Wednesday, March 22, 2017 07.19PM / ARM Research
In contrast to the macro-induced sell-offs across the broad equities market in 2016, palm oil producers had a stellar year as policy changes in response to the FX pressures handed the sector a lifeline. Specifically, CBN’s proscription of FX access for palm oil imports changed sector dynamics as it provided a competitive edge in pricing for local producers over CPO importers. Accordingly, the sector reported stronger revenues and higher margins in the period which fueled the positive price performance over 2016 (vs NSEASI: -6%). In this report, we outline our views regarding the key drivers of 2016 performance and set out our expectations ahead of FY 16E earnings releases.
CPO Prices ascend as importers exit the supply picture: In the aftermath of CBN policy pronouncement regarding CPO imports, domestic prices surged 144% over 2016 to
N661.4/kg as importers who account for 29% of local supply cutback on imports.
Upward price movement inflates sector margins: While the upsurge in CPO prices drove sector revenue to a record high of
N22.8 billion, its impact was more pronounced on operating margin (+12pps YoY to 53%) as the largely domestic sourcing of raw materials and labour kept cost (COGS and OPEX) in check.
Low cost financing help moderate FX losses: Another positive policy handout for the sector was CBN’s renewed supply of concessionary loans, which given already weak naira outlook drove coverage companies to change the currency character of their debt. FCY borrowings as a share of total debt shrank 5pps YoY to 13.8% while total borrowing cost contracted 7% YoY over the review period.
Conservative on dividend payout despite record high earnings: Overall, reflecting robust top-line gains and financial efficiency, we estimate that core earnings should climb 108% YoY to a record high of
N8.1 billion in FY 16. That said, despite our strong view on earnings, we expect dividend payout ratio to come below trend levels as management of coverage companies guide to capacity expansion plans from retained earnings. We project Presco’s 2016E DPS of N2.02 to be higher than that of its domestic peer, Okomu ( N1.77).
Sector players remain cheap: Notwithstanding strong YTD price performance, we believe current pricing is yet to fully reflect the stellar earnings performance reported so far, but more importantly, the robust earnings outlook. Particularly, at 9.1x, the sector’s mean P/E remains cheap relative to trend levels (3 year: 11.4x, 5 year: 11.3x) and Bloomberg Africa peers (10.1x). Across our coverage, we prefer Presco due to its larger oil palm plantation (2015 mature area hectares of 10,949 vs. 8,671 for Okomu) and homogenous product mix, which makes it a greater beneficiary of improved conditions in the domestic CPO market. Accordingly, our FVE embodies a 46% upside from current pricing for Presco (
N68.84) relative to 40% for Okomu ( N67.43) and we have a BUY rating for both companies.
Table 1: Valuation Changes
Figure 1: Peer Comparison
Table 2: Relative valuations with EM peers
Local CPO Prices ascend as importers exit the supply picture
In response to the decline in FX reserves, following the collapse in crude oil prices, the CBN resorted to demand management by directly targeting selected imports with a list of 41 items exempted from the interbank FX market. Given the inclusion of Crude Palm Oil (CPO) in the list of banned items, the wider NGN depreciation at the parallel market and, to a lesser extent, recovery in global CPO prices deterred importers as cost of imports surged 73% YoY by our estimates. Given the mismatch between domestic CPO production (2016: 970KMT) and consumption (2016: 1470KMT), the pullback in CPO imports as importation costs tracked higher underpinned a steep rise in domestic CPO prices over 2016 (9M: +39% YoY, FY 16: +69% YoY). Unsurprisingly, reflecting the favourable pricing regime and modest volume growth (+8% YoY by our estimate), which stemmed from improved yields on matured plantation, CPO sales of publicly listed palm oil companies surged 50% YoY. The robust CPO turnover more than offset weakness in Rubber sales (-7% YoY) to drive overall top-line to a record high of N22.8 billion. Management of Okomu linked the lower rubber sales to decline in global prices as well as weaker production.
Figure 2: Trends in CPO demand and supply in Nigeria (KMT)
Figure 3: Palm oil sector revenue growth (YoY)
Figure 4: Trend in parallel market exchange rate and domestic CPO prices
Figure 5: Revenue breakdown
Positive for sector margins
Interestingly, impact of higher CPO prices was more pronounced on operating margin of the sub-sector (+12pps YoY) as the largely domestic sourcing of raw materials and labour underpinned subdued movement in both COGS and operating cost.
Figure 6: YoY growth in COGS and OPEX
Figure 7: Trend in Gross and EBIT margins
Low cost financing helps moderate FX losses
Given the elevated interest rate in the domestic environment as well as the long lead time required for CPO seedlings to develop into matured products (3-5 years), coverage companies had resorted to foreign borrowings from their parent companies to finance their expansion plans. However, owing to the weak naira outlook and more importantly availability of increased concessionary loans from the CBN, palm oil producers intensified the refinancing of their external debt, with foreign debt now constituting only 14% of total borrowings from 30% in 2014. Hence, despite a 55% NGN depreciation over the year, effective interest rate fell 94bps YoY to 10.2% translating to a 7% YoY decline in the borrowing costs. The foregoing combined with robust top-line gains underpinned sector’s core earnings increase by 93% YoY to N6.6 billion with earnings margin expanding 7.2pps YoY to a record high of 28.7%.
Figure 8: Breakdown of debt profile
Figure 9: Trend in earnings and earnings margin
Overall, despite the generally dour macro environment, systematic changes which inhibited competition as well as access to cheap financing bolstered the sector’s operating performance. Particularly, gains from higher product pricing, domestic sourcing of inputs, which limited losses from currency weakness, as well as cost containment impelled earnings. Accordingly, over 9M 16, our coverage CPO companies delivered 93% earnings growth with PAT margin up 7pps YoY to 29%. The improved earnings underpinned the strong performance of the share price of coverage companies.
Higher CPO prices to propel strong finish to 2016
Over the final quarter of 2016, domestic CPO prices surged a further 45% QoQ bringing average CPO price for the review period to N557/kg (+106% YoY). Furthermore, global rubber prices rebounded over Q4 16 (+53% YoY) following cartel like cuts by leading rubber exporters. Inputting the Q4 prices in our models, we project 97% YoY rise in sector revenues to N8.7 billion which brings FY 16 sales to N31.5billion (+56% YoY).
Figure 10: Palm Oil sector’s revenue growth (N’ billions)
Having tracked below trend levels over the first nine months of 2016 as management across Presco and Okomu deferred clearing activities to Q4 16 on greater than expected rainfall (9M 16: +20% YoY), we believe the dry season of Q4 would underpin elevated input cost in the period, which we forecast at N4.3 billion (+30.7% YoY). Similar sentiments surround our higher OPEX estimate for Q4 162 which we estimate at N2.0 billion (+110% YoY). The weighty YoY growth largely reflects sizable jump in Okomu where over accruals of OPEX over 9M 15 resulted in the company reporting an operating income of N436 million in the final quarter of 2015.
Figure 11: COGS to Sales ratio
Largely reflecting the sturdy revenue gains, Q4 16 core earnings should rise over threefold YoY to N1.7 billion. Overall, 2016 bottom-line is projected to come in at a record high of N8.1 billion3 (+108% YoY).
Figure 12: Trend in Palm-oil sector’s earnings
OKOMU OIL PALM PLC: Price action pumps up earnings
CPO price increase to drive strong 2016 sales close: 2016 has been a spectacular year for Okomu, with 9M 16 EPS already surpassing that of FY 15. The improved operating performance largely stemmed from higher CPO prices which drove overall revenue growth (+41% YoY), despite a 7% YoY cutback in rubber sales reflecting softer global prices and lower production. Over the last quarter of 2016, management noted a recovery in rubber prices and subsisting momentum in CPO prices. Consequently, we look for topline growth of 112% YoY as guiding to a strong Q4 16 and by extension FY 16E revenues of N15.1billion (+55% YoY).
Lower finance costs to mask higher OPEX over Q4 16: Following the scale down in foreign debt and increased drawdown of CBN single digit financing, Okomu reported 27% YoY cutback in net finance charges over 9M 16 to N228million. In our view, this pattern should continue over Q4 16 and should help mask impact of higher cultivation activities on cost lines (COGS and OPEX) over the last quarter. Particularly, management noted that labour constitutes the biggest chunk of cost, with the wage bill over 2016 negotiated only 5% higher despite inflationary pressures.
Mounting capex outlay to keep a lid on dividend pay-out: On balance, we think the higher pricing and benign finance costs should drive Q4 earnings 51% higher YoY, raising 2016E EPS to N5.05 (+83% YoY). That said, while Okomu’s record profit raises prospects of a return to bumper pay-out as in 2011-12, management guides towards using retained earnings to finance expansion plans which hints at a likely cut in pay-out ratio from trend mean levels (six-year average: 42%). Consequently, assuming a pay-out ratio of 35% (FY 15: 4%), we project FY 16E DPS at N1.77 which implies dividend yield of 3.7% on current pricing.
Catalysts: The subsisting FX ban on imported CPO at the interbank market leaves importers subjected to the vagaries at the parallel market. Hence in a situation where naira weaken further or global CPO prices resume a bullish trend, importers could be further deterred with cutback in domestic supply driving CPO prices higher. In addition to a potential currency weakness, bullish trend in global prices could see rubber turnover significantly higher than 2016 irrespective of the continued decline in production.
Valuation: Largely reflecting upswing in CPO prices, we revise our FVE for Okomu to N67.37 (vs. N49.78 previously), which implies a 40% upside from current pricing. Okomu trades at a current P/E of 9.95x (2016E: 9.50x) relative to 10.1x for Bloomberg African peers. We upgrade our rating on the stock to BUY (vs. NEUTRAL in previous communication).
PRESCO PLC: Producing palm-oil with glamour
CPO price boon drives top-line to record high: Presco, as the only integrated oil palm production company in Nigeria4 benefitted immensely from favourable pricing environment which underpinned a strong rise in both top-line and earnings. Importantly, Presco’s 9M 16 sales of N11.9 billion (+48.4% YoY) eclipsed previous sales peak of N11.3 billion in FY 12, buoyed by higher CPO prices and to a lesser extent modest volume growth, which we estimate rose 7% YoY. Given upward local price movement in Q4 16 (+106% YoY), we estimate Q4 revenue at N4.5billion (+85.1% YoY) which brings FY 16E sales to N16.4 billion (+57% higher than historical average).
Subdued cost movement buoys operating profit: In addition to the robust turnover, costs rose tamely over the period (9M 16: COGS: +3.4% YoY, OPEX: +37.8% YoY) reflecting economies of scale and deferral of cultivation activities to Q4 16. Consequently, operating profit blossomed, rising nearly two-fold (+86.5% YoY) with related margin expanding 11.4pps YoY to 55.8%. Ahead of the Q4 16 results, whilst operating margin should remain robust relative to trend level (31%), we expect upsurge in input cost (+62% YoY) to apply downward pressure, against the backdrop of increased clearing activities related to the dry season. Overall, we project an EBIT margin of 39.8% over Q4 16, bringing full year operating margin to 52% (+14.5pps YoY).
Higher Biological asset gains propels earnings: Another catalyst to Presco’s result is the upsurge in biological asset gains (+98% YoY to N4.4 billion) reflecting impact of higher CPO prices as well as improved yields on the company’s biological asset. This together with lesser finance charges (-27% YoY to N423 million) helped offset losses on foreign exchange translation (+92% YoY to N967 million). Having repaid all its outstanding external debt, the FX loss stemmed from dollar financing for the purchase of chemicals and fertilizers, equipment, and spare parts, all which according to management contributes 20% of its entire cost. Consequently, earnings surged 98% YoY to a record high of N6.8 billion.
Excluding the biological asset gains, PAT would have been 99% higher at N2.4 billion. Given flat movement in FX rate over Q4 16, which portends lower FX loss, as well as higher CPO prices which bodes well for biological asset gains, we project the final quarter’s bottomline to print at N1.1 billion (Q4 15 loss after tax of N1.1 billion) bringing full year earnings at N7.9 billion (+239% YoY, 2016E core earnings: +161% YoY to N3.3). We forecast DPS to rise 102% YoY to N2.02 using a four-year average dividend payout of 25%.
Catalysts: Bullish trend in global crude palm oil prices as well as further naira weakness could see local crude palm oil prices resume its upswing. This together with increased assess to concessionary borrowings from the CBN, which would result in the abandonment of expensive commercial loans could bolster earnings.
Valuation: Presco is trading at a current P/E of 8.27x (19.21x excluding gains from biological asset) vs. 10.1 for its Bloomberg Africa peers. Net impact of adjustments to our model result in upward adjustment in our FVE to N68.84 for the stock from N48.70 previously. Consequently, we upgrade our rating on the stock to BUY (vs. NEUTRAL in previous communication).