We believe Sime Darby (Sime) is fairly-valued at this juncture, given its diversified earnings base, which makes it difficult to perform in line with higher CPO prices. Maintain NEUTRAL with a revised SOP-based TP of MYR7.70 (1% upside). This implies an EV/ha of USD19,000. Although this is lower than its big-cap peers of USD30,000-40,000, we argue that this is justified, given that Sime is a much more diversified company, with only 40-45% of its earnings coming from the plantation division.

Not all pistons firing. Despite higher CPO prices and an anticipated slow recovery in the industrial division, we believe Sime’s earnings would continue to be held back by the still-sombre outlook for the motor and property divisions. We cut FY16 (Jun) earnings by 8% and tweak FY17-18 forecasts upwards by a slight 2-4%. We lift our SOP-based TP to MYR7.70 (from MYR7.60), after raising Sime’s plantation division target P/E to 20x (from 19x), in line with its peers. This implies an EV/ha of USD19,000. Although this is lower than its big-cap peers of USD30,000-40,000, we argue that this is justified, given that Sime is a much more diversified company.

Higher manuring and replanting costs. Despite a stronger-than-expected recovery in FFB production from Indonesia, Sime’s 1H earnings disappointed due to higher replanting and manuring costs during the quarter. This is part of Sime’s strategy to combat the El Nino impact as well as to rejuvenate its age profile (currently averaging 14 years).

Key briefing highlights

Core net profit was down 27% YoY in 1HFY16 on a 5% rise in revenue. All divisions – except for the energy & utilities (E&U) division – recorded lower YoY earnings, due to higher throughput at Weifang Port. The plantation division saw a 29% YoY decline in EBIT due to lower CPO prices offset by higher FFB production, while the motor division continued to see lower profits due to start-up losses in Taiwan and lower sales volumes in Malaysia. The heavy equipment division continued to see weakness, with 2QFY16 EBIT being the weakest quarterly contribution ever from the merged entity listing. Key briefing takeaways: i) Sime revises up its FFB production target to a growth of 11% YoY in FY16 (including New Britain Palm Oil Ltd (NBPOL)), iii) CPO costs rose due to higher manuring and replanting costs, iii) better prospects for the heavy equipment division in 2HFY16, and iv) asset monetisation plans.

Raising FFB output guidance. In 1HFY16, Sime recorded an increase in FFB production of 15%, mainly from contributions from its NBPOL acquisition, which contributed some 749,000 tonnes of FFB, or 13% of group production, as well as a recovery in the Indonesian estates, which grew 14% QoQ in 2QFY16. Management has raised its FFB production target for FY16 to an increase of 11% from an increase of 5-6%, due to the improvement seen at its Indonesian estates. However, management continues to expect the El Nino to have a negative impact on Malaysian estates, projecting a reduction in output of about 5% YoY. In total, Sime expects FFB output for FY16 to be around 10.7m tonnes. Accordingly, we revise our FFB growth numbers to reflect an 11% increase for FY16 (from 5%), followed by a 5-6% growth for FY17-18 (unchanged).

Higher manuring costs. Sime’s unit production cost was MYR1,490 per tonne in 2QFY16, up 7% QoQ from MYR1,390 per tonne in 1QFY16, due to higher manuring and replanting costs during the quarter. In 1H, Sime applied 60% of its fertiliser requiremets for the year (vs 40-45% in 1HFY15), as it was preparing for the onset of the El Nino, when manuring would not be able to be done effectively. As such, manuring costs rose 37% YoY in 2Q16. Going forward, this should moderate, given that only 40% of requirements remain to be applied in 2H.

Heavy replanting underway. As for replanting, Sime intends to rejuvenate its trees by replanting 5% of its planted areas in Malaysia and 7% of its areas in Indonesia pa. In 1HFY16, Sime replanted 17,000ha out of its total target of 21,000ha for FY16, at a total replanting cost of MYR159m. For FY16, Sime is expecting to spend as much as MYR414m for replanting. By 2020, Sime is targeting to have 30% of its areas replanted, to bring its average age down to 12 years from 14.5 years currently. It currently expenses out its replanting costs to the P&L immediately, which explains weaker profitability of this division in 2QFY16. However, management is likely to adopt the new accounting policy (IFRS41) within the next quarter or so, which would enable it to capitalise its initial replanting expense, and only start amortising it when it becomes mature. This will bring down the total cost relating to replanting charged to the P&L, given that additional depreciation cost would be lower than the replanting cost.

Raising production cost assumptions. Until such time that this is implemented, we will continue to assume an immediate charge-out of replanting expenses. Management is targeting to reduce its unit cost to MYR1,400 per tonne for FY16, which is higher than its previously-targeted MYR1,200 per tonne. As such, we raise our unit production cost assumptions for FY16 to reflect a unit cost of MYR1,400-1,450 per tonne (from MYR1,350-1,400 per tonne previously).

Better prospects for heavy equipment division in 2HFY16. Management continues to see better prospects for the heavy equipment division in 2HFY16, on the back of some new contracts secured recently, as well as improving demand for coal, with exports in Queensland up 4-5% YoY, and lower cost structures (Sime has cut 1,812 staff since 2014). Orderbook stood at MYR1.6bn in December (down from MYR1.8bn as at end-September). Based on this positive tone, it is likely that Sime expects the weak earnings in 2QFY16 to be the bottom, with more upside to come in the coming quarters. As this is in line with our projections, we are leaving our forecast for this division unchanged. Asset monetisation plans. Sime had previously mentioned its plans to monetise its assets within the next six months. We understand the likely scenario would be a structure where Sime would sell some of its property assets into a private fund, in which it would own a 25-30% stake. The fund could be co-owned by one or more joint venture partners. With this structure, the fund could buy or sell property assets not within the Sime group of assets, which would help generate recurring income in the form of rental yields and the like. The assets being considered include three Singapore commercial assets and 13 Australian industrial land assets. Based on its study done, the yield for such structures in Australia could be as high as 6.5%, while in Singapore it is about 3.5%.

With this sale, Sime is targeting to net MYR1.5bn in cash which would help pare down its debt. This, together with the MYR2bn sukuk raised recently, would help bring down Sime’s current net debt to 54% by end-FY16 from 63% currently.

Risks Main risks include: i) a convincing reversal in the crude oil price trend that results in a reversal of CPO and other vegetable oil prices, ii) weather abnormalities resulting in an oversupply or undersupply of vegetable oils, iii) a change in the emphasis on implementing 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 Earnings forecasts lowered. After adjusting for higher FFB production and higher unit production costs, we reduce our earnings forecast for FY16 by 8% pa, while our FY17-18 forecasts are tweaked upwards by a slight 2-4%. We highlight that every MYR100 per tonne change in the CPO price could affect Sime’s earnings by 4-6%. Note that Sime is not lowering its MYR2bn net profit KPI target at this juncture, expecting earnings to catch up in 2HFY16 from the plantation and property divisions.

Valuation and recommendation Maintain NEUTRAL. Post-earnings revision, we lift our SOP-based TP minimally to MYR7.70 (from MYR7.60), after raising Sime’s plantation division target P/E to 20x (from 19x), in line with its peers, This implies an EV/ha of USD19,000. Although this is lower than its big-cap peers of USD30,000-40,000, we argue that this is justified, given that Sime is a much more diversified company, with only 40-45% of its earnings coming from the plantation division. We maintain our NEUTRAL recommendation on the stock. Despite the positive impact of potentially higher CPO prices, we believe Sime’s earnings would be held back by the still sombre outlook for the heavy equipment, motor and property divisions, on the back of unexciting coal prices and weak consumer sentiment.

SWOT Analysis

Source: RHB Research - 25 Feb 2016