CPO Price Outlook
Since India imposed higher tariffs of 30% (from a previous 10%) on CPO imports in November, CPO prices has dropped from a level of RM2,700-2,800 to the current RM2,380 (a decrease of ~13%). However, it is important to note that the fall in CPO prices in RM is also largely attributable to the strengthening of the ringgit, which have increased to Rp3,562/RM from around Rp3,200/RM in November, an increase of 11.3%.
One of the causes for the resilience of CPO prices is that Malaysia decided to not charge an export duty for CPO for the period up to March 2018. In the short-term, there is a considerable downside risk in CPO prices due to:
- outlook of higher palm oil production in 2018 as the effects from 2015’s El-Nino cease
- Malaysia will implement export duties again
- India have increased import tariffs for CPO yet again from 30% to 44%
- Record harvests of soybean in Brazil (for the second year in a row) – meaning soybean prices are less likely to increase much this year
- In a technical point of view, CPO prices can go down to RM2,150.
However, CPO prices will be supported by a higher oil price (affecting demand for biofuels) and higher economic growth world-wide. The Saudi government will do whatever it takes to keep crude oil near $70 to get a good valuation for its Aramco IPO. Overall, I still believe CPO prices will remain weak throughout 2018.
Medium to Long-Term Outlook
Demand Side: Palm oil will remain an integral part of people’s lives, being used for: cooking oil, chocolate, cheap processed foods, soaps, biofuels. Palm oil as a percentage of world vegetable oil exports have been steadily increasing, and is expected to reach 60% of total vegetable oil exports. Demand dynamics for top palm oil consumers:
- Indonesia is expected to increase its palm oil demand, coinciding with economic growth as a developing country and more use of biofuels
- India’s palm oil consumption is expected to keep increasing with their economic growth as a developing country
- China has been steadily decreasing its palm oil imports for the past few years, as they prefer soybeans which they can process at home, and can be used as animal feed.
- EU – There have been many negative campaigns against palm oil in the EU, citing environmental reasons such as: land degradation, loss of biodiversity, burning of forests. The EU also plans to ban palm oil biofuel imports by 2021 citing that the land is better used for food production. This can dramatically reduce demand for palm oil, because EU is the top 3 importers of palm oil, and 46% of palm oil imports to EU are used for biofuel. (I personally believe growing palm oil is better for the environment, because you can produce much more palm oil (5-10x more) per hectare of land compared to other vegetable oils such as soybean, rapeseed, and sunflower. However, since the EU cannot grow palm oil, they would rather support their own farmers who can grow rapeseed and sunflower oil)
If the EU does go through with its palm oil ban, we can see a fall in overall demand for palm oil. The effects on palm oil should not be catastrophic, since demand from other countries should keep increasing.
Supply Side: Palm oil prices has been in a downtrend since its peak at RM3,800 in 2011. Coinciding with this, many firms are reluctant to do much new plantings, and decided to keep going with old plantations. In the coming years (probably around 2020), accelerated replanting will be required for the old estates, since a palm oil trees’s useful life is around 20-25 years (but can be extended up to 30 years). In a year with accelerated re-planting, I believe we can see negative supply growth of palm oil.
My Verdict: Palm oil demand can grow slower than expected if the EU decides to limit palm oil imports with the many negative campaigns on palm oil. However, for me, what’s important is the balance between demand and supply. After a long period of subdued palm oil prices, I believe many are more reluctant to invest in palm oil, and coinciding with the limited useful life of palm oil plantations, we can see negative supply growth in the coming years. If we see negative supply growth, I am confident of higher CPO prices which could reach RM3,000 in 2020 (In many ways, I see many similarities to the coal story where demand is decreasing worldwide due to environmental concerns. However, coal was able to rally in 2016-2017 due to the negative supply growth). In addition, with so many negative sentiments on palm oil right now, I believe the current CPO price has priced in a lot of negatives. Hence, I believe there are more potential upside stories.
Where should I invest my money?
So, we have shown that palm oil prices are likely to stay weak in the short-term, and should be stronger in the long-term. As a result, we would want to invest in a company which is a low-cost producer (to survive the current weak palm oil prices), but will also experience great production growth in the next 4 years to take advantage of the potential higher CPO prices due to the potential palm oil supply growth deficit. This criteria leads to Dharma Satya Nusantara (DSNG).
DSNG – A Low Cost Producer
Helped with a young plantation age of 8.6years (9.5 years for nucleus only), DSNG was able to achieve one of the highest ROE in 2017 among the listed palm oil companies in IDX at 18.5% (only losing out to SSMS at 19.5%, which has an average plantation age of 8.3years). However, if we only accounted for continuing operations (DSNG discontinued an engineering door business in 2017 with a loss of Rp83Bn), DSNG’s ROE would be at 21.5%, making it the highest return palm oil company. DSNG was able to produce such high returns in a relatively subdued CPO price environment due to:
- Young plantation age – Palm oil trees experience the greatest yields at an age of 9-14 years
- High Mill Efficiency and Effectiveness: with high OER (23%) and low FFA (2.96)
- Use of Financial Leverage – DSNG has a debt-to-equity ratio of 1.29. I believe having a high financial leverage is warranted for DSNG, given it is a low-cost producer (which reduces its operating leverage).
In 2017, DSNG had a cash cost of Rp3.87million/ton of CPO
With an FFB yield of 22.8t/ha, DSNG is one of the most efficient producers out there. To get high yields, it requires good management and good Standard Operating Procedures. DSNG has many experienced people in its management ranks. Its former President Commissioner, Benny Subianto, was the person who built Astra Agro Lestari, one of the most well-respected palm oil companies in the country. They also have Arif Rachmat (Triputra family) and Toddy Sugoto (Persada family) as commissioners, who are co-founders of Triputra Agro Persada, a palm oil plantation company with 160,000ha of planted area and 300,000ha total land area.
Meanwhile, with a palm oil tree age distribution as shown above, we should see production growth for the next 4 years.
As stated before, DSNG had an FFB yield of 22.8t/ha in 2017, a figure which I believe is not the maximum DSNG can achieve. Note that productivity of palm oil trees in 2017 has not fully recovered yet from El-Nino, and hence we should expect higher productivity in 2018. With a nucleus planted area of 60,500ha, this leads to a total nucleus production of 1.38million tonnes in 2017. If we also accounted for plasma estates (DSNG has 20,920ha of plasma estates), total production was 1.55million tons in 2017.
With a better weather, and thus a yield of 25.1t/ha (based on Class II soil yield), and a total mature area of 66,400ha, we can expect 2018 nucleus-only FFB production to be 1.67million tons, or a 21% growth YoY. Note that from 2011-2015, when the weather was conducive, DSNG was able to achieve a Class II soil yield. Hence, I believe I am not being too optimistic that DSNG can achieve a Class II soil yield in 2018. Meanwhile, with a young plasma estate, I forecast that plasma FFB production can increase to 200,000 tonnes in 2018. That brings total forecasted FFB production to 1.87million tonnes, a rise of +20.6% YoY.
In 2017, DSNG managed an average selling price (ASP) of Rp8.1million/ton of CPO. For 2018, with the downside risks mentioned before, I forecast a lower ASP of Rp7.8million/ton of CPO.
Earnings Forecast – CPO Division
DSNG has 2 divisions, the CPO division and Wood Product division. In the past few years, the Wood Product division has been reporting losses. However, I believe the wood product division will at least break-even from 2018 onwards, after discontinuing the Engineered Door business and consolidating its production plants to one area only (hence resulting in higher efficiency). Note that if we removed the Engineered Door Business from 2017 wood product division earnings, the division’s earnings would be positive.
As a result, I will form my earnings forecast based on the CPO division only, and attach a zero value on the wood product business (until we see more promising signs in the future). I forecast CPO prices at RM2,300 for 2018, and will rise to RM2,500 in 2019 and RM2,800 in 2020. I assume the current MYR/IDR exchange rate of 1RM=Rp3560 persists. I also assume an inflation of 5% p.a.
2018 Target Price
For the 2018 Target Price, I will use a 12x P/E multiple on 2018F earnings considering:
- DSNG’s 73,000ha unplanted area for future growth – which is a very prized asset as it is now difficult to get new land rights for plantations from the government. (Case in point: AALI)
- Continued production growth up to 2020 a certainty (unless it is due to external weather conditions)
- With CPO prices having been subdued since the 2011 peak, and the potential supply growth deficit, there is a high chance of higher palm oil prices (which I have built into my 2019F and 2020F forecasts) beyond 2018 which will further fuel high earnings growth.
- Best-in-class management – I believe DSNG should be similarly valued to AALI when they were in their prime, around 15x P/E, apart from the liquidity premium.
- Short-term downside risk for CPO prices in 2018, although it will be cushioned by higher crude oil prices.
This leads to a Target Price of 936, a 116% upside from the current price of 432 as of 30 March 2018. DSNG is currently trading at 5.5x 2018F P/E and 1.14x 2018F P/BV.
Key Risks to Target Price
- Weather – which will affect amount of FFB harvested
- CPO price – the above TP is based on a RM2,300 CPO price
- MYR/IDR – The above TP is based on a RM1=IDR3560 exchange rate
- Foreign Exchange Risk – As of 2017, DSNG has a net exposure of +GBP8.4million and -USD33million. A weakening of the Rupiah by 3% to GBP will increase net profit by Rp3Bn, while a weakening of the Rupiah by 3% to USD will reduce net profit by Rp10Bn.
- Interest Rate Risk – DSNG’s debt are all bank loans on a floating interest rate. However, the company believes a change in interest rates would not have a material impact on Profit or Loss.