KLK’s recent downstream investments may take some time before reaping significant positive returns, in light of the refining overcapacity in Indonesia and narrowing margins for oleochemicals. However, KLK’s plantation profits remain its stable backbone, comprising close to 70% of EBIT. We reiterate our NEUTRAL recommendation with a lower SOP-based TP of MYR21.50 (4% downside). .

Key takeaways from our recent visit: i) refinery investments in Indonesia are not seeing positive returns yet, ii) a fourth Indonesian refinery is in a different location, iii) oleochemical division is active in merger and acquisition (M&A) activities, but margins are under pressure, iv) end-FY15 (Sep) FFB production is likely to post a small positive growth, v) not much land is left for planting, vi) production costs are up YoY, due to higher fertiliser costs, vii) stable property division earnings, and viii) new sukuk issuance and capex requirements.

Downstream expansions aplenty. Over the last few years, Kuala Lumpur Kepong (KLK) has invested some MYR150m in expanding its downstream footprint in Indonesia via three refineries, totalling 3,600 tonnes/day of capacity. Unfortunately, this came at a time of massive refinery building in Indonesia, resulting in a refinery overcapacity of approximately 30%. As a result, refining margins in Indonesia continue to be negative at this juncture. On the oleochemical front, KLK has expanded its existing plant capacities as well as acquired two plants in Europe recently – one in Belgium and one in Germany. With these expansions and acquisitions, KLK’s oleochemical capacity is set to rise to an estimated 2.5m tonnes by FY16, up 50% from FY12. However, margins for this division are narrowing due to competitive disadvantages caused by low petroleum prices, which have made synthetic alcohol prices very competitive.

Reducing earnings forecasts slightly. After reducing our Indonesian refinery utilisation rates, trimming our oleochemical division EBIT margins and lowering capex projections, we lowered our FY15-17 earnings forecasts by 3-4% pa.

Still a NEUTRAL. We revise our SOP-based TP lower to MYR21.50 (from MYR22.00), post-earnings revision. We believe valuations are fair at this juncture and maintain our NEUTRAL stance on the stock. We also highlight that every MYR100/tonne change in CPO prices could affect KLK’s net profit by 4-6% pa.

Key takeaways from our recent visit: i) refinery investments in Indonesia are not seeing positive returns yet, ii) a fourth Indonesian refinery is in a different location, iii) the oleochemical division is active in M&A activities, but margins are under pressure, iv) end-FY15 FFB production is likely to post a small positive growth, v) not much land is left for planting, vi) production costs are up YoY, due to higher fertiliser costs, vii) stable property division earnings, and viii) new sukuk issuance and capex requirements.

Refinery investments in Indonesia not seeing positive returns yet. Over the last few years, KLK has invested some MYR150m in expanding its downstream footprint in Indonesia via three refineries, totalling 3,600 tonnes/day of capacity. This expansion was originally aimed at integrating KLK’s interests in Indonesia as well as to get around the change in export tax structure implemented in Sep 2011, which was kinder on exports of refined oil than CPO. Unfortunately, many palm oil players in Indonesia had the same idea, and in the last three years, refinery capacity in Indonesia has ballooned to an estimated 40m tonnes (from 27m tonnes previously). This, in comparison to Indonesia’s 30m tonnes of CPO production, has resulted in a refinery overcapacity of approximately 30%. As a result of intense competition for external CPO in Indonesia, refining margins continue to be negative at this juncture. KLK has not escaped this, as it recorded negative refining margins in 1HFY15 in Indonesia, although its Malaysian refineries are still recording small positive margins. We understand two of KLK’s Indonesian refineries are running at low utilisation rates of 40-50%, while the third refinery in Dumai (which is a 50:50 tie-up with Astra Agro Lestari (AALI IJ, BUY, TP: IDR28,337)) is not operating at this juncture. KLK’s Malaysian refineries are still running at decent utilisation rates of 60-70%. We have therefore lowered our capacity utilisation assumptions for the Indonesian refineries to 40-50% (from 50-60% previously) for FY15-16.

A fourth Indonesian refinery joint venture (JV) in a different location. Besides these three refineries, KLK also entered into a JV with IJM Plantations (IJMP) (IJMP MK, BUY, TP: MYR3.90) in Nov 2014, to establish a fourth refinery in Indonesia, this time in East Kalimantan. KLK will have a 63% stake in this refinery, while IJMP will have a 32% stake, with the remaining 5% will be owned by local individuals. We understand the size of the refinery will be 2,000 tonnes/day and will cost approximately MYR120m. KLK is more upbeat on the prospects of this particular refinery, as there are very few refineries in East Kalimantan currently, and this refinery will be sufficient to service both KLK and IJMP’s estates in East Kalimantan. We project this refinery to be up and running by FY17.

Oleochemical division active in M&A activities, but margins under pressure. Further downstream, KLK’s oleochemical manufacturing operations have also been expanding of late. Besides new acquisitions, KLK has also expanded its existing plants in Malaysia, Germany and Switzerland organically over the last few years. In Sep 2014, KLK acquired a Belgian surfactant manufacturer, Tensachem (140,000-tonne capacity), for MYR70m. In May 2015, KLK proposed to acquire Emery Oleochemicals’ operations (240,000-tonne capacity) in Germany for MYR162m. With these expansions and acquisitions, KLK’s oleochemical capacity is set to rise to an estimated 2.5m tonnes by FY16, up 50% from FY12. While KLK continues to see stable demand for its oleochemical products, with utilisation rates still running at 70- 80% on average, margins have been trending downwards, due to competitive disadvantages caused by low petroleum prices, which have made synthetic alcohol prices very competitive. EBIT margins for this division fell to 4% in 1HFY15, from a high of 7% in FY13. Management continues to cite a difficult operating environment going forward, which means EBIT margins could weaken further going forward. We therefore revise our EBIT margin projections for the downstream division down to 3.5-4.5% for FY15-17 (from 4.0-5.5% previously).

End-FY15 FFB production likely to post small positive growth. On the upstream front, KLK’s FFB production for YTD-May FY15 is flat YoY. Management expects FFB production to improve over the next few months as we head into the peak production season, and is targeting to end the year with a 3% YoY growth. Although this is slightly higher than our projected 2% growth target, we prefer to remain conservative for now. Although management highlighted that the weather is still slightly hot and dry now in its Sabah and Indonesian estates, it is improving, unlike the significant dryness seen during the El Nino periods. As such, management remains cautious on CPO prices in the near term, expecting prices to stay range-bound between MYR2,100-2,300/tonne for the next three months.

Not much land left for planting. In Indonesia, KLK estimates that it will only be able to plant up another 10,000ha of landbank over the next few years, due to issues like environmental moratoriums, among others. Planting this remaining landbank will likely be slow at 2,000-3,000ha per year, in line with our forecasts. Given KLK’s replanting schedule of a similar 2,000-3,000ha per year, KLK’s planted area is likely to remain relatively stagnant for the next few years. As for its 21,018ha of landbank in Liberia, management is still working on getting all the necessary environmental studies done before starting the planting process there. This is likely to only start in FY16.

Production costs up YoY on higher fertiliser costs. For FY15, KLK expects its CPO production cost to average close to MYR1,300/tonne, or an increase of 8.6% YoY. The increase is mainly due to higher USD-based imported fertiliser costs. This is in line with our projected 10% YoY increase in production cost for FY15. For FY16-17, we project production costs to increase 5-8% pa.Stable property division earnings. KLK’s property division is still holding steadily, although contribution from this division to group EBIT should continue to be small, at 5-7% pa. For FY15, targeted GDV remains at MYR200m. Take-up rates for its recent launches have dropped to about 50% (from 60-70% previously), although KLK has managed to preserve EBIT margins at an admirable 40-50%. New sukuk issuance and capex requirements. In April, KLK announced its plans to raise up to MYR1.6bn in a 12-year multi-currency sukuk. Management highlighted that this may be done in tranches, as it does not have any urgent need for the cash at this juncture. Other than the fourth Indonesian refinery and the recently-announced Emery Oleochemicals plant acquisition, KLK does not have any more major acquisitions or expansions in sight. As such, it reduces its FY15 capex guidance to approximately MYR700m (from MYR800m previously). This can be easily funded by its operating cash flow of MYR800-1,200m pa. As at end-Mar 2015, KLK had a very manageable net gearing level of 21%. We adjust our capex assumptions downwards accordingly for FY15-17.

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 Reducing earnings forecasts slightly. After reducing our Indonesian refinery utilisation rates, trimming our oleochemical division EBIT margins and lowering capex projections, we tweaked our FY15-17 earnings forecasts down by 3-4% pa. Valuation and recommendation Still a NEUTRAL. We lowered our SOP-based TP to MYR21.50 (from MYR22.00), post-earnings revision. We believe valuations are fair at this juncture and maintain our NEUTRAL stance on the stock. We also highlight that every MYR100/tonne change in CPO prices could affect KLK’s net profit by 4-6% pa.

SWOT Analysis

Company Profile

Kuala Lumpur Kepong (KLK) is an integrated plantations company with palm oil plantations landbank in Malaysia, Indonesia and Papua New Guinea. It also operates in the downstream manufacturing segment through its edible oil refineries and oleochemical businesses. In addition, KLK is involved in the property development business.

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Source: RHB Research - 6 Jul 2015