Kuala Lumpur Kepong – Fully valued, but just for now

January 12, 2009 at 4:54 am Leave a comment

• Plantation old timer. Kuala Lumpur Kepong has a long and illustrious history as a palm oil plantation company in Malaysia and has, since incorporation, expanded its business downstream and into other businesses like retail and property development. The company is helmed by Dato’ Seri Lee Oi Hian who has been CEO since 1985. From its peak in Feb 08, the company lost some 92% off its share price and as we issue this report, the stock has made a decent comeback from its low of RM6.75 seen in October last year.
• 216,548ha of land with 78% maturity profile. KLK has a total hectarage of 216,548ha spread amongst Peninsular Malaysia (32%), Sabah (19%) and Indonesia (predominantly Kalimantan 49%). Of this area some 69% is planted area and some 78% is matured hectarage. Of the remaining 21% immature acreage is mostly from new plantings in Indonesia. That said growth going forward would be predominantly driven by plantations in Indonesia. Downstream, the Group has some 1,012 per mt of milling capacity and 2,000 mt per day of refining capacity.
• Healthy estates. KLK’s yields are generally healthy amongst its peers at 23-25mt/ha (higher without immature hectarage in Indonesia) and they achieve an OER of 20.5-21% on average.
• Crabtree & Evelyn the only hindrance. The group has a long standing reputation for efficiency and good management practices however despite this; the retail segment has been a drag on earnings for years now. Looking forward, we believe the Group intends to place more focus on the segment to bring it back into profits. On other segments, property is expected to have a soft year ahead given the state of the property industry.
• Initiating with HOLD. We initiate our coverage on KLK with a HOLD call citing a target price of RM9.90 using a discounted cash flow valuation methodology (KLK’s WACC is 9.13%). We make our HOLD call with the idea that at current prices, we see that downside is limited but there are
no major catalyst that would push the stock price back to 2007 levels in the coming 12 month term. The market has already recognized that FY09 will be a bad year and bought in on the potential recovery which has happened over the week. We deem the recent recovery in CPO prices to be necessary but possibly premature as more negative economic data is expected in coming months.

Company Brief
Kuala Lumpur Kepong (KLK) has a long and illustrious history (since 1906) as a palm oil plantations & rubber plantation company in Malaysia and has since incorporation, expanded its business downstream and into other businesses like retail and property development. The company is helmed by Dato’ Seri Lee Oi Hian who has been CEO since 1985. He is also director at Yule Catto & Co Plc, a UK listed company that KLK has an 18.8% stake in and is deemed connected to KLK’s holding company, Batu Kawan Berhad. A recap of recent corporate activities of the group in reverse chronological order include:-
• October 2008 – Proposed additional 17% acquisition of PT Sekarbumi Alamlestari (PTSA) for an estimated RM45m of which the company already owns 48%. PTSA has 6200ha of planted land in Kabupaten, Kalimantan and intends to acquire an additional 5200ha in a neighbouring area.
• October 2008 – applied for another deferment of its US300m convertible bond issue.
• May 2008 – Consolidated acquisition of Ladang Perbadanan Fima which had a fully planted hectarage of 8171ha in Peninsular Malaysia and of which remaining shares were purchased for RM153m. The company now adds some 3-4% of group FFB output.
• March 2008 – disposal of 60% equity interest in KL-Kepong Cocoa products resulting in an RM86.5m gain on disposal from the RM256m sale to Swiss company Barry Callebaut (BC). The company continues to be held at associate level as KLK then entered into a JV with BC of which it holds 40% and is involved with sourcing supplies of cocoa beans from West Africa while BC handles the manufacturing side of the business.
• November 2007 – Purchase of Chinese oleochemical company for some RM13m. Operations are located in the Jiangsu province and the company contributes to <5% of the Group downstream business.
• September 2007 – Purchase of Uniqema (Malaysia) SB for RM67.7m. The company has a 100,000mt pa fatty acid and soap noodle capacity as well as 15,000mt pa production of fatty acid esters.
• February 2007 – Acquired 22,400 ha of plantation land in Indonesia.
• November 2006 – New mill with 120mt/hr starts production in Kluang, Johor.

Plantations – Upstream
KLK has a total hectarage of 216,548ha spread amongst Peninsular Malaysia (32%), Sabah (19%) and Indonesia (predominantly Kalimantan 49%). Of this area some 69% is planted area and some 79% is matured hectarage. Of the remaining 21% is mostly immature acreage from new plantings in Indonesia.
As for milling capacity, total Group milling capacity equals to 1012mt per hour which comes up to an estimated 8m mt of FFB processed per annum based on a 90% utilisation expectation. On average the Group achieves an oil extraction rate at 20.5-21% hence total CPO output per annum approximated 1m mt. As for refining capacity, KLK has some 2000mt per day in Malaysia but no refining plants in Indonesia.
KLK’s production costs ranks similarly amongst its peers at an estimated RM1100 per MT of which up to 30-40% of that consist of fertilizer costs and the second bulkiest item being transportation which makes up another 20%. This figure also includes all taxes paid like the windfall tax, export tax, and FFB cess. Currently, Indonesian plantations bring up the Group’s production costs as the bulk of the trees are still immature. Excluding Indonesia, the Group is actually able to achieve some RM900 per mt costs in Malaysia. As for forward selling policies, KLK doesn’t have a formalised policy buy practices a 3-6 month formula depending on CPO prices.
To note, besides palm oil, the Group is also the largest rubber estate owner in Malaysia with 19,584 ha of rubber estates in Peninsular Malaysia and a production of 22, 942mt/pa as of FYE07. Rubber contributes some RM200m to revenue per annum and made good profit with a 45% margin last year. Going forward however, margins are expected to decline given weaker rubber prices.

Plantations – Downstream
KLK’s palm oil downstream business can be considered one of the largest in the world for oleochemicals especially with the realization of 2 major acquisitions. First is Kolb of Switzerland (consolidated starting March 2007) and Uniqema Malaysia. All in, KLK has some 1m mt production capacity of oleochemicals per annum. Plants of the group are located in Switzerland, Netherlands, China and Malaysia. Products produced by the Group include oleochemicals like soap noodles, fatty acids and plastic additives. Through Kolb, the group produces non-ionic surfectants for the paper industry as well as other derivatives for the personal care and cosmetics industry, textile industry and coatings. Over the past 2 years, the Group has been pushing forward its focus on oleochemicals hence the shutting of its rubber glove business (Masif Latex) and disposal of 60% equity in KL-Kepong Cocoa. Going forward, they have indicated interest in expanding further their oleochemical business in terms of capacity and and also through acquisition. Margins of the segment are generally on the low side given the nature of the business
where feedstock makes up the bulk of the costs. Margins are expected to stabilise going forward as feedstock costs have come off significantly and more importantly, are seen stabilising. To note, 3Q08 earnings saw a significant dip despite CPO prices at the time owing to an impairment to subsidiary Davos Life Sciences (RM74.1m) as well as a writedown of investment in Yule Catto (RM53m), a UK listed coatings manufacturer.

Retail – Crabtree & Evelyn
The Group’s retail business, Crabtree & Evelyn has always caused a drag on Group earnings. Besides that, their earnings are subject to heavy seasonality and generally only pick up in 1Q for the Group which is during the Christmas festive season. Usually the earnings made in that season sustain the following quarter’s losses on a yearly basis. Speculation has been rife on KLK selling off the Crabtree &Evelyn franchise and manufacturing business but it has yet to happen for some years now. In any case given the condition of earnings currently, the Group would not likely be able to get an ideal valuation for the company. So in stead, KLK has been working on trimming expenses in the business as well as rebranding and launching newer products and this restructuring process has already been ongoing for some 2 years now. The Group notes a pick up of sales in the Asian region but the dip in sales from EU, UK and US has offset this increase. 2009 looks like a year further more bleak for the segment given global economic weakness that has
increasing spread to Asian countries.

Property Development
The property segment now only takes up a very small portion of total group earnings as can be seen from the past 8 quarters. Going forward, the Group plans to slowly roll out its Desa Coalfields project in Sungai Buloh which comprises of 230 ha of mixed residential developments. Besides this, they also have a 50:50 JV with Kumpulan Sierramas for the illustrious Sierramas project also in Sungai Buloh.

Plantation Sector Outlook
Due for a recovery (excerpt from our sector upgrade dated 8th December) The industry will 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 12 below, the industry appears to be approximating the end of the peak production cycle and yields are already beginning to taper off. Indeed, the peak production cycle has been stronger and longer this time around due to heavy planting done over 2001-2002. Yields still 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, 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 (figure 14) 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.

Exports could be choppy in the near term
In terms of exports, there has been some reported recovery over the month of December (and November before that) but not enough to cover the production increases. Independent cargo surveyor has so far reported a promising 25% increase in exports for December. As these numbers usually make for good indicators, we can expect a rise in exports come the January release of MPOB data. Following months however, things are uncertain given poor global economic conditions from major importing countries. 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 starting November 2008 with prices averaging RM1546 and then averaging RM1566 in December. And due to a high amount of aggregate open interest in futures trading, CPO prices averaged up to RM1775 in the first few days of this year (see figure 22 behind report).
We are also on the view 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.

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 price recovery
China’s imports of edible oils have been driving the industry for some years now given the country’s growing population, increasing per-capita 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 17 below, this has well been the case and could continue to plague the industry. .
We compare quarterly GDP with quarterly Malaysia exports to China and find that the supposed peak quarter 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 policies 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 19 below confirms this. Besides this, initiatives to meet with fertilizer traders to set price ceilings for imported fertilizers is also in progress.
• 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. We are on the general belief that with the holding back of placing in forward orders, traders will eventually have to clear stock at lower levels.

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 some of 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.

Expecting RM1,850 average for 2009 and RM2,300 average for 2010
For FY09, we are expecting KLK to have the lowest CPO price average amongst peers due to their September year end. Sime and IOI’s year averages benefit from the still strong 3QCY08 where most companies hit average prices of RM2,800 and above due to some forward selling while KLK’s FY starting in September, missed the quarter high. Earnings for the year are indeed expected to be only lukewarm because of this despite that there would be some FFB production growth of 3-5% from the Indonesian plantations. That said, CPO prices have made a good start to this year closing above RM1,900 as of 7th Jan.

Valuation and Recommendation

Initiating Coverage with a HOLD. TP RM9.90
We start our coverage on KLK with a HOLD citing a target price of RM9.90 using a discounted cash flow valuation methodology (KLK’s WACC is 9.13%). 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.
We make our HOLD call with the idea that at current prices, we see that downside is limited but there are no major catalysts that would push the stock price back to 2007 levels in the coming 12 month term. The market has already recognized that FY09 will be a bad year and bought in on the potential recovery which has happened over the week. We deem the recent recovery in CPO prices to be necessary but possibly premature as more negative economic data is to be seen in coming months. Also, the key reason for CPO prices trending up currently is that aggregate open interest is at very high levels on CPO futures trade.
In term of earnings prospects in a nutshell, we see that KLK would naturally suffer a steep drop over 2009 but then record strong growth over 2010 due to a better CPO ASP achieved. We expect also that the Group would be able to maintain their FFB yields of 22-23mt/ha even in low production periods due to trees coming into maturity in Indonesia. As for other segments, manufacturing segment should continue to see flattish low margins as long as CPO prices do not fluctuate wildly. Also, the retail segment is slated for another tough year given the economic conditions of main operating markets US and EU. Rest assured that the Group is beginning to place more focus to bring the Crabtree & Evelyn chain into profits. Property Development is expected to have a difficult year given the conditions of the property market. All in all, FY09 is a trying year for KLK especially if compared to FY08 so the focus will be on earnings recovery in 2010.

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Deepening Trade Contraction in November Supports At Least Further 50bps of OPR Cuts in 1Q09 8 January 2009 Newz Bits

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