Our visit to Lahad Datu, Sabah with clients was an eye-opening experience, as we saw first-hand the impact of the 5-month dry spell on palm oil trees, where there were many trees with multiple unopened spears, signalling tree stress. We believe this could have a negativeimpact on FFB production in Sabah particularly from 1H16 onwards, which could trigger an upward CPO price movement. We make no changes to our NEUTRAL sector recommendation.

The Lahad Datu experience. We recently took clients to Lahad Datu,Sabah to visit a few plantation-related facilities, including KL Kepong’s (KLK) (KLK MK, NEUTRAL, TP: MYR21.50) refinery – KLK Premier Oils,Genting Plantations’ (GP) (GENP MK, BUY, TP: MYR11.50) palm oil estate – Genting Sekong estate and its CPO mill – Genting Trushidup mill, GP’s biodiesel plant in its Integrated Biorefinery Complex as well as the Palm Oil Industrial Cluster (POIC) in Lahad Datu.

POIC Lahad Datu – an interesting place. Overall, it was an interesting trip, as we learned about the situation of the prolonged dry spell in Sabah particularly in Lahad Datu, saw lots of action at the refinery and mill operations of KLK and GP, gained some understanding about GP’s biodiesel operations in Sabah, and appreciated the vastness and business opportunities offered by the POIC in Lahad Datu.

Long dry spell in Sabah spells trouble for FFB production. The biggest takeaway from this rip was the on-the-ground evidence of the dry weather in Lahad Datu and Sandakan, which have not seen much rain for the last five months. We believe this dry weather phenomenon could start affecting the productivity of large plantation players in Sabah more significantly from 1H16, given the normal more severe 12-month impact, which could, in turn, trigger an upward CPO price movement. Companies like GP, IJM Plantations (IJMP MK, BUY, TP: MYR3.90), IOI Corporation, Felda Global Ventures (FGV MK, NEUTRAL, TP: MYR1.60) and Hap Seng Plantations (HAPL MK, NR), amongst others, could experience disappointing productivity from their Sabah estates next year.

Maintain NEUTRAL sector call. Overall, we maintain our NEUTRAL rating on the Malaysian plantation sector, with a preference for the less expensive Indonesian and Singaporean plantation sectors. IJM Plantations remains our Top Pick in the Malaysian plantation space, due to its strong FFB production growth, which should somewhat help offset the effects of the current sober CPO price environment.

We recently took clients to Lahad Datu, Sabah to visit a few plantation-related facilities, including KLK’s refinery – KLK Premier Oils, GP’s palm oil estate – Genting Sekong estate and its CPO mill – Genting Trushidup mill, GP’s biodiesel plant in its Integrated Biorefinery Complex, as well as the Palm Oil Industrial Cluster (POIC) in Lahad Datu.

Overall, it was an interesting trip, as we learned about the situation of the prolonged dry spell in Sabah particularly in Lahad Datu, saw lots of action at the refinery and mill operations of KLK and GP, gained some understanding about GP’s biodiesel operations in Sabah, and appreciated the vastness and business opportunitiesoffered by the POIC in Lahad Datu.

KLK Premier Oils refinery Our first stop was the KLK Premier Oils (KLKPO) refinery, which is a 450,000-tonne pa refinery sitting on 8.8 acres of land. This refinery is situated 2km from Lahad Datu town and is serviced by KLK’s palm oil estates nearby in Tawau (20,954ha) and Lahad Datu (19,399ha). KLK generally only sources 30-40% of its required CPO for this refinery from its own estates, with the rest coming from external sources. Given KLKPO’s average utilisation rate of close to 90% currently, we estimate approximately 240,000-280,000 tonnes of CPO coming from external sources annually.

This plant has obtained Roundtable on Sustainable Palm Oil (RSPO) and International Sustainability and Carbon Certification (ISCC) certifications, and is sometimes able to sell RSPO-certified refined oil at a premium of USD100/tonne, when there is demand. However, in order to ensure the entire process is RSPOcertified, KLK would also need to ensure its external CPO also comes from RSPOcertified sources, which would require it paying a USD65/tonne premium to the CPO millers. We believe this could be a contributing factor for its impressive performance, as we were pleasantly surprised to find that KLK’s refinery is currently making decent profits, with operating margins of MYR20-30/tonne, given the current competitive environment.

While we were impressed with KLK’s efficiency at its KLKPO refinery, we make no changes to our earnings forecast or NEUTRAL recommendation on the stock, as we believe valuations are fair at this juncture. Our SOP-based TP of MYR21.50 remains unchanged. We highlight that every MYR100/tonne change in CPO price could affectKLK’s net profit by 4-6% pa.

Genting Sekong estate and Genting Trushidup Mill Our next visit was to GP’s Genting Sekong estate and Genting Trushidup mill, which took us about 1.5 hours in travelling time from Lahad Datu town. The first thing we noticed as we were travelling on the road was the abundance of unopened spears on the palm oil trees as we drove past the estates belonging to IOI Corporation (IOIC MK, NEUTRAL, TP: MYR4.40), TSH Resources (TSH MK, BUY, TP: MYR2.57) and FGV, amongst others. This signifies that the weather has been dry and that the treesare likely to be facing stress and producing fewer fruits.

When we got to Genting Sekong estate, we also sighted very similar looking trees with many unopened spears. GP’s general manager in charge of its entire Sabah plantation operations confirmed our suspicion that Lahad Datu was facing a water shortage, with minimal rainfall being recorded over the last five months of the year. This water shortage is also being experienced in Sandakan, although Lahad Datu’s shortage has been more severe. Our checks with the Malaysian Bureau of Meteorology confirm that rainfall in these parts of Sabah has been 60% below average over the last few months. Given this scenario, GP’s estate manager expects FFB production at Genting Sekong estate to come in below expectations, possibly recording a decline of as much as 10-15% YoY for FY15. We highlight that GP’s YTD-July FFB production is still up 1.9% YoY, although about 20-30% of GP’s FFB production comes from its Indonesian estates.

At the estate, we saw the use of buffalos to collect the fruits, which helps to reduce labour requirements. We also witnessed a harvesting demonstration, a centralised weevil hatchery, and empty fruit bunch applications, amongst other. Genting Sekong estate is 3,037ha in size and has an average age of 15 years, so the trees are all very well-developed and tall, bearing admirable FFB yields of about 25.8t/ha (as at FY14).

Source: RHB Research - 14 Aug 2015