Plantations – It is Darkest Before Dawn

December 10, 2008 at 8:10 am Leave a comment

Production numbers have not come off yet, but seasonality effects are set to kick in the coming 3 months hence easing the pressure of high stock levels. On exports, we see choppy numbers coming through before demand kicks back in along with economic health of importing countries.
Governments and companies have come together to help bring the industry back to healthier times but while their initiatives might be a tad delayed, it should nonetheless help swiften the recovery. We believe that it is going to continue to be a rough ride in the coming 3-6 months before CPO prices see the light of day hence our very apt title of this report.
After tweaking our 2009 CPO expectations down from RM2,300 to RM2,175 as well as moving on to DCF valuation methodologies, we continue to see many conviction BUYs amongst our coverage. We believe that current market conditions warrant a good opportunity to cherry pick at severely sold down CPO stocks hence we are upgrading the sector from Neutral to Overweight. Top picks are Sime Darby, IOI and Asiatic.

CPO PRICES, due for a mild recovery
Back in August we were fishing for a bottom for CPO prices as they continued to plunge on a daily basis. However at around the RM1,500 per MT level, we believe that we are either at/near the bottom considering how things have been holding up. Looking as historical CPO prices as per figure 2, prices have hovered at the RM1,500 level for some 24 months (July 2004 to July 2006 hence forming a type of support price for CPO. But operating conditions then (over 2004-2006) and now are distinctly different in that operating costs of planters has gone up significantly. Besides that, CPO has been spun into the whirlwind that is commodity trading and as a result it has been closely pegging crude oil and diverging with the USD as opposed to only tracking its substitute, soy. Besides that, the emergence of biodiesel efforts have gotten many to believe the interconnectedness of CPO – a food commodity with crude oil – a transport/energy commodity. Also new developments like the Trans fatty acid issue have cast new light over CPO in recent years.

From looking at 10 years of CPO prices, we found that the 10 year historical average price for CPO is RM1,695 per mt. From 1998 to 2003, prices averaged RM1,447 per mt and from 2003 to YTD, prices have averaged RM1,992 per mt. CPO prices have historically stayed below the RM2,000 level as can be seen above coming off a high in 1998 up until early 2007. It would appear from the chart that a 10 year cycle has come and gone and we are likely to see prices go into a 5 year lull again. But based on fundamental changes to the industry, we are bent on believing that CPO prices will find a new, higher level to comfortably trade at in coming months.

Correlations
We decided to find out what CPO prices were most closely related to over the past year using a simple correlation function. Our finding show that CPO prices (we used MPOB daily prices) tend to correlate the strongest with soybean oil futures prices (BOZ8 Cmdty) while the correlation was less strong when tested with crude oil prices. Soy however, appears to have a stronger relation to crude oil as compared to CPO prices, likely due to the advent use of soy for biodiesel input. Further to this, we tested both these oils using the Granger causality test and are able to deduce that it could be the changes in CPO that are playing a part in influencing soybean oil prices. We figure this could be the case considering that CPO is in terms of volume of production and exports much larger than soybean oil.

We believe that the lower correlation in CPO and crude oil could be due to recent activity only where, by way of figure 4 above, there appears to be some mild decoupling of CPO and crude oil. Whether this will prolong or fall back into pattern is anyone’s guess but we believe that the two cannot be too highly correlated due to different nature and uses of both commodities. That said, CPO futures prices over 3&4th December fell further again hence this would likely be reflected in MPOB prices when released.

Also, stock prices and CPO prices, naturally, prove to have a strong correlation except for Sime Darby with the weakest. This is likely due to the conglomerate nature of Sime Darby. This is also seen in Boustead where correlation is slightly lower than the rest.

Soy fundamentals – different from CPO, but still not favourable
In any case, statistics aside, we nonetheless still need to keep up with the on goings of CPO’s closest substitute. Last month, Oil World warned that oil seed prospects in South America (SA) were deteriorating due to unfavourable weather (particularly in Argentina) in their now crucial planting season. To note South America accounts for some 53% of world soy output and the remainder largely covered by North America where there has been no production issues and harvesting season has almost come to a close. This would be a pertinent change as soybean output from the SA region has been on an uninterrupted growth path for some 6 years now. However, on 2nd Dec, Oil World again reported that rainfall has been seen in drought stricken parts of Argentina and has replenished soil moisture and improved growing conditions. However, there is still a risk of production coming in below expectations because of the prior unfavourable weather which resulted in lower than expected plantings.

The credit crisis has also worsened things for Southern Hemisphere plantings. Without funding, it was reported that many farmers in Brazil have stopped paying debts so that the banks have partly seized farm machinery, bring fieldwork to a stop on certain farms. Besides this, for existing crops, lack of funding could lead to the lack of fertilizer application and spraying to defend crops against the Asian rust fungus. Besides this, with the plunge in commodity prices it was read that Argentina and Brazil reduced exports over the September and October period and this will likely be the case for November data as well as farmers hold back selling. As a response to this, it is reported that shipments from the US have increased instead.

Overall, soy stocks have grown only modestly and do not compare to the over stock situation that is happening with CPO (see figure 7 below). Soy instead suffers from a more severe demand/consumption dip than CPO and this is also expected going forward. We believe this to be the case as soy is now significantly more expensive than CPO by some 33% (this has increased from a discount of only 17.6% at the beginning of 2008) hence from a food consumption point of view, the substitution effect comes into play. Besides this, it has been reported that soy used for biodiesel might come out below Oil World estimates largely due to the exclusion of Soya oil based biodiesel by Germany in coming months. Following this, many biodiesel producers have suffered due to the credit tightening in the US leading to lower biodiesel output. Also, with the advent of low crude oil prices, the argument for biodiesel becomes somewhat less relevant.

But wounds take time to heal…
Now, we have recognized that should CPO prices recover, so would stock prices given the high correlation. Also, we have come to know that at this point of time, CPO would have a price advantage towards soy and the substitution effect could already be in place given the poor demand for soy. Besides this, correlation indicated that we could finally be seeing a mild decoupling from crude oil prices hence demand and supply factors for oil seeds would come into clearer play should fundamentals improve. Besides this, it could be the case, based on the causality test, that CPO doesn’t need improvement in soy fundamentals to see the light of day and in fact, could be the leading indicator. We now discuss some very basic fudamentals that point towards some eventual recovery in CPO prices.

Seasonality effect coming through soon – production to dip
The industry might soon be able to breathe a sigh of relief as over the coming 6 months, FFB production is set to come off as per seasonality. Looking at the very pertinent figure 9 below, the industry appears to be approximating the end of the peak production cycle and production and yields are expected to taper off significantly soon. Indeed, the peak production cycle has been stronger and longer this time around due to heavy planting done over 2001-2002. Yields continue to be high at the moment but not as high as was seen in Sept04 and Sept06 when FFB yields hit 1.97 mt/ha. To note, October saw the industry hit an all year high yield of 1.9mt/ha but production scaled ahead to see an all time high of 1.65m mt. For the full year of 2008, we expect that the industry would achieve production of some 17.5m mt which is almost 11% higher than production in 2007.

Following the oncoming dip in production, it would indicate that stock levels would also come off and return to more reasonable levels in the 1.5-1.7m mt range. We believe that this would similarly be the case for Indonesia although they still expect production growth on a YoY basis as was reported in the media recently. As on total stock levels of Malaysia, Indonesia and Thailand, numbers reported are that levels exceed the 6m mt mark currently. With Indonesia having carrying the bulk of stocks at an estimated 3m mt.

What about exports?
In terms of exports, there has been some reported recovery over the month of November as measured by cargo surveyors SGS and Intertek. SGS reported a 15% increase in shipments for 1-25th November and cited the increase was led by shipments to China (27.4% increase) and Pakistan (29% increase). Intertek on the other hand reported a 12% growth in shipments so far for November. As these numbers usually make for good indicators, we can expect a rise in exports come the December release of MPOB data.
Looking into the longer term outlook; the recent slump in exports of CPO is led by the significant drop in CPO prices as buyers waited to get better pricing. This occurred in the unfortunate form of defaults and contract deferments which led to a further unwinding of CPO prices. Then of course came the credit crunch and buyers the world over were hit by difficulties in getting LCs for the import of palm oil. With this dramatic episode now behind us, we have seen some stability in prices come through in November. MPOB CPO prices actually staged a mild recovery in November by 10.4% and prices averaged at RM1528 per mt during the period.

We are also on the views that demand for a food commodity cannot be held back for a prolonged period of time. After all, in good times or bad, realistically, consumption needs to continue. The only problem of course, is that it is probably at a slower pace in the space of time where economies are weak. To note, exports over 2008 have continued to see healthy YoY growth of 11.6% YTD.

Looking into historical export trends to major destinations as shown in figure 13 above, we can see that 2008 has been a little different in terms of export growth leaders. Exports to India, Pakistan and the US have picked up significantly during the year with percentage growth of exports to the US itself picking up by 24.1% while exports to India staged a 46% recovery. Exports to the EU saw a decline likely due to environmental issues with palm oil plantations while China would at best show flattish growth YoY despite that it has been the major leader in terms of growth for the past 10 years. We believe that going forward, there could be more prominent exports to the US as the non-trans fatty acid legislation becomes formalised in more states and amongst more food producers. However, it is undeniable that the industry is hugely dependant on China to sop up production.

China could prolong CPO’s recovery
China’s imports of edible oils have been driving the industry for some years now given the country’s growing population, increasing percapita income and hence voluminous propensity to consume. We had concerns initially that our CPO exports to China could come off more should China’s economy suffer a hard landing. Or that even a soft landing could warrant a slow enough demand that could offset the dip in production and looking at figure 15 below, this has well be the case.
We compare quarterly GDP with quarterly Malaysia exports to China in the figure 15 below and find that the supposed peak quarter in 2008 is significantly slower than 2007’s peak quarter. Export numbers tend to be the strongest leading up to the end of 3Q and then dipping sharply over 4Q. Hence we are actually fairly concerned over exports numbers in the coming 6 months. This is especially so since that China is expected to report another quarter of softer GDP numbers. Looking at the chart that matches China’s GDP to CPO prices, there appears to be a lag effect in CPO prices. This continued to hold true especially so in 4Q08 where prices have averaged at RM1620 so far compared to RM2764 over 3Q08. Hence we wonder if in 1Q09 numbers come in weaker, CPO prices could actually see more downside, before finally recovering.
On the flipside, the substitution effect argument crops up again. China has had many strong years of growth and in recent times of economic weakness, there could finally be more switching from soy to palm oil given the huge discount hence slightly offsetting seasonal effects of CPO imports coming off after the 3Q.

Government & industry Initiatives – small efforts could urge things along
We believe that government initiatives taken so far would be able to help the industry along and perhaps magnify/speed up the recovery process. Just to recap some of these initiatives:-
• Biodiesel mandates. Malaysia expects that the B5 diesel mandate will ease some 500,000 mt of CPO from stock levels by 2010 As for Indonesia; they expect that their biodiesel industry would be able to mop up 1.5m mt by 2010 by bringing up the blend to 2.5% to 5%.
• Replanting efforts. Both Malaysia and Indonesia are going forward with formalising replanting and also offering incentives for companies to replant. In Malaysia, the Government is paying planters RM1000 per hectare to replant areas >25 years old. The area to replant is 200,000 ha and upon completion, would take off a maximum of 600,000mt of CPO by the end of 2009 (based on our parameters of a 15mt/ha ffb yield and 20% OER). Indonesia is also pushing ahead with
replanting efforts but on a smaller scale of 50,000 ha over 2009.
• Lowering fertilizer prices. The Government had issued a 15% cut to fertilizer prices to ease margin pressure of plantation companies. This was argued vehemently within the industry that the cut was not substantial enough as fertilizer prices (the crude oil derivatives especially) had come off more significantly that 15%. Figure 17 below confirms this.
• Group of 6 companies take matters into their own hands. Given only the small cut by the Government, 6 companies had come together to discuss initiatives to take to achieve lower fertilizer costs and guard their margins. This included regulating the use of fertilizer up to holding back on purchases in the near term to put pressure on fertilizer suppliers.

And on the exporters’ side, India has put in a 20% import tax on all soy imports and this could help along CPO imports given a bigger price differential. Notably, as we have seen in our discussion on exports above, CPO exports to India have picked up significantly of late.
We believe this again to be the substitution effect in play. Also, most Indian imports generally come from Indonesia and there could have been some switching last 2 months before Indonesia decided to completely scrap their taxes.

RM2,175 per MT for FY09, RM2,300 per MT for 2010.
Going Overweight.

So now comes the crucial part in setting a reasonable and achievable CPO price average for 2009. Before, we had set an average of RM2300 but due to the stronger than expected production numbers coming on as well as the credit crisis issue that led to problems with exporters hence we see a slower recovery in CPO that would probably only take place in the second half of next year. For 2010, we maintain our RM2300 average price but for 2009, we are bringing down the average to RM2175. Naturally, for companies with June/September year ends, they would be bearing the brunt of the low in CPO prices.

As for costs, we are maintaining our estimates of RM1100-RM1300 per MT as we expect that fertilizer costs would come off in coming months hence making 2008 costs levels well achievable in 2009. Looking into the changes made above, we have moved IOI, Asiatic, TSH and Kim Loong into DCF valuations while Sime Darby and Boustead remain as sum of parts valuations. We believe DCF to be a fairer method of valuing plantation companies given that PE valuations would be somewhat arbitrary with current market conditions and consistent volatility in stock prices and the market PE. DCF naturally would judge the company by its ability to generate cash flows which is of prime importance now. For most companies, target prices have come off except Asiatic due to their aggressive planting in Indonesia that would increase their planted hectarage by some 50% upon completion. To note, we have used a 20 year period to reflect the useful life of a tree and note that most WACC’s are >10% given high beta’s seen in all stocks currently.
Despite the downgrades to 2009 earnings across the board and changes to valuations, we note that most stock continue to trade at a discount to our target prices. We strongly believe that when CPO prices improve, even marginally, so will all stock prices. Therefore we note that now and coming months would be a good time to accumulate. Hence we are going from Neutral to Overweight on the sector.

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Sime Darby 1QFY09 : Too early to tell… Telecommunications Weekly Review: 1st – 7th December 2008

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