This article first appeared in Corporate, The Edge Malaysia Weekly, on July 11 - 17, 2016.

SHARES of plantation companies staged a brief rebound in January as the El Niño weather phenomenon fuelled a rally in crude palm oil (CPO) prices. Now that El Niño has come to an end, will the coming of La Niña further improve the price of palm oil in the second half of the year?

According to the National Oceanic and Atmospheric Administration, there is a 75% chance that La Niña will develop by the end of the year, which could be a key catalyst for the CPO price. In a note to clients last week, RHB Research analyst Hoe Lee Leng says the leading indicator for plantation share prices to perform is CPO price movement.

“We believe that in order for share prices to perform, the leading indicator is usually CPO prices. If a strong La Niña occurs, history tells us that CPO prices will also react positively, as strong soybean prices — caused by drought in the US, Argentina and Southern Brazil — ought to pull CPO prices up,” she writes.

“[However], given the faster-than-expected retreat of CPO prices, we are downgrading the sector to ‘neutral’ from ‘overweight’. We continue to expect some price support for CPO in the near term on the back of the current low inventory levels in Malaysia and Indonesia.”

Hoe is of the view that Kuala Lumpur Kepong Bhd (KLK) is the best proxy play for rising CPO prices when La Niña materialises.

The integrated plantation company has palm oil plantations in Malaysia, Indonesia and Papua New Guinea. It is also involved in the downstream manufacturing segment through its edible oil refineries and oleochemical businesses. For the six months ended March 31 (6MFY2016), plantations contributed 63.3% to its pre-tax profit, followed by manufacturing (35.9%) and property development (0.7%).

In a July 4 report, issued after her company visit, Hoe says management expects fresh fruit bunch (FFB) output to improve in the second half of its financial year ending Sept 30 (2HFY2016), offsetting the 4.5% year-on-year drop in FFB output from January to May. All in, KLK expects to end FY2016 with flat to marginally positive FFB output growth and sees small single-digit growth in FFB for FY2017.

KLK is currently benefiting from the sale of more certified sustainable palm oil (CSPO) products as a result of IOI Corp Bhd’s suspension from the Roundtable on Sustainable Palm Oil’s certification scheme. The proportion of its total palm products sold with a CSPO premium has risen from 30% to about 50%, while its premium prices have increased from US$20 to US$25 per tonne to US$35 to US$40 per tonne.

“We like KLK as its more geographically-diversified land bank reduces the risk in extreme weather situations. Benefiting from its integrated facilities, KLK has been able to capture margins all the way down the value chain, even in periods of lower CPO prices. Its downstream facilities also continue to record improving margins, thanks to a continued increase in capacity utilisation and profitability at its Indonesian refining facilities. We highlight that every RM100 per tonne change in the CPO price could affect KLK’s net profit by 4% to 6% per year,” Hoe adds.

Kenanga Research also favours KLK, citing a positive outlook for its upstream plantation business and stable margins for its downstream refinery business while the downside is limited given its big-cap status. The research house, which has a “neutral” call on the plantation sector, has upgraded the stock to “outperform” after the company announced 1QFY2016 results on May 16.

In 1HFY2016, KLK’s plantation revenue jumped 38.3% year on year to RM4.3 billion while its manufacturing revenue increased 23.8% to RM3.6 billion. After stripping out a one-off gain on disposal of land, foreign exchange and derivative changes, the company’s core net profit improved 12.7% to RM478.2 million, largely driven by a 30.1% growth in revenue and improved manufacturing margins.

However, Bloomberg data shows that most analysts have a “neutral” recommendation on KLK, with 14 out of the 24 analysts covering the stock assigning a “hold” call, partly because of its premium valuations. The stock closed at RM23.20 last Friday with a market cap of RM24.73 billion, trading at a forward price-earnings ratio of 22.2 times. 

Nevertheless, more analysts are bullish on the stock with six analysts now giving it a “buy” call, up from just three a year ago.

“Among larger cap players, we view KLK as the key quality play, but this is reflected in its valuations, hence, we are ‘neutral’ on the stock. Supporting factors to our ‘neutral’ call, despite premium valuations, are its maturing Indonesian estates, value-added downstream operations, and strong financials,” remarks JP Morgan.

It says that about 45% of KLK’s total estates are in the young and immature category, located largely in Indonesia. The average age of the Indonesian estates is nine years, with a significant proportion maturing and moving up to peak maturity.

“In addition, its higher value-added oleochemical operations provide the group an edge downstream amid the competitive market, while we believe planned capacity expansion from 2.2 million to 2.6 million tonnes by 2016 in Malaysia, Europe and China will drive longer-term growth.

“KLK also has a healthy balance sheet with total net gearing of 27% in 1QFY2016 and positive free cash flow enabling future expansion or acquisition opportunities. US dollar debt accounted for 19% of total borrowings as at end-2015 versus 30% to 100% for its peers,” says JP Morgan. 

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