils & fats market with about 31% market share. Compounding the situation later was the restriction on movements to help manage the spread of COVID-19. This disrupted the ability to move workers about, leading to labour shortages in the palm oil sector which affected output for CY21. The impact was particularly felt in Malaysia where the sector employs 750,000 workers, about 85% of whom are guest workers according to the CEO of the Malaysia Palm Oil Association.

With tight supply prevailing, CY21 saw CPO prices firming up to reach record levels in October 2021. This coincided with the peak harvesting season for oil palm, a most welcome combination for many planters in Indonesia and Malaysia. However, the share prices of many listed plantation companies did not reflect this positive uptrend in CPO prices. Instead, the Bursa Plantation Index (KLPLN Index) is down 10% YTD while the CPO price rose 36%. The KLPLN Index also lagged both the FBM Shariah Index and the FBMKLCI (see charts above).

Outlook for CY22. The oil & fats market is expecting strong supply recovery in CY22. Not only from improving palm oil output as the authorities in Malaysia are easing the entry of guest workers to address labour bottlenecks but also sizeable soya bean harvest in South as well as North America.

Not surprisingly, prices of oil & fats have been facing downward pressure with CPO prices having moderated from the record levels achieved in October 2021. However, this is still premised on an anticipated upswing in supply actually coming through. Until inventories have really improved to an adequately comfortable level, there is little room for the oil & fats market to manoeuvre or absorb negative news, be it poor weather or another lockdown to logistical disruptions, any of which - if serious enough - could derail or dampen the forthcoming anticipated supply upswing in CY22.

As such, we expect CPO prices staying at RM4,000 per MT for 1QCY22 before easing over the months to about RM3,000 per MT as the end of CY22 approaches.

Our thoughts on the sector. Expect good 4QCY21 and 1QCY22 results but with CPO prices already softening, we sense caution among investors. An understandable sentiment amidst expectation of a commodity price down-cycle, hence our NEUTRAL stance on the sector. However, we expect the sector to reward investors with higher dividends, and pare down borrowing or both thanks to stronger cashflows. However, what would be even more appealing is a sensible expansion plan.

Stay NEUTRAL on the plantation sector. Although CPO prices may have started easing from the October peak prices on expectations of supply uptrend from palm oil, soya bean oil and rapeseed oil in CY22, current inventory levels remain tight and improvements have been gradual. Hence, until the stronger projected output in CY22 is able to eventually lift inventory levels, price downside for CPO may be limited until 2QCY22 and possibly beyond that. Overall, for CY22, we are expecting CPO price of RM3,500 / MT.

Factors to watch out for in CY22 are. (a) palm oil, soya bean and to some extent rapeseed supply trend, (b) bad news that lead the oils & fats market to downgrade current expectation of improving supply in CY22, and (c) the launch of B40 palmbased biodiesel blend by Indonesia. The prospects of an end-CY22 launch is no longer likely due to strong palm oil prices but an earlier rollout will be positive for the sector as Indonesia is the third largest producer and user of biodiesel.

Our integrated pick is KLK (OP; TP: RM26.50) which has just expanded its effective planted area by 35% after buying 95% of IJM Plantations and 60% of PT Pinang Witmas Sejati. Net gearing is set to exceed 50%, but should dip below 50% by FY22 thanks to strong CPO prices. Management is experienced with good track record. Its plantations are geographically diversified between Indonesia and Malaysia, thus reducing exposure to any continuing labour issues in Malaysia. KLK also has a sizeable downstream manufacturing business and is a Shariah-compliant stock. For trade-oriented nimble investors who wish to capture the near-term earnings upside from still elevated CPO prices, our top small cap pick that is also Shariah-compliant is Hap Seng Plantations. It is a pure upstream planter with net cash that yields an attractive dividend yield of 5%.

Source: Kenanga Research - 30 Dec 2021