This article first appeared in The Edge Financial Daily on October 1, 2018

Kuala Lumpur Kepong Bhd
(Sept 28, RM24.96)
Maintain hold with an unchanged fair value (FV) of RM27.50: Our FV is based on a financial year 2019 forecast (FY19F) price-earnings ratio (PER) of 27 times. In the past five years, Kuala Lumpur Kepong Bhd’s (KLK) PER has ranged from a low of 19.9 times to a high of 28.5 times. The average PER was 24.9 times. We are keeping our FY18 net profit forecast for KLK. Our FY18 net profit forecast for KLK is 10.8% below the consensus.

We have assumed that KLK’s fresh fruit bunch (FFB) production would inch up by 2.7% in FY18 versus 10.8% in FY17. The group’s FFB rose by 1% in the cumulative 11 months of FY18. We believe that KLK’s FFB output would be stronger in the final financial month of September 2018, compared to the negative year-on-year growth of 3% recorded for September 2017.

Looking ahead, we have assumed that KLK’s FFB output would expand by 4%, underpinned by a 3% or 5,600ha increase in mature areas, in FY19. Indonesia is expected to drive the increase in the group’s FFB production in FY19. Indonesia accounts for about 51% of KLK’s annual FFB output. About 44% of KLK’s plantation land bank in Indonesia is located in Kalimantan, while another 41% is in Sumatra. The balance 15% of KLK’s palm plantations in Indonesia are in Belitung.

Barring any impairment or provision, we expect the earnings before interest and taxes (Ebit) margin of KLK’s oleochemical division to hover between 4% and 4.5% in 4QFY18 (3QFY18: 4%) on the back of a smaller fair value loss in foreign currency forward contracts and lower cost of refined, bleached and deodorised (RBD) palm stearin.

On the flip side, the price of palm kernel oil (PKO) is rising. According to the Malaysian Palm Oil Board, since June 2018, the average monthly price of crude PKO in Peninsular Malaysia has climbed by 7.8%, while the price of RBD palm stearin for local delivery has fallen by 6%. PKO and palm stearin are the feedstock used to produce oleochemical products.

We forecast KLK’s oleochemical Ebit to grow by only 7% in FY19 versus 164% in FY18. Going forward, we believe that operating conditions of the oleochemical industry would remain challenging. As KLK produces basic fatty acid products and not the high-margin specialised ones, the group faces more competition. The unit’s earnings rebound in FY18 comes after a slew of impairments and provisions in FY17.

The intense competition has driven down prices of basic oleochemical products in the European Union (EU). In China, selling prices of oleochemical products have been weak due to competition from imports. Due to an unfavourable tax structure, it is cheaper to import oleochemical products instead of buying those produced locally. KLK has about one million tonnes of oleochemical production capacity in the EU and 450,000 tonnes of capacity in China per year. — AmInvestment Bank, Sept 28