We believe there is value in Kulim, created by excessive pessimism on its oil exploration venture, the risk of which we believe is limited. Keep BUY with a SOP-based MYR2.95 TP (14% upside, plantation at 16x 2016 earnings). Its breakup value is worth much more at MYR3.66. This is conservatively assuming zero value for its oil exploration business, which is worth MYR0.19/share if 10% of its reserve is recoverable.

• Post-New Britain disposal. On 26 Feb, Kulim Malaysia (Kulim)completed its disposal of 73.5m shares in New Britain Palm Oil (New Britain) at GBP7.15 per share. Following the receipt of the proceeds, Kulim has paid out 37 sen in special dividend. The company has committed to another special dividend of the same quantum next year.
• Oil exploration. We believe the market is overly pessimistic on Kulim’s venture into oil exploration in Sumatra, Indonesia . We believe the risk to Kulim as a whole is very limited. Based on the terms of the exploration, the Indonesian Government will compensate the company for all its expenses incurred. Should the whole venture fail, the maximum risk to Kulim is USD133m, which is its equity stake in the venture.
• Malaysian plantation. In 1Q15, Kulim posted a 5.4% YoY decline in FFB production likely due to excessive dryness in 1Q14. This resulted in poor 1Q earnings performance. However, production is already recovering with a significant surge in April production, which brought its first four months’ production to a mere 0.7% decline. Management is expecting a 7% production growth this year.
• In good shape. Kulim’s age profile is at its best ever with 42% of trees in prime age, which will likely drive FFB yield to record levels in the next few years, barring any short-term production disruption from adverse weather.
• Stock undervalued. We believe Kulim’s stock price has priced in the worst-case scenario in its oil exploration venture. The pessimism has created a bargain stock, which could turn surprise on the upside.

Updates Kulim has proposed to buy a 60% equity stake in PT Citra Sarana Energi (PT CSE) for USD133.35m. PT CSE has been awarded a 30-year production sharing contract (PSC) of South West Bukit Barisan (SWBB) in Sumatra by the Indonesian Government, via Satuan Kerja Khusus Pelaksana Kegiatan Usaha Hulu Minyak & Gas Bumi (SKK Migas). The SWBB block, measuring 779 square km, is located onshore in West Sumatra province and is near Chevron Texaco’s Duri field. According to Kulim’s annual report, production testing on SWBB indicates prospective and contingent resources of 404m barrels of oil equivalent (MMBOE). Production can begin in early 2016.Despite the positive progress, management warns that risks of the oil and gas venture remain and is taking measures to mitigate them. Nevertheless, we are comforted by the fact that:

1. Kulim has a very good track record in value creation from its strategic ventures. A case in point is its acquisitions of New Britain and QSR Brands, both of which were controversial at the time but proved to be huge winners.

2. Taking a hands-on approach in the oil and gas venture with the effort led by a Kulim veteran and executive director Hj Abdul Rahman Sulaiman, who was one of the original members of the Kulim team making the New Britain acquisition in 1996.

3. In the worst-case scenario of the Bukit Barisan exploration not working out, Kulim’s maximum loss is limited to its equity investment of USD133.35m.

All the buzz about its disposal of New Britain stake has overshadowed the progress at its Malaysian plantation. The replanting efforts since 2008 coupled with the acquisition of Johor Corp’s estates in 2012 have brought its average age down to 11.37 years as of end-2014 from 12.90 years in 2010. Its percentage of old trees (19 years onwards) declined to 16% in 2014 from a high of 32% in 2010. At the same time, the percentage of its prime age trees rose steadily to 42% in 2014 , a level we have never seen, from 29% in 2010.

The rise in prime age trees’ percentage should help drive its FFB yield higher over the next few years, bearing in mind that the replanting has been done using higher yielding material, including clonal palm and Dami material from New Britain. In fact, Kulim’s FFB yield is already on the rise, hitting 22.34 tonnes per hectare last year, its highest since 2008. Barring adverse weather, its production should grow by 7% this year, raising FFB yield to an estimated 23.74 tonnes per hectare (ha). We expect yields to continue to rise, noting that its yield has hit much higher levels of 25.61 tonnes in 2006 and 26.91 tonnes in 2003.

The company’s oil extraction rate (OER) hit a record high of 20.58% last year. At the same time, its kernel extraction rate (KER) has inched down to 5.56% from 5.99% in 2009. Besides the improvement in mill technology and drier weather last year, we believe the increase in OER and corresponding decline in KER have been the result of its replanting using material with thicker mesocarp and smaller kernel. Hence, as its 8,972ha of immature area gradually mature, the trend of rising OER and falling KER should continue.

Kulim’s cost of production per tonne has been easing for the last two years due to falling fertiliser prices as well as rising yield per ha. While fertiliser prices continue to ease in USD terms, weakening MYR means fertilizer costs should be slightly more expensive this year in MYR terms. We expect some 3-5% increase. Nevertheless, with the rising FFB yield helping to offset higher fertiliser prices, we believe Kulim’s cost of production should remain flattish this year.

Kulim (together with New Britain) had achieved 100% Roundtable of Sustainable Palm Oil (RSPO) some eight years ago when other plantation companies were just starting their certification process. The percentage went down following the acquisition of Johor Corp estates in 2011 and 2012 as some of the acquired estates were not certified. Certification works since have brought all of its 47,000ha of oil palm plantation to being RSPO-certified. At this juncture, we believe only Sime Darby(SIME MK, NEUTRAL, TP: MYR8.75) has achieved the 100% RSPO-certified status.

Valuation We value Kulim stock at MYR2.95, based on sum-of-parts with 1. Plantation at 16x 2016 earnings as a going concern 2. Net cash at company level 3. EA Technique stake at market price 4. Menara Ansar, a 16-storey office building in Johor Bahru City at 1998 book value 5. Zero value for its oil exploration business

We note that the company’s breakup value is worth even more at MYR3.66 per share, if the company disposes of all its assets, repay all debt and return the balance to shareholders. This is based on valuing its 47,000ha of oil palm planted area in Johor at MYR74,000 per ha, which is the market value of Sabah plantations. We believe this is a conservative number considering that Kulim’s plantation land has property development value.

Even if we were to write off its investment of USD133.35m in the oil exploration business, its breakup value is still worth MYR3.30 per share, a significant upside of 27% from current stock price levels.

On the other hand, if we assume 10% of the abovementioned 404m barrels of oil equivalent is extractable, it could add about MYR250m in net present value or MYR0.19 per share to Kulim’s value.

Source: RHB Research - 2 Jun 2015