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DB: Potential 40% Upside From Top Palm Oil Producer
Aspire | 24 July 2015
By: Lim Si Jie
Articles (169) Profile

Analysts are anticipating a renewed bullish prospect for Crude Palm Oil (CPO) prices driven by structural supply tightness. The recent change in policies in Indonesia and US is expected to drive CPO demand while CPO production growth continues to fall. Deutsche Bank expects First Resources, one of its top CPO producer picks, to thrive in the current environment attributed to its strong management team and track record.

Indonesia Biodiesel Policy Creating Biodiesel Demand To Save CPO

Given the shorter-than-peers storage lifespan of CPO (six-12 months versus two years for oilseeds), CPO prices have always been at the mercy of others. The significance of CPO to Indonesia’s economy has led to a mandatory biodiesel usage policy to support CPO prices.

With the lack of strong demand from importing countries, Indonesia introduced mandatory biodiesel (B10/20) usage in 2012 where 20 percent of fuel has to be mandatorily replaced by CPO by 2020. While Indonesia had a disappointing start in 2012-2014, the government was determined to ensure the sustainability of the biodiesel policy.

If the biodiesel policy were successful, Indonesia would consume 9.4 million metric tonnes of CPO, representing 15 percent of world CPO production, based on analysts’ estimates. The initial teething pain is expected to be resolved as a higher CPO price is vital to Indonesia’s economy (the sector is the second-largest employer in Indonesia and contributes three to five percent of its GDP). B10/20 should lower global stock days by 15 to 20 days from 60 days.

US TFA Usage Ban To Boost CPO Demand

After a year of delay, there is renewed effort to enforce a country-wide trans-fatty acid (TFA) usage ban in the US. This will likely boost CPO demand as it is the cheapest alternative to a TFA-free solution. The potential spill-over effects on European nations also cannot be discounted.

CPO Production Growth Deceleration 

The annual incremental demand for vegetable oil has averaged five million metric tonnes since 2002 (excluding 2005-2008 when biodiesel demand rose strongly), with nearly 40 percent fulfilled by CPO, whose main supplier is Indonesia. The big four planters’ (AALI IJ, IFAR SP, GGR SP and WIL SP) new planting data poses a worrying trend, having fallen eight to 32 percent per annum since 2007.

Aggressive annual replanting at four to five percent (double the usual annual replanting rate) of planted area by Malaysian planters should further reduce near-term supply growth as it takes three to five years to reach fruition.

Analysts expect continued environmentalist pressure to slow down CPO output growth and are forecasting a modest production growth of around four percent for 2015-16.

First Resources: Strong Management Team And Track Record

Analysts highlight First Resources (FR) management team as the main factor that sets it above its peers. Its focus on cost control, both (Cost of Goods Sold) COGS and (Selling, General & Administrative Expenses) SG&A, and active capital management has ensured that FR weathers through the CPO down-cycles better than its peers. In particular, FR CEO’s compensation is tied to profit performance, demonstrating good corporate governance.

Maximizing Profits through Holistic Operational Planning

FR has expanded into refining and biodiesel in a timely manner to navigate through Indonesia government’s preferential revenue tax on processed-CPO, in order to maximise profitability. In 2012, FR escaped the CPO down-cycle as it forward sold its output at a higher price in 2011. The forward sale is a strong demonstration of risk management exercise as FR did not sell beyond its internal output. Had the CPO price gone against FR’s forecast, it would only have lost opportunity cost.

Transparency and Active Capital Management

First Resource Geographical presence

Source: First Resources Annual Report

FR is a rare breed amongst the Indonesian planters that report monthly production data. As such, there is little room to disappoint on earnings as the only unknown factor is cost. While FR’s operation is based in Indonesia, its management actively seeks the cheapest capital options to fund its growth outside of Indonesia.

FR has been authorised to issue Islamic Medium Term Note (MTN) in Malaysia, enabling it to enjoy the recent MYR depreciation and lower interest rates. Its effective interest expense rate has reduced to five percent since FY10.

Deutsche’s current price target of $3 is pegged to 20x PE on FY16E EPS to account for potential earnings upside led by a likely CPO rally.

Recommendation: TP $3, BUY

Si Jie is no stranger to investing having started his journey at a young age. He is heavily influenced by acclaimed investors such as Benjamin Graham, Peter Lynch, and John Rothchild.

Please click here for more information about this author.

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