Kuala  Lumpur  Kepong  (KLK)’s  growth  is  expected  to  come  from expansion in  its downstream division, while FFB production growth  in its  upstream  division  should  be  in  the  low  single-digit  range  going forward.  While  KLK  remains  a  solid, well-focused  plantation  company that we like, we deem its valuations a bit rich.  Maintain NEUTRAL,  with a slightly lower SOP-based FV of MYR26.00 (from MYR26.80).

• Key  highlights  from  management  include:  i)  small  single-digit production  growth  expected  for  FY14,  ii)  a  more  neutral  view  on  CPO prices now, iii) CPO production costs  are expected to be flat  in FY14, iv) Indonesian landbank should be fully planted up by FY16/17, v) a setback in  Papua  New  Guinea  (PNG),  vi)  two  Indonesian  refineries  up  and running,  with  one  more  in  the  pipeline,  and  vii)  its  oleochemical expansion may be delayed further.
• Trimming  FY15  forecast.  All  in,  we  are  revising  our  FY15  forecast downwards by 6-7%, after taking into account delays in the completion of its  refineries  and  oleochemical  plants.  Our  FY14  forecast  remains relatively unchanged.
• Growth  to  come  from  downstream  division.  While  KLK  remains  a solid,  well-focused  plantation  company  that  we  like,  with  good  growth prospects from its new downstream facilities –  which should  continue  to come onstream in FY14-15  –  coupled with  higher CPO prices, we deem its valuations a bit rich.
• Maintain  NEUTRAL.  Post-earnings  revision,  we  lower  our  SOP-based valuation  to  MYR26.00  (from  MYR26.80).  Our  valuation  basis  remains unchanged at  a  target P/E of 18x CY15 for its plantations division, 12x CY15 for its manufacturing and property divisions and market value for its associate stake in Synthomer Plc (formerly known as Yule Catto).  We maintain our NEUTRAL recommendation on the stock. 

Key  highlights  from  management  include:  i)  small  single-digit  production  growth expected  for FY14, ii)  a  more neutral view on CPO prices now, iii) CPO production costs are expected to be flat in FY14, iv) Indonesian landbank should be fully planted up  by  FY16/17,  v)  a  setback  in  Papua  New  Guinea  (PNG),  vi)  two  Indonesian refineries  up  and  running,  with  one  more  in  the  pipeline,  and  vii)  its  oleochemical expansion may be delayed further.

Small single-digit production growth  for FY14.  In YTD-April  2014, KLK recorded FFB production growth of -2.7% y-o-y. The decline was attributed to the impact of the dry weather in 2HCY13, as well as 1QCY14. Management expects production to pick up in 2HFY14, closing the year with  small positive  single-digit  growth.  This is in line with  our  projected  growth  of  4.6%  for  FY14  (FYE  September).  The  growth  is expected to come mainly from KLK’s Kalimantan estates, which have already seen a stronger recovery from April/May.  For FY15, we project FFB production growth at a similar 4-5%.  

More neutral view on CPO prices now.  Management has  turned  more neutral on CPO prices from  a  relatively bearish  view previously. It estimates  CPO prices in the range of  MYR2,400-2,600/tonne over the next six months. We highlight that KLK’s average CPO price  of  MYR2,499/tonne in 2QFY14 was  some  7-8% lower than the average MPOB price of MYR2,693/tonne in the same period.  This was attributed to two  factors:  i)  lower  CPO  prices  in  Indonesia  (vis-à-vis  Malaysia)  of  MYR100-200/tonne (we estimate that Indonesia contributes close to 40%  of KLK’s production), and ii) some forward sales done  earlier for  1Q-2QFY14  production. We understand that currently, not much forward selling is being done.  

CPO production costs  expected to be flat.  In 1HFY14, KLK’s average production cost was  flat y-o-y at about MYR1,300/tonne.  Management expects  production costto remain stable for the rest of the year, which is in line with our projections. Indonesian landbank to be fully planted up by FY16/17.  As at end-FY13, KLK had about  17,846ha  of  plantable  reserves  in  Indonesia,  including  East  Kalimantan  and Sumatra. In 1HFY14, KLK had already planted up about 3,000ha of new land, well on track to achieving its targeted 5,000ha for FY14.  At a planting pace of 5,000ha per year,  KLK  should  complete  planting  up  its  Indonesian  landbank  by  FY16/17.  The company  may  therefore  need  to  start  planting  up  its  other  greenfield  landbank  in PNG and Liberia soon.

Setback  in  PNG.  KLK  recently  faced  a  setback  In  PNG,  as  non-governmental organisations (NGOs)  like Oro Community Environmental Action Network (OCEAN), Rainforest  Action  Network  (RAN)  and  Greenpeace  have  obtained  an  injunction restraining  any  activity  on  38,350ha  of  land  (out  of  the  total  44,342ha  originally agreed  upon in  the  acquisition  announcement in 2012). The NGOs claimed that the PNG Government had failed to obtain the consent of the customary landowners of the  land  prior  to  the  issuance  of  the  agricultural  lease  of  the  land.  As  the  PNG Government did not defend the suit, KLK has agreed to comply with the injunction. The company is now left with 5,992ha, or 13.5% of total land in PNG, which is  under a  99-year  state  lease.  As  KLK  has  already  paid  up  about  46%  (USD3.6m)  of  the purchase price of USD7.8m for  its stake in the JV, it  has stated that it will take steps to recover a proportionate amount of the purchase price from the vendor. Assuming all the land is valued equally, this would translate to approximately USD2.55m – not a significant  amount.  We  expect  KLK  to  continue  to  look  for  new  landbank  in  PNG despite this setback, in order to gain economies of scale for its operations. In Liberia, KLK has 25,547ha of landbank, of which 3,750ha  are planted (but the trees are old).

As it  intends to replant some 2,000ha  of this land by  FY15, new planting activities in Liberia may therefore only start in FY16/17. Two Indonesian refineries up and running, one more in the pipeline. So far, only two  of  KLK’s  three  Indonesian  refineries  are  up  and  running.  In  Belitung,  its  1,000 tonnes/day  refinery has been running since end-April 2013, operating at about 50% utilisation  rate. We understand that this  refinery is already profitable.  In Mandau, its 1,600  tonnes/day  palm  kernel  (PK)  crushing  plant  and  refinery  has  been  running since  Nov  2013,  also  operating  at  about  50%  utilisation  rate,  and  is  also  already profitable. In Dumai, its 2,000 tonnes/day refinery, which  was due to be completed in 1Q2014,  has  again  been  delayed,  and  is  now  only  scheduled  to  be  completed  in June 2014, due  to shortages of skilled labour and the importation of parts . We have therefore  adjusted  our  forecasts  accordingly  to  take  this  delay  into  account.  We continue  to  be  wary  of  the  prospects  of  KLK’s  aggressive  refinery  expansion  in Indonesia,  given  the  intensifying  competition  for  CPO  feedstock  going  forward,  as more new refinery capacity is expected to come onstream in Indonesia over the next 1-2 years. Note that we have imputed very low utilisation rates of 50% and below for the initial years.Nevertheless, in the event of an upswing in CPO prices, these  refineries will allow KLK  to  remain  very  competitive  given  the  nature  of  the  export  duty  structure  in Indonesia, which gives refiners a competitive edge  with  higher CPO prices  against Malaysian refiners.

Oleochemical  expansion  delayed  further.  As  for  KLK’s  oleochemical  expansion, the  completion of the 165,000-tonne-p.a. facility in Dumai, Indonesia will be delayed to  June  2014  (from  1QCY14),  while  the  completion  of  its  facilities  in  Germany, Switzerland  and Malaysia has  also been delayed to end-CY14  (from end-CY13). All in, KLK’s oleochemical capacity  should  rise  by 38%  to about 2.2m tonnes by FY15 (from  1.6m  tonnes  in  FY13).  We  have  adjusted  our  forecasts  to  account  for  the delays in completion. We are more positive on the prospects of KLK’s oleochemical division at this juncture, given the low CPO feedstock price environment, which has resulted  in  a  7.9%  rise  in  1HY14  EBIT  margins  for  this  division  (from  6.1%  in 1HFY13).  Nevertheless,  we  project  FY14-15  EBIT  margins  of  about  6%,  to  be conservative.

Risks
Main risks.  Main risks include: i) a convincing reversal in the crude oil price trend, resulting  in  the  reversal  of  CPO  and  other  vegetable  oils’  price  trends,  ii)  weather abnormalities resulting in an over-  or undersupply of vegetable oils, iii) a revision in global biofuel mandates and trans-fat policies, and iv) a slower-than-expected global economic recovery, resulting in lower-than-expected demand for vegetable oils.

Forecasts
Trimming FY15 forecast. All in, we are revising our FY15 forecast  downwards by 6-7%,  after  taking  into  account  delays  in  the  completion  of  its  refineries  and oleochemical plants. Our FY14 forecast remains relatively unchanged.

Valuation and recommendation
Maintain  NEUTRAL.  While  KLK  remains  a  solid,  well-focused  plantation  company that we like, with good growth prospects fro m its new downstream facilities  –  which should continue to come onstream in FY14-15 – coupled with higher CPO prices, we deem  its  valuations  a  bit  rich.  Post-earnings  revision,  we  lower  our  SOP-based valuation to MYR26.00 (from MYR26.80). Maintain NEUTRAL.

Source; RHB