Log supply shortages in Sarawak and weak Japanese plywood demand are offsetting the positive impact of stronger log prices and the effect of the weakening MYR/USD rate. We remain NEUTRAL on the sector. On the palm oil front, flattish CPO prices are offsetting the impact of stronger FFB production. Our top pick is Ta Ann, due to its decent valuations and exposure to both timber and plantations sectors.

Log shortage worsens. We believe the clampdown on illegal logging had an indirect effect on the timthe companies now have to get the customs documentation and inspection done at the point of logging instead of at the log ponds. This requires additional time and manpower, implying that delays could occur quite easily. The added risk of an upcoming El Nino weather phenomenon could also hamper the log transportation system, as river levels may not be high enough for the log barges. As such, we cut our log production forecasts for the companies under our coverage, to reflect a decline of 5-15% for FY15 (from a decline of 4-8%), followed by flattish production for FY16-17 (from an increase of 2-3%). We expect log harvests in Sarawak overall to decline by 4-6% YoY in 2015 on the back of these circumstances. With this supply shortage, meranti log prices are, therefore, expected to continue rising in 2015. For 2015-2016, we have projected a price rise of 4-6% pa, which we are keeping for now.

Japan plywood imports still declining. The rate of decline of Japan’s housing starts has slowed, with YTD-April starts down 3.9% YoY, from a decline of 13% YoY in Jan 2015. In terms of plywood imports, however, this has deteriorated, plummeting by 15.5% YoY YTD-April. Due to the log supply shortage in Malaysia, plywood manufacturers have highe r log costs and lower volumes to export. Hence, they would try to keep plywood prices up to offset the higher log costs. Plywood prices have,therefore, remained flattish despite the weak sales volumes – likely due to the pass-through of high log costs. We are leaving our average plywood price assumptions at +0-3% YoY for 2015-2016.

Still NEUTRAL. While we continue to expect the current state-wide log supply shortage situation to help keep log prices up, this would be slightly offset by the impact of weaker log sales, as a result. Earnings fro the plywood subsector are anticipated to remain weak, givensombre plywood demand from Japan and lacklustre plywood prices. On the palm oil plantations front, FFB production should increase on improving maturity of oil palm plantations hectarage, although CPO prices remain flattish currently. However, if El Nino happens, the consequent FFB production decline would generally be more than offset by the rise in CPO prices. The exchange rate factor is also a positive, which would help boost earnings for the sector, as 60-80% of timber companies’ earnings are in USD, while costs are all in MYR. We now have one BUY recommendation (Ta Ann (TAH MK, BUY, TP: MYR4.40)) and remain NEUTRAL on Jaya Tiasa (JT MK, NEUTRAL, TP: MYR1.40)and WTK (WTKH MK, NEUTRAL, TP: MYR1.00).

Log supply shortage worsening Log production in Sarawak fell 9.2% YoY in 4M2015, on the back of the extra-wet monsoon season in 1Q15 as well as the aggressive clampdown on illegal logging by the Sarawak State Government. The timber companies under our coverage suffered more significant declines in logging harvests during the same period, as seen by the 25.6% YoY decline in Ta Ann’s harvests, the 16.4% drop in Jaya Tiasa’s harvests and the 19.2% fall in WTK’s harvests.

We believe the clampdown on illegal logging has had an indirect effect on the timber companies under our coverage, as the companies now have to get the customs documentation and inspection done at the point of logging instead of at the log ponds. This requires additional time and manpower, which means delays could occur quite easily. The added risk of an upcoming El Nino weather phenomenon could also hamper the log transportation system, as river levels may not be high enough for the log barges.

Besides the illegal logging clampdown, the Sarawak State Government is also revamping the state’s timber licensing policy, in light of its renewed commitment to sustainability and conservation. We believe this could potentially result in a reduction in logging quotas for the timber companies during the upcoming quota review in July – although we do not think the reduction, if any, will be substantial. We understand that, within each timber concession, there are protected areas of the forest that are not harvested. The State Government may decide to exclude those areas from the timber licence, which could subsequently result in an overall reduction in the annual logging quota. Nevertheless, as the timber companies under our coverage generally do not even log to their annual quotas every year, we do not think this will have a significant impact to their bottomlines.

We are, therefore, reducing our log production forecasts for the companies under our coverage, to reflect a decline of 5-15% for FY15, followed by flattish production for FY16-17. We expect log harvests in Sarawak overall to register a decline in 2015, of 4-6% YoY, on the back of these circumstances.

With this supply shortage, meranti log prices are, therefore, expected to continue rising in 2015. In May 2015, log prices are still up 15 -16% YoY, although from the end of 2014, the rise is a small 2%. For 2015-2016, we have projected a price rise of 4-6% pa, which we are keeping for now.

No joy on the plywood The rate of decline of Japan’s housing starts have picked up, with YTD-April starts down 3.9% YoY, from a decline of 13% YoY in Jan 2015. In terms of plywood importshowever, this has deteriorated – plummeting by 15.5% YoY in YTD-April. Japan Lumber highlighted that due to the log supply shortage in Malaysia, plywood manufacturers have higher log costs and lower volumes to export, and therefore try to keep plywood prices up to offset the higher log costs. As a result, Japan has switched its imports to Indonesian plywood from Malaysian plywood in the first few months of the year – which led to a 4-month decline of Malaysian plywood imports and three months of increases in Indonesian plywood imports.

Plywood prices have, therefore, remained flattish despite the weak sales volumes,which is likely due to the pass-through of high log costs. Concrete panel prices remain at around USD550-560 per cu m – up 1-2% YoY, while floorbase prices are around USD680-690 per cu m, or down 0-1% YoY. We are leaving our average plywood price assumptions at +0-3% YoY for 2015-2016.

Exchange rates to help support earnings The further strengthening of the USD against MYR would continue to help offset the impact of weak sales volumes and flattish price trends, giv en that timber companies export their products in USD while costs are mostly in MYR. We have revised our MYR/USD rates to eflect RHB’s latest in-house forecasts of 3.62/3.55 for 2015/2016. However, we continue to highlight the sensitivity of every MYR0.10/USD change in the exchange rate in the table below.

No changes in CPO prices, but watch out for El Nino impact As for the plantation divisions, we maintain our CPO price assumption of MYR2,500/tonne for 2015 and 2016. We expect CPO prices to strengthen in 2H15,due to the 12-month impact of this year’s dry weather. One catalyst to look out for would be the El Nino weather phenomenon, which would boost CPO prices.

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

Valuation and recommendation We make no change to our NEUTRAL sector rating. While we continue to expect thecurrent state-wide log supply shortage situation to help keep log prices up, this wouldbe slightly offset by the impact of weaker log sales as a result. Earnings from theplywood subsector are anticipated to remain weak, given sombre plywood demandfrom Japan and lacklustre plywood prices. On the palm oil plantations front, FFBproduction should increase on the improving maturity of oil palm plantationshectarage, although CPO prices remain flattish currently. However, if El Ninohappens, the consequent FFB production decline would generally be more than offset by the rise in CPO prices. The exchange rate is also a positive factor, whichwould help boost earnings for the sector, as 60-80% of timber companies’ earningsare in USD, while costs are all in MYR. We maintain our SOP-based valuations forthe timber companies, valuing their log concessions using DCF, their plywoodfacilities using replacement value and a target 16x 2016F P/E for the plantationdivisions. We now have one BUY recommendation (Ta Ann) and two NEUTRAL (Jaya Tiasa and WTK) stocks.