Description

This is an idea for the new inflationary world we find ourselves in. We like United Plantations Bhd (UPL), which trades on the Bursa Malaysia. As a palm oil plantation owner, it is a direct beneficiary of rising palm oil prices. The company is debt-free and attractively valued at trailing valuation multiples of 13.6x P/E, 7.6% FCF yield, and a 6.4% dividend yield. UPL also generates consistently double digit ROE and ROCE which is top decile for the industry based on public peers. Because of the company’s hedging strategy, we believe its income statement has yet to reflect the rising palm oil prices in 2021, let alone the recent surge in 2022. We believe using spot palm oil prices the stock would be trading at around 5-7x P/E. This is very compelling compared to the stock’s average P/E over the past decade of 15x.

Palm Oil Market

Palm oil is one of a number of commodities which have recently experienced supply shortages and sharp price increases. In fact nearly all edible oil prices are rising sharply including soybean, palm, sunflower, and rapeseed. Not surprisingly, these edible oil prices are correlated as they can sometimes be substituted for one another in domestic and industrial cooking applications.

Why are palm and other edible oil prices soaring?

• Soybean oil production has been negatively impacted by droughts in South America, especially Brazil, Argentina, and Paraguay which account for 50% of global production. Soybean crops from these countries are estimated to be down around 10% compared to last year’s crop.

• The Russia-Ukraine war has cut production and shipments of sunflower oil, which is primarily produced in Ukraine

• Palm oil production has fallen modestly the past two years in Malaysia because of migrant labor shortages due to Covid-related travel restrictions. Moreover, there was flooding of palm plantations in parts of Malaysia in December 2021

•  New land for palm oil production is relatively difficult to find now in Malaysia and Indonesia due to ESG concerns

• Rising use of hydrotreated vegetable oil (HVO) for biodiesel, such as palm oil in Indonesia, is reducing production volume available for edible oils

On top of these issues listed above, the Indonesian government has been attempting to control domestic prices of cooking oil since the beginning of 2022 to keep consumer price inflation under control. First, the government tried setting domestic price caps in January. Then, the government added a domestic market obligation (DMO) for Indonesian palm producers to sell 20-30% of production domestically in February. These initial measures were not effective and the government scrapped the DMO in March and added steep export levies on palm export. This again proved ineffective so on April 25 the government announced a complete ban of palm olein exports to begin on April 28. Our understanding is that palm oil producers can still export raw palm oil and refine it in other countries if they can find refining capacity. It is unclear what effect this will have once implemented and whether it can achieve the government’s goal of keeping domestic cooking oil prices in check. But it seems likely that the policy will create additional upward risk for palm oil prices.

Indonesia accounts for 59% of global palm oil production and 33% of global edible oil export volumes so if strictly enforced, the export ban is likely to have a material impact on international edible oil markets. Even if the Indonesian government backs down from these policies, we think the other factors driving prices higher may remain intact for some time to come. 

United Plantations (UPL)

UPL is a Malaysian-Danish plantation company established in 1906. The company is focused on the cultivation of palm oil and coconuts with a cultivated landbank of 63,000 ha, or 243 square miles. UPL has 10 estates in peninsular Malaysia (71% of the landbank) and two estates in Central Kalimantan, Indonesia (29%). It is one of the larger medium-sized Malaysian plantation companies.

UPL also owns subsidiaries involved in downstream edible oil refining and producing specialty fats based on certified sustainable palm oil. The downstream operations have averaged around two-thirds of external sales but less than 10% of operating profit in recent years. From an earnings perspective, this is largely an upstream plantation operation. The group is 49.98% owned by the original Dutch founding families via their holding company, UIE Plc listed in Denmark, and some additional family holdings.

UPL generates more than 80% of palm oil production volume in Malaysia. The company therefore should stand to benefit much more from higher global palm oil export prices, than it stands to suffer from potentially lower domestic Indonesian palm olein prices. If current global palm oil prices stay steady around MYR 7,000/mt, we estimate that UPL’s realized prices could increase more than 40% and earnings may increase by at least as much in 2022. Of course there are a lot of unknowns including what future policies the Indonesian government pursues, where palm oil prices trend for the rest of the year, and how much of 2022 production UPL management has already hedged and at what price.

Q1 2022 Results and Hedging Activity

It should be noted that the recently released Q1 2022 UPL results were somewhat disappointing. Although sales increased 60% y/y, operating profit declined 16% y/y and EPS declined 20%. This was blamed on CPO hedges entered into at lower prices, with the losses booked in the downstream palm oil processing segment during the quarter. We don’t believe this means that hedging losses will offset all the potential gains from higher palm oil prices this year. The same thing happened in Q1 2021 and the company went on to report 30% full year earnings growth. 

To quote management in the Q1 2022 earnings release, “These hedging losses realized through buybacks of earlier sold BMD CPO futures will be reversed through higher contribution in the coming quarters in a similar manner as last year as the delivery of finished goods are sold at current market prices but produced with significantly lower raw material prices (CPO) purchased earlier in connection with UP’s forward sales. Nevertheless, due to the large inverse in prices between the spot and future month contracts, contribution has been reduced somewhat. The current refinery results are not reflective of the underlying business and it is expected that the results of this segment for the full year will be better than 2021.”

Shareholder Return Policies

UPL management has adopted a 70-80% dividend payout via regular and special cash dividends. The company also has a share buy-back mandate of up to 10% of shares outstanding which it may use if the share price is weak. Unlike some commodity companies, we believe shareholders of UPL will benefit from the boom times.

Please note that UPL goes ex-dividend MYR 0.85 on April 28, 2022.

Valuation

UPL is currently trading at a trailing P/E of 13.6x and P/B of 2.6x. Both of these metrics are in-line to lower than average 10-year historical valuations for the stock. Moreover, we expect strong earnings growth in 2022 as UPL’s realized CPO price rises closer toward the spot market price of MYR 7,400 per MT. The spot price is currently more than double UPL’s 2021 realized price of only MYR 3,300. While we don’t expect UPL to achieve spot price on CPO sales this year due to the hedging strategy and portion of production in Indonesia, we think the company’s realized price is likely to rise more than 50% and earnings are likely to grow by a similar or higher amount. Therefore we estimate that UPL is trading at a mid-single digit P/E ratio on 2022 earnings.

ESG

While this stock probably won’t be found in many ESG portfolios, it does seem to check the boxes as a sustainable palm oil producer and ranks highly on a relative basis within the industry. It was the first plantation company to be certified by the Roundtable on Sustainable Palm Oil (RSPO) in 2008, and today 77% of its plantation land area is RSPO certified. The company also has its own strict policies of No Deforestation, No New Planting on Peat, and No Exploitation. UPL also maintains an 8k hectare conservation area in Indonesia which accounts for 41% of the total concession area in the country. 

 Risks

Input Cost Inflation: UPL’s input costs are rising including energy, fertilizers, chemicals, and building materials. Nevertheless we think that margins have scope to increase because of the strong rise in palm oil prices and operating leverage which should occur despite inflationary pressures.

Labor Shortages: Guest workers comprise 85% of the Malaysian plantation sector workforce and we believe the ratio at UPL is similar. Covid-19 and related migration challenges created labor shortages in 2020-21 and these will likely continue to some extent in 2022.

Hedging: Management's hedging strategy is somewhat opaque and it is possible that hedging losses detract more from profitability this year than we expect. This might obscure the underlying earnings power of the business in the current environment.

Indonesian Operations: It is uncelar how the Indonesian policy changes will impact the profitability of UPL's Indonesian operations this year. We like the company for its predominantly Malaysian operations but it is possible that Indonesia will create a larger than expected earnings drag due to government policies.

Catalyst

Further squeeze in palm oil prices

Strong earnings growth for the rest of 2022

Share buybacks