Downgrade to UNDERWEIGHT. For the first time in three years, we are turning negative on the plantation sector. Given the rising regulatory risks and slowing earnings momentum, we can no longer justify the large P/E premium accorded to the sector and downgrade it from Overweight to UNDERWEIGHT. Key de-rating catalysts are the softening CPO price outlook, lower crude oil price and higherthan- expected operating costs.
Regulatory risks underestimated by market. Regulatory risks for the sector have increased, which could limit earnings leverage to CPO price. If CPO prices continue to head higher, governments may levy higher taxes on planters to rein in inflation. There is also an increasing risk that biofuel targets may be scaled back.
Rising cost environment. Cost pressures on planters are on the rise as fertiliser price has more than doubled YTD. From our recent checks with Malaysian plantation companies, we gathered that fertiliser costs, which make up 20-30% of estate operating costs, have almost doubled YTD, adding around RM200-300 or 20-30% to the per tonne cost of production for CPO.
CPO price to peak this year. We think that CPO price will most likely peak in 2008 as the high prices in the past three years have spurred new plantings of oilseeds and curbed demand growth in low-income countries.
Cutting target prices across the board. We are cutting our earnings forecasts for all the planters under our coverage by 2-20% to account for higher operating costs and recent changes in windfall tax. We have also slashed our target prices by 12-39% to account for a lower target P/E and weaker earnings prospects.
Recommendation changes. In Malaysia, we are downgrading IOI Corp and KLK from Neutral to UNDERPERFORM while Hap Seng Plantations and Asiatic are cut from Outperform to NEUTRAL. Sime Darby remain an OUTPERFORM and our top pick for Malaysia. In Singapore, we have cut Wilmar from Outperform to NEUTRAL while reduced Golden Agri from Trading Buy to NEUTRAL and Indofood Agri from Outperform to UNDERPERFORM. In Indonesia, we have cut London Sumatra and Bakrie Sumatra from Outperform to UNDERPERFORM and reducing Sampoerna Agro from Outperform to NEUTRAL while maintaining an UNDERPERFORM on Astra Agro.
Sector comparisons
Background
Bullish on the sector for three years. We have been actively promoting the plantation sector for more than three years now (see sector update dated 11 July 2005) as we believed then that we were at the start of a CPO price upcycle. Along the way, we predicted that the price cycle would last longer than previous cycles due to the structural change in demand arising from biofuel and US transfat labelling issues. These have all panned out, thanks partly to record crude oil prices, some governments’ aggressive biofuel targets and adverse weather in some key planting regions.
Share prices have significantly outperformed the market. Over the past three years, the planters have been blessed with a perfect storm, i.e. the combination of positive structural changes in demand, supply deficits due to weather woes and favourable equity market conditions. As a result, plantation share prices hit new highs. The plantation stocks that we cover in Malaysia and Indonesia have delivered absolute returns of more than 600% over the past three years (refer to Figure 1 & 2). Singapore planters under coverage have also chalked up absolute returns of 30-106% since Feb 2007, when IndoAgri was listed (refer to Figure 3). The rising CPO price coupled with M&A activities have helped to propel some plantation stocks in Malaysia and Singapore to the ranks of the top five largest stocks by market capitalisation.
Figure 1: Share price performance of Malaysian planters against KLCI index from July 2005
Figure 2: Share price performance of Indonesian planters against JCI index from July 2005
Figure 3: Share price performance of Singapore planters against FSSTI index from Feb 2007
Reality check. Recently, we have come to the realisation that our overweight call on the sector is increasingly tenuous given the heightening regulatory risks, which could limit plantation companies’ earnings leverage to CPO price. We are of the opinion that it will be increasingly difficult for producers to pass on any increase in taxes to consumers when CPO output is increasing and inventories are building up. This, coupled with the three-fold rise in certain fertiliser prices from a year ago, will be a drag on plantation earnings in 2009. The P/E gap between the planters and the market has also widened due to the significant de-rating of regional markets over the past three months. The wide P/E rating may not be sustainable given our expectation of a decline in plantation earnings in 2009 due to lower selling prices and higher operating costs. In this note, we reassess the sector’s fundamentals for 2H08 and 2009.
Regulatory risks
Although regulatory issues are not new to the plantation sector, we believe that the market has not fully priced in this risk. We think that the plantation sector has reached a tipping point in terms of regulatory risk and this may limit planters’ earnings leverage to CPO price. Below, we discuss recent concerns and the potential impact of these regulatory risks on CPO price and earnings prospects.
Risks of higher export tax? In mid-Jun 07, the Indonesian government started raising the CPO export tax from 1.5% to 6.5%. Due to the low export price at that time, the additional tax worked out to be only US$26.5/tonne for CPO. In Sep 07, the government decided to impose a progressive tax of up to 10% to replace the flat export tax of 6.5% on CPO. In Feb 08, the export tax was raised from 10% to 25%, when international prices exceeded US$1,100 per tonne. Due to tight supply, the planters have at times been able to pass on the higher tax rate to consumers, translating into higher CPO prices in the international market.
However, we believe that it will become increasingly more difficult for producers to pass on the higher taxes in view of rising supply and high palm oil inventory in Malaysia. This means that future tax increases may have to be increasingly borne by the Indonesian producers. If CPO price continues to climb higher, there is a high possibility that the Indonesian government will raise the export tax rate. Furthermore, due to the current progressive export tax regime, when CPO price is in the US$1,100- 1,300 range, Indonesian planters do not gain from higher prices but have to bear fully the rise in operating costs.
Recently, the Indonesian government indicated that it is planning to revise the export tax to maximise revenue. It may narrow the range of base prices and tax rates so that the tax does not fluctuate wildly every month. Currently, export tax for palm oil products is adjusted every month according to movements in international price. Worst-case scenario, this could mean a flat export tax of 25% even at a lower CPO price range. This would be negative for planters.
Figure 4: Historical CPO export tax in Indonesia
Figure 5: Indonesia’s current export tax schedule for palm products
Windfall tax may rise with crude oil price? Effective 1 July 2008, the Malaysian government imposed a windfall tax to replace the cooking oil stabilisation scheme (COSS). The new taxes translate into a higher CPO tax for Peninsular Malaysia estates and lower tax collection from east Malaysian estates. There were subsequent modifications to the formula to exclude smallholders and to levy the tax on FFB instead of CPO and CPKO. Overall, the earnings impact on planters is not very significant at the current price. However, under the new tax formula, the Peninsular Malaysia players will be significantly worse off than the East Malaysian players if CPO prices rise (see Figure 6).
We continue to hold the view that the government is unlikely to raise windfall tax on CPO in the immediate term provided that crude oil price remains at the current price range. If crude oil price rallies to a new high in 2H08 and stays elevated, it may put more strain on the Malaysian government’s budget given that petrol price in Malaysia is subsidised at a crude oil price of around US$120/barrel. The government may have to tap other sources for revenue to fund the higher subsidies and this may raise the risk of higher windfall taxes on Malaysian planters.
Figure 6: Comparing new and old windfall tax schemes at various CPO prices
Biofuel policy at risk. Biofuel appears to be at the losing end in the food vs. fuel debate as it is increasingly being fingered as the key culprit in the rise of food prices. Recently, the Guardian newspaper uncovered a World Bank draft internal report, which estimated that the drive for biofuels has pushed food prices up 75%, in sharp contrast to the US state secretary’s claim of a rise of only 2-3%.
The implication is that biofuel will increasingly be viewed by the world as the chief cause of food riots, starvation and high inflation around the world. This may prompt governments around the world to curtail their biofuel targets, thereby reducing the growth in edible oils for energy usage.
It was reported that during the recent G-8 meeting in Japan, most prime ministers stated that a downward revision of biofuel targets is needed to bring down food inflation. Within the European governments, there is also increasing resistance to biofuel. In a recent vote, the environment committee in Europe requested that the share of biofuels in total transport fuel be lowered to around 5-6% in 2020 from the previous goal of 10%. Under this scenario, the demand growth prospects for edible oils will not be as rosy as earlier expected and this may dampen CPO price upside and sentiment.
Figure 7: Share of biofuel in edible oils consumption
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Food and others 94%
Biodiesel 6%
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Operating costs on the rise
Rising cost environment. Cost pressures on planters are on the rise as fertiliser price has more than doubled YTD. From our recent checks with Malaysian plantation companies, we gathered that fertiliser costs, which make up 20-30% of estate operating costs, have almost doubled YTD, adding around RM200-300 or 20-30% to the average per tonne cost of production for CPO, depending on the productivity of the estates.
Fertiliser, fuel and labour cost rising. The recent fuel price increase of 41% in Malaysia and 33% in Indonesia will raise transportation costs at estates as well as HQ costs. One planter estimated that this could raise its cost of production by as much as RM40-50 per tonne, which is equivalent to a cost increase of around 5%. However, other estate owners that we talked to have indicated a slightly lower cost increase. Bearing in mind the higher inflation rate, we also expect a higher rate of increase in labour costs, which make up 30-40% of operating costs. The bulk of the cost increases may not be felt in the current year as some planters have locked in at least half of this year’s fertiliser requirements at the rates prevailing at the beginning of the year.
Operating cost may rise as much as 30%, squeezing margin. All in all, we expect estates’ operating costs to rise by 20-30% in the current year and another 10-20% in the following year, assuming that fertiliser prices stay at around the current level. We are increasingly concerned about the cost pressures given that CPO prices are likely to peak this year and trend down next year. The combination of these factors will squeeze planters’ operating margins in 2H08 and 2009.
How are planters coping? All the listed planters we spoke to reveal that reducing fertiliser application is not an option as it could dampen future FFB yields of the estates. We understand that the planters are looking at more targeted application of fertiliser to reduce usage but this may increase labour costs marginally. Part of the increase in fertiliser costs could be absorbed by improved productivity at the estates.
Figure 8: Rising fertiliser prices (US$/tonne)
Figure 9: Rising fuel price in Malaysia
CPO price outlook remains intact
Expect average CPO price to peak in 2008. Our CPO price forecasts of US$1,105 (RM3,350 per tonne) for 2008 and US$1,090 (RM3,000 per tonne) for 2009 remain intact as CPO price still trades at an attractive discount of US$400 per tonne to its key competitor, soybean oil. Furthermore, consumption of edible oils is rising in China and India.
We are also maintaining our view that 3Q08 CPO price will be volatile and will trade within the RM3,000-3,600 range as rising demand ahead of festive events will offset the seasonally higher palm oil production season in Malaysia and Indonesia. We believe CPO price will most likely peak in 2008 as the high price in the past three years has spurred new plantings of oilseeds and curbed demand growth in lowincome countries. Our forecast of a crude oil price of US$120 per barrel in 2009 suggests that the current oil price of US$136 is unlikely to be sustained in the coming year, thus limiting the growth in demand for edible oils for energy usage.
Figure 10: CPO price forecasts
Figure 11: Widening price gap between palm and soya oil (US$ per tonne)
Valuation and recommendation
Lowering earnings estimates. We have re-looked at our earnings estimates for our universe of plantation stocks to account for higher fertiliser costs, fuel prices and Malaysia’s recent modification of windfall tax. Overall, we have lowered our EPS for listed planters under our coverage by 2-20%.
Earnings growth momentum to slow. We expect most planters to report lower earnings growth in FY09 as costs are expected to rise at a faster pace than selling price, resulting in lower margins. Overall, we expect the sector to report slower earnings growth in FY09.
… difficult to justify P/E premium over market. Over the past three years, we have been able to continuously justify a higher P/E rating for the plantation companies against the market in light of the rising CPO price and strong earnings growth momentum. However, we expect the earnings momentum to slow in the coming year. Furthermore, rising regulatory risk could limit the companies’ earnings leverage to future rises in CPO price. Hence, we find it increasingly difficult to justify the widening P/E premium, especially since the sector used to trade at a discount (see Figure 12).
Figure 12: Plantation P/E gap against market P/E
Lowering target P/E rating of planters. In view of the sharp de-rating of the equity markets, slowing earnings momentum and rising regulatory risks, we have scaled back our target P/Es by 1-4x though we continue to accord a premium P/E for the planters given the defensiveness of their earnings relative to other sectors. This has the effect of lowering our target prices by 12-39%.
Recommendation changes. In Malaysia, aside from policy risks and CPO price outlook, foreigners own substantial slices of the listed planters’ shares (see Figure 14). In view of the potential negatives, we are downgrading IOI Corp and KL Kepong from Neutral to UNDERPERFORM while cutting Hap Seng Plantations and Asiatic from Outperform to NEUTRAL. Sime Darby remain an OUTPERFORM and our top pick in Malaysia. We also advise investors to switch to stocks with high dividend yields. In Singapore, we have cut Wilmar from Outperform to NEUTRAL while reducing Golden Agri from Trading Buy to NEUTRAL and Indofood Agri from Outperform to UNDERPERFORM. In Indonesia, we have cut London Sumatra and Bakrie Sumatra from Outperform to UNDERPERFORM and reduced Sampoerna Agro from Outperform to NEUTRAL while maintaining an UNDERPERFORM on Astra Agro. We are also advising investors to switch from the plantation to the banking sector in Singapore and Indonesia.
Preferences within the sector. We continue to prefer Malaysian planters over their Indonesian counterparts in view of lower policy risks. However, our preference has shifted from pure planters to integrated or diversified planters whose earnings will be cushioned somewhat from CPO price declines. Among the purer planters, we prefer those which offer cost savings potential from mergers, i.e. Wilmar and Sime Darby.
Figure 13:
Figure 14: Foreign shareholding of Malaysian plantation stocks
Downgrade to UNDERWEIGHT. We are downgrading the sector from Overweight to UNDERWEIGHT owing to concerns over rising regulatory risks, slowing earnings momentum and the weak equity market. In view of these concerns, we can no longer justify the current large premium P/E rating accorded to the sector. Key de-rating catalysts are the softening CPO price outlook, lower crude oil price and higher-thanexpected operating costs.
Risks to our call. Adverse weather developments in key planting areas, higher crude oil price and more favourable biofuel policy could lead to higher-than-expected CPO prices. However, part of the CPO price increase will have to go towards covering higher fertiliser costs of at least US$60 per tonne of CPO and about US$10-30 per tonne increase in other operating costs in 2009. We are also of the view that we have reached a tipping point where any advances in CPO price would attract higher regulatory risks due to the inflationary concerns. Also, for planters to sustain the earnings growth momentum of the past two years, CPO price would need to increase by around US$300 per tonne (the average increase over the past two years), suggesting that CPO price would need to average around US$1,345 (RM4,300) per tonne for 2009, which we believe is a tall order.
filed: The grass is no longer green.pdf
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