SINGAPORE (Apr 29); Before the welcome relief in the form of thunderstorms towards the end of April this year, the weather was hot and dry. Meteorologists appear to be forecasting more hot and dry weather for parts of the Indonesian archipelago in the coming months. That is not good for palm oil production as yields could suffer, according to the Malaysian Palm Oil Board (MPOB).
“As a tropical plant, the oil palm requires an evenly distributed annual rainfall of 1,500mm to 2,000mm or more without a defined dry season,” says a research paper, “The Impact of Climate Variability on the Palm Oil Industry”, by the MPOB.
The best fresh fruit bunch (FFB) yields, from which crude palm oil (CPO), is obtained, are in places with temperatures of 22°C to 29°C and around five hours of sunlight a day. Because of these requirements, the oil palm tree is cultivated only in tropical parts of Asia, Africa and South America.
Meteorologists are expecting the formation of an El Niño climate pattern. The Asean Specialised Meteorological Centre announced on April 11 that its El Niño-Southern Oscillation monitoring system has moved to the “Watch” status from “Neutral” this month. “Model outlooks from international centres for 2H2019 show a wide spread of possible outcomes, ranging from a neutral to strong El Niño. The range of possible outcomes from model predictions can be expected to become narrower over the next three months,” the ASMC says.
Predictable demand, volatile supply
CPO prices are affected by demand and supply. Palm oil products are necessities, ranging from foods to soaps and moisturisers. Demand is predictable, but supply is not. Demand is likely to grow. In the short term, the World Bank is forecasting higher demand from China of 5.7 million tonnes for 2019, up 5% y-o-y, and from India, of 9.3 million tonnes, up 7% y-o-y. However, supply is affected by the vagaries of the weather and other natural disasters.
Supply may be affected by a prolonged drought from El Niño, which could temper FFB yields. Against this background, the World Bank is forecasting a rise in CPO prices this year, to US$601 (RM2,405) a tonne from an average of US$590 a tonne in 2018.
Almost in anticipation, selected plantation stocks on both sides of the Causeway have rallied in recent weeks. As at April 23, Wilmar International was up 16.6% year to date, Golden Agri-Resources gained 20% and First Resources rose 17.3%. Indofood Agri Resources, a small-cap stock, also rallied, but mainly because of an offer from its major shareholder Indofood Sukses Makmur — which owns 74.34% — to privatise it at 28 cents.
On Bursa Malaysia, Sime Darby Plantation (SDP) leads large-cap plantation companies with a 10.8% rise in share price this year. Other gains by the big Malaysian companies have been more modest. Genting Plantations is up 5.2%, Kuala Lumpur Kepong gained 2% and IOI Corp is almost unchanged since the beginning of the year.
Among the crop of companies, KLK is unique, as it holds its properties and plantations at cost, less depreciation. All the other companies carry their assets at fair value. Hence, KLK’s share price is somewhat stable. Based on price to net tangible assets (P/NTA), KLK is near the low end of a five-year range (see Chart 5).
KLK is also mechanising operations at its plantations to improve productivity. Among the mechanised tasks are the spraying of young immature oil palm trees with insecticide to combat the damaging effect of the rhinoceros beetle, and precision fertilising with machines. Another example of mechanisation is an in-house-developed FFB collection machine that collects the FFB from the trees and places them in roadside bins. KLK owns plantations in Malaysia, Indonesia and West Africa and has diversified into property development in Peninsular Malaysia.
Difficult to value
Among the issues that have arisen for plantation companies are those surrounding the valuation of assets. For the plantation companies in general, several factors affect the cash flow from the various assets such as plantations and mills. Fluctuations in CPO prices, production yields and outlook, inflation and exchange rates — CPO is priced in ringgit and US dollars — all affect the fair value of so-called biological assets.
For the Indonesian companies, discount rates used in valuation models are in the teens, mainly owing to perceived risk and Indonesia’s own risk-free rates.
To mitigate risk, several plantation companies have expanded overseas, mainly to politically less stable countries in West Africa. Liberia and Ghana have risk-free rates in the mid- to high teens, although Coast D’Ivoire’s risk-free rates are in the mid-single digit.
In addition to too many variables in assessing the net asset values (NAVs) of plantation companies, none of the companies have high dividend yields (see Table 1). Moreover, many of the plantation companies carry goodwill because they have been acquiring assets. Hence, our valuation charts use P/NTA and not price-to-book.
Among the acquisitions, KLK acquired Putra Bongan Jaya in April last year, adding to its total plantation hectarage (but its assets are valued at cost less depreciation).
On the other hand, Indofood Agri’s auditors have been reticent about commenting on the valuation and impairment required for the goodwill balance of IDR3,245.3 billion ($307.6 million), which arose largely from the acquisition of Perusahaan Perkebunan London Sumatra Indonesia (Lonsum). The market cap of Indofood Agri is just $391 million. Hence, its reported NAV of 79.6 cents may not be reflective of the company’s NTA and its true valuation.
Elsewhere, in order to stabilise earnings — and not be held hostage to the vagaries of the weather or politics — companies such as Wilmar and SDP have diversified to own the entire value chain of vegetable oils, from the plantation all the way to the supermarket shelf. Wilmar has further diversified into sugar while SDP owns rubber and sugar plantations.
Interestingly, SDP and KLK have R&D divisions that are researching genomes and epigenetics for higher-yielding, pest-resilient crops that can weather climate change.
At present, although Wilmar has the largest market cap among the plantation companies because of a more diversified business model, SDP is the world’s largest oil palm plantation company by planted area and certified sustainable palm oil (CSPO) production. SDP’s CPO production of 2.71 million tonnes (see Table 2) last year accounted for 4% of global CPO production of 70.46 million tonnes in 2017.
SDP is involved in the production and sale of oleochemicals, refined oils and fats, biodiesel products and derivatives to MNCs such as Nestlé and Royal Dutch Shell. SDP is 53%-owned by Pemodalan Nasional Bhd (PNB), a Malaysian government-linked entity.
Climate change versus rising demand
Unlike fossil fuels, which are in a structural decline, demand for CPO is likely to rise over the long term, as products made from palm oil are necessities. The largest consumers of palm oil products are in countries such as India, China and Pakistan.
According to global forecasts, by 2050, the world population is projected to reach 9.8 billion while global demand for palm oil is expected to be between 120 million and 156 million tonnes, accounting for 65% of all oils traded. To feed the world, palm oil is actually part of the solution, says SDP. According to the US department of agriculture, in 2018, world demand stood at 70.4 million tonnes compared with supply of 73.5 million tonnes.
With climate change, yields of FFB could be affected. In a recent report, OCBC Research has blamed the decline in Malaysian CPO inventories in March on El Niño. OCBC Treasury Research and Strategy is forecasting CPO price to average RM2,300 a tonne in 3Q2019 and RM2,400 a tonne in 4Q2019. “This would mean a 13% upside from current levels to 4Q2019, and [firmer CPO prices] are likely to support -CPO-related stocks as well,” OCBC says.
“However, do note that CPO prices are historically volatile and subject to factors such as weather (which impacts supply), politics (EU and Indonesia, Malaysia), regulatory policies (for example, Indonesia’s and Malaysia’s mandatory use of diesel containing locally produced biofuel), amongst other [factors],” the local bank adds.
It has “hold” recommendations on plantation stocks such as Wilmar and Golden Agri-Resources and says they are fairly valued. In Malaysia, Maybank-Kim Eng has “hold” recommendations on SDP and KLK, while CIMB has a “reduce” call on IOI Corp.
For Wilmar, though, and despite the unexciting analysts’ views, there could be a price catalyst. It is the largest producer of consumer pack edible oils in the world. In China, Wilmar has a 45% share for edible oils under its Arawana brand. In a recent report, UOB Kay Hian says: “Wilmar’s China IPO is getting closer and the market has started to factor in upside from rerating. Management is guiding [for] the listing [to be scheduled] in 4Q2019.”
The IPO is likely to be on Shanghai’s A-share market and the regional press is reporting that the market cap could be as high as US$12 billion. Wilmar’s market cap is around $23 billion (see Table 1).
