While we continue to like the still-promising prospects of  the log sub division, this is offset by the sombre outlook for the plywood segment as  the  Japanese  economy  has  fallen  back  into  a  recession  on  top  of weaker CPO prices. One bright spot, however, is  the positive impact of a  stronger USD on timber  exports, given that costs are mostly in MYR.Maintain NEUTRAL on the sector. 

Prices of Malaysian tropical logs have risen by 18%  YoY.  This was partly due to the impact of the ban on log exports from Myanmar, which was implemented from 1 Apr 2014, and  stronger demand from India (as Sarawak’s  log  exports  to  the  South  Asian  nation  rose  to  64%  of  totalexports  from 61% in 2013). We maintain our assumptions of a 6-8% per annum increase  in  log prices  for  2014  and  4-6% for  2015-2016, to  be conservative. In the longer term, investors should look out for the impact of  the  recent  new  timber  licensing  policy  in  Sarawak,  which  enforces sustainable certifications as well as the crackdown on illegal logging in the state. 

The economic recovery in Japan has seemingly  reversed.  This is on the East Asian nation  technically falling back into a recession in 3Q14. Housing starts have reflected this, with a further decline of 7.1% YoY in 9M14  from  the  -3.4%  recorded  in  1H14.  The  Japanese  Government intends to address this issue by: i)  delaying the second consumption tax hike  (to  10%  from  8%)  to  Apr  2017  (from  Oct  2015),  ii)  implementing some strategies to revive home sales,  and iii) calling for a snap election, which was held on 14 Dec.  This should translate to lacklustre plywood prices in the medium term. Plywood prices have not moved much,  as a result. We are leaving our average plywood price assumptions at +2-3% YoY for 2014-2016.  

Saving  grace  is  the  strengthening  USD.  The  saving  grace  for  the timber  industry  is  now  the  exchange  rate.  While  weaker  consumer spending in Japan – a result of a weakening JPY against the USD – has affected plywood sales volumes, this is more than offset by the impact of the  strengthening  of  the  USD  against  the  MYR.  Timber  companies export their  products in USD while  their  costs are mostly in MYR. While we  continue  to  assume  exchange  rates  of  MYR3.15-3.20/USD,  we estimate  every  MYR0.10/USD  change  in  the  exchange  rate  affects timber companies’ earnings by 10-17% per annum.

We maintain our NEUTRAL stance on the timber sector. We maintain our target  2015F P/Es of 10-12x for the timber divisions and 16x for the plantation  businesses.  We  have  one  BUY  recommendation,  Ta  Ann (TAH MK, TP: MYR4.40). We are  NEUTRAL  on  WTK  Holdings (WTKH MK,  TP:  MYR1.25)  and  recommend  SELL  on  Jaya  Tiasa  (JT  MK,  TP: MYR1.70).

Still NEUTRAL.  While we continue to like the still-promising prospects of the log sub division,  this  is  offset  by  the  sombre  outlook  for  the  plywood  segment.  This  is because the Japanese economy has  reversed back into a recession  and also due to weaker  CPO  prices.  One  bright  spot,  however,  could  be  the  positive  impact  of  the stronger USD on timber exports, given that costs are mostly in MYR.

Log production in Sarawak is still on the rise.  However, the  rate of growth has moderated slightly to +4% YoY in 7M14 (down from +6.9% in 1H14). We highlight that not  all  the  companies  we  cover  recorded  increases  in  log  volumes  during  the same  period.  Of  the  three  companies  we  cover,  two  recorded  increases  in  log production in  the same period, namely Ta Ann (up 26% YoY)  and WTK  (up 13.4% YoY). Meanwhile, Jaya Tiasa recorded a 5.7% YoY decline. We believe this is due to the  fact  that,  in  previous  years,  the  company  was  always  logging  at  close  to  its concession quota of 1.1m cubic metres (cu m)  of logs per annum. Ta Ann and WTK, on the other hand, have ample room to increase harvesting, based on their quotas of 590,000 cu m and 600,000 cu m of logs per annum respectively.

India  absorbing  growth  in  log  volumes,  log  prices  still  on  the  rise.  The increasing log volume is still being absorbed by India, driven by Myanmar’s log export ban and continued infrastructure spending in the country. Log exports to India from Sarawak remains at 60-65% of total log exports in 9M14, although meranti  log prices have  remained  flattish  since  Aug  2014,  at  about  USD290/cu  m  (up  18%  YoY). Although this is higher than our projected price increase of 6-8% per annum for 2014 and 4-6% for 2015-2016, we prefer to remain conservative for now.

Look  out  for  impact  of  two  factors  in  future.  Going  forward, the  market  should look  out  for  the  impact  of  two  factors.  Firstly,  the  implementation  of  the  Sarawak Government’s  new  timber  licensing  policy  (announced  in  August),  in  which  it  is extending the tenure of forest concession licences to up to 60 years (from 5-15 years currently) provided that the licence holders achieve Forest Management Certification within three years of issuance. This certification can come from the Malaysian Timber Certification Scheme (MTCS) as well as from internationally-recognised bodies like the  Forest  Stewardship  Council  (FSC)  in  New  Zealand  or  Programme  for  the Endorsement of Forest Certification (PEFC)  schemes. While we do not expect this to change  the  logging  concessionaires’  log  harvesting  volumes  or  quotas,  this  could incur  higher  costs  from  the  certification  process.  In  the  longer  term,  if  smaller concession holders do not comply with the certification requirement, this could result in some concessions being re-allocated. Secondly, the recent crackdown by the new Chief Minister of Sarawak on illegal logging activities and the freezing of new logging licences could see fewer logs coming out of the state from illegal sources . This  could result in  a reduced log supply in 2015. It is difficult to quantify the quantum of illegal logging at this juncture.

Japan’s economic recovery seems to have reversed.  The economic recovery in Japan has seemingly reversed, with the East Asian nation technically falling back into a  recession  in  3Q14.  Housing  starts  have  reflected  this  dynamic,  with  a  further decline of 7.1% YoY in 9M14 vs -3.4% recorded in 1H14. The Japanese Government intends to address this issue by delaying the second consumption tax hike (to 10% from 8%) to Apr 2017 (from Oct 2015), implementing some strategies to revive home sales  and  calling  for  a snap  election  –  which  was  held  on  14  Dec  2014.  All these should translate to lacklustre plywood prices in the medium term.

Flattish plywood prices.  Concrete panel prices have not moved much over the last eight months, remaining at USD540-550 per cu m  –  up 5-6%  YoY, while floorbase prices are also unchanged at USD690-700 per cu m, up 2-3% YoY. We are leaving our average plywood price assumptions at +2-3% YoY for 2014-2016.

Saving grace is the  strengthening USD.  The saving grace for the timber industry is  now the exchange rate. While weaker consumer spending in Japan  –  a result of a weakening JPY against the USD –  has affected plywood sales volumes, this is more than offset by the impact of the  strengthening of the greenback  against MYR. Timber companies  export  their  products in  USD  while  costs  are mostly in  MYR. While  we continue  to  assume  exchange  rates  of  MYR3.15-3.20/USD,  we  highlight  the sensitivity of every MYR0.10/USD change in exchange rate in Figure 6.

No changes in CPO price assumptions. As for the oil palm plantation industry, with the  weather  being  the  single  potential  driver  going  into  2015,  being  bullish  on  the sector  at  this  point  in  time  is  a  risky  proposition.  Nevertheless,  the  weather  is traditionally the single biggest driver of agricultural prices and,  by  itself,  sufficient to result in a  sustained upswing in prices. In any case, damage to 2015 production has already been done by  the  2H14  dry weather  in Kalimantan, Indonesia. We maintain our  CPO  price  assumptions  of  MYR2,400/tonne  for  2014  and  MYR2,500/tonne  for 2015. We expect CPO prices to strengthen in 2H15, due to the 12-month impact of this year’s dry weather.

Risks

Main  risks.  These  are:  i)  a  reversal  in  Japan’s  economic  recovery  resulting  in  a decline  in   the  country’s  housing  starts, ii) log  production  recovering  in  a  significant manner  from  Malaysia  or  if  Indonesia  lifts  its  ban  on  log  exports,  iii)  a  significant change in direction of the MYR/USD exchange rate, and iv) the imposition of import duties on large export markets like India and Japan.

Valuation and recommendation
We maintain our NEUTRAL rating  on the sector.  Although we expect continued strong log demand,  rising log prices and increasing FFB production from improving maturity  of  oil  palm  plantations  hectarage,  these  would  likely  be  offset  by  weaker plywood volume, lacklustre plywood prices and lower CPO prices. We maintain our target  2015F  P/Es  of  10-12x  for  the  timber  divisions  and  16x  for  the  plantation divisions. We have one BUY recommendation (Ta Ann), one NEUTRAL (WTK) and one SELL (Jaya Tiasa).

Source: RHB