By ARM Research,
Weaker CPO prices dim sector outlook
Following the H1 18 results and our recent discussion with Management, we update our assessment of the palm oil sector and outlook for Okomu and Presco. In the wake of weakening global crude palm oil (CPO) prices and relative stability in the naira at the parallel market, domestic CPO prices have trended lower with passthrough on margins and earnings of our coverage companies. We also look at the current market dynamic and the inherent opportunities that abound for sector players given Nigeria’s position as a net importer of CPO.
We believe the recent sell-off in the shares of Okomu and Presco provides upside opportunity for investors as valuations remain undervalued to the inherent sector opportunities and earnings outlook. Particularly, at 8.8x, the sector’s mean P/E remains cheap relative to Bloomberg Africa peers (13.65x). Across our coverage, we prefer Okomu due to expectation of lower interest expense emanating from its slimmer debt profile compared to that of Presco. Also, the demand/supply gap for CPO coupled with Okomu’s expansion plans guides to stronger earnings in the medium term. Hence, our FVE embodies 26% upside from current pricing for Okomu (N92.45) and a 26% for Presco (N67.47). Accordinlgy, we have a STRONG BUY rating on Okomu, been a top 20 stock and a BUY rating on Presco.
Earnings suffer setback on CPO price plunge
So far this year, the palm oil sector has struggled to replicate the spectacular feat in earnings achieved last year. The uninspiring performance over H1 2018 was mainly driven by lower CPO prices which declined 7.3% YoY on the back of widening glut in the global CPO market (4.5MMT in 2018 vs 3.2MMT1 in 2017).
The glut expansion stemmed from improved weather patterns, large oil extraction from high yield seedlings in Indonesia and Malaysia, and more importantly India’s decision to raise crude and refined palm oil tariff to their highest level in over a decade further dampened export prospects and prices – India is the largest consumer of CPO.
Consequently, given that local prices are reflective of global CPO prices, Okomu had an average price of N395,032/MT over H1 18 which is 16% lower than last year’s average price. In addition, the relative stability in the naira, particularly at the parallel market segment encouraged smuggling activities into Nigeria which further exerted downward pressure on domestic CPO prices. Specifically, the management of Okomu alluded to rising illegal CPO import flowing from Benin Republic as providing support to lower domestic CPO prices.
From our findings, over the last five years, importation of CPO into Benin Republic has been exceeding its domestic consumption. For context, Benin Republic imported 314,591MT of CPO from Malaysia in 2017 whereas its domestic consumption stood at 135,000 MT in the same period, and its import in H1 2018 of 110,826 MT is only 18% shy of touching last year’s annual domestic consumption. In our view, it appears the excess CPO imports have been finding its way illegally into Nigeria thus, bypassing imports duties and providing further legroom for cheaper CPO in the Nigerian market.
Furthermore, local refined CPO prices also buckled under falling global CPO prices with FEWSNET reporting an 18% YoY drop in prices to N505,023/MT. This largely accounted for the 9.1% YoY dip in Presco’s top line over the first half of the year.
Downtrodden Rubber Prices
Global rubber prices also towed similar path as CPO over H1 2018 with prices falling 15% YoY to $1.52/kg due to glut following expiration of an agreement between Thailand, Indonesia and Malaysia to reduce exports (the 3 countries accounts for ~ 70% of global rubber supply). Thus, given that Okomu exports all its rubber, its rubber prices were largely reflective of external influences as management reported that prices plunged 12% to N419,340/MT over H1 2018.
However, Okomu entered into a forward contract with off-takers for its rubber before delivery (six months to one year) at a higher price which provided cover against sliding global rubber prices and translated into a 13% YoY expansion in export sales over H1 2018. However, going into subsequent quarters, the pass through of weaker rubber prices could filter into earnings as current contracts reflects weaker prices. Meanwhile, we did not see the impact of dwindling rubber prices on Presco’s earnings as its rubber trees are yet to mature.
CPO Volumes: Resilient half year
On volumes, Okomu witnessed a brilliant first quarter with volumes touching a thirteen-quarter high of 14,972 MT. According to management, this reflects the impact of favorable weather condition, expansion in matured area to 10,620 (+8% YoY) and higher Fresh Fruit Bunches (FFB) yield/ha (9% YoY) over the period.
However, due to the onset of the lean season, yield on Okomu’s plantation dipped resulting in a 13% YoY plunged in volumes to 11,696 MT in Q2 18. Also given that Presco’s revenue dipped 9% YoY over H1 2018 on the back of falling refined CPO prices (-10% YoY to N435,320) we believe volumes were slightly higher over the period. This stemmed from supply to wholesalers and blue-chip consumer goods companies such as Nestle Nigeria and Dangote Group which saw improved top line growth.
Market dynamics provides room for cheer
We highlight that a large percentage of Nigeria’s CPO production is controlled by numerous small-scale farm holders with CPO output from key producers including Okomu and Presco accounting for ~8% of the total market although, individually holding sizeable market share due to their robust capacity (combined annual capacity at 78,000MT) compared to small farmers. However, despite recent government efforts to boost domestic production of CPO, local production still lags behind overall domestic consumption. In fact, according to available data from United States Department Agency (USDA), production has remained around 970 thousand MT, in the last 5-years, trailing domestic consumption of 1.4 million MT over the same period.
We attribute the short fall to slowdown in investment from large corporates into the sector even despite sufficient arable land conducive for palm oil cultivation in Nigeria. That said, the demand/supply gap, which presently is around 430 thousand MT makes Nigeria a net importer of CPO with its imports largely sourced from Malaysia and Indonesia where production of CPO outweighs consumption.
However, in recent times we have seen renewed interest in Nigeria’s CPO market with PZ Wilmar investing more than $650 million oil palm plantations and processing facilities. The company has planted almost 26,500 hectares of palm oil in Cross river state and installed about 65 tonne per hour palm oil mill which by our estimate translates to annual capacity of ~40,000 MT. No doubt, this is a drop in the ocean given Nigeria’s current deficit picture (430,000 MT). In the light of this, we believe there is still scope for sector players— Okomu and Presco to expand capacity and grow volumes which guides to a possible leap in earnings in the medium to long term.
Moving Forward with Expansion Plans
Over 2018, Management of Okomu hinted at N12 billion capital expenditure plan majorly to meet expansion needs at its newly launched Extension 2 plant with likely funding sources from cheap CBN/BOI Agric lending facilities (~9%) and retained earnings. Accordingly, the company raised N1.95 billion in term loans from the Bank of Industry under the Agriculture Credit loan at an interest rate of 10% in April 2018 which led to a jump in terms loans from N1.1 billion in Q1 18 to N2.9 billion in Q2 18.
In terms of specific project, management guided to building two new oil mills at its Extension 2 plant, both 30 ton/hour at peak which is expected to cost N5 billion. The First plant is scheduled to be commissioned in 2020, while the second will come on board between 2021 and 2022. Furthermore, according to management the first area to mature in Ext 2 will be what was planted in 2016 which is expected to add 1300 hectares to its existing matured area in 2018.
In a bid to diversify its revenue base, Presco plans to tap into the rubber markets which should be an additional source of foreign exchange (aside Palm Kernel export). In line with its plan, Presco has concluded the acquisition 17,600 ha of land in Edo state where it plans to plant palm oil and develop a bud wood garden nursery for the actualization of its investment in rubber.
In terms of expertise to manage the rubber business, PRESCO can take advantage of the expertise of its parent company—Siat NV, which already produces rubber in Ivory Coast, Gabon, Cambodia, Belgium and Ghana. However, we are yet to reach management of Presco to get clarity on the timing for the maturity of its first set of planted rubber trees hence, we did not factor it into out valuation for the company.
OKOMU OIL PALM PLC: Lower CPO price submerge earnings
On the heels of lower than expected CPO prices over 2018 we cut our FVE by 10% to N92.45. However, given current share price of N73.2 which implies a 26% upside on the stock we have a STRONG BUY rating on the stock. Okomu trades at a FY 18E P/E of 8.29x which is at a discount to Presco’s 9.2x and Bloomberg MENA peers of 13.65x. At current price, our dividend expectation of N2.28 over FY 18E translates to a dividend yield of 3%.
- Revenue plunge on price slip: Going forward, the expectation of weaker global CPO prices provides scope for lower domestic CPO prices. Overlaying this with lower global rubber prices which could translate to weaker export sales, we project a 6% YoY drop in 2018E revenues to N19.02 billion.
- Higher Cost fuels gross profit contraction: Management stated that the abysmally low COGS (N22 million) reported in Q2 17 was an error and stated that the FY 2017 COGS of N4.23 billion reflects adjustments made to make up for error. Thus, we normalize Q2 17 COGS to N591.7 billion to reflect 5-year historical COGS average for the company. Based on new adjustments, over Q2 2018, Okomu faced cost pressures with cost of sales significantly higher (+93% YoY to N1.14 billion in Q2 2018). Management linked the spike in cost of sales to the onset of lean season, higher cost of fertilizer purchased earlier in the year and Energy pressures due to bottleneck faced with achieving its planned Energy mix (40% Genset and 60% BEDC3) as Energy mix of 65% genset and 35% BEDC fell short of target. Going forward, while management guided to normalization of cost of fertilizer in Q3 2018, the onset of lean season which is usually the planting period for Okomu presents the possibility for higher cost going into rest of the year. More so, given the lingering bottlenecks faced by the BEDC we see scope for higher cost of sales over the rest of the year. Thus, we raise our cost of sales expectation for 2018 by 15% YoY to N4.85 billion.
- Slimmer Finance costs to offset Higher OPEX: Having fully paid down the FCY portion of its long-term borrowings (€10 million) owed to its parent company—SOCFINAF S.A in Q1 2018, we model a 43% YoY decline in interest expense over 2018. In our view, this should help mask impact of higher operating expenses (FY 18E: +5% YoY to N5.3 billion) over the rest of the year.
- Catalysts: Further depreciation in the naira at the parallel market and uptrend in global CPO prices would drive CPO prices higher which is positive for Okomu’s revenue.
- Valuation: On balance, we now look for FY 18E PAT of N7.5 billion (-18.1% YoY). Base on the forgoing we cut our Fair value estimate (FVE) by 10.5% to N92.45 which implies a 26% upside from current pricing. Hence, we have a STRONG BUY rating on the stock. Okomu trades at a P/E of 8.29x relative to Presco’s 9.2x and 13.65x for Bloomberg MENA peers.
PRESCO Plc: Bumpy road ahead
Following lower than expected CPO prices as well as expectation of higher interest expense tailing ramp up in Presco’s debt stock over the period we cut our FVE by 2% to N67.47 which retains our BUY rating on the stock. Presco trades at a FY 18E P/E of 9.2x relative to Okomu’s 8.29x and Bloomberg MENA peers of 13.65x. At current price, our dividend expectation of N1.13 over FY 18E translates to a dividend yield of 2%.
• Price plunge prompts revenue slip: We expect an 8.3% YoY drop in revenue to N20.5 billion over FY 18E. This is largely driven by tamer refined CPO prices (FEWSNET: -15% YTD to N466,700/MT) which is in consonance with falling global CPO prices. However, in line with recent trend where cost pressures have been dissipating, we model a faster drop in input cost (17% YoY) to N4.9 billion with gross margin expanding +260bps YoY to 76% over 2018.
• Higher borrowings propel interest expense higher: So far this year, Presco’s borrowings is up 149% to N9.9 billion from December 2017 levels as it continues its expansion drive into FY 18E. Accordingly we expect that this would translate to higher finance expense over FY 18E thereby, informing our upward review of Interest expense to N1.55 billion (+58.9% YoY). Based on the foregoing, interest coverage ratio is expected to trail five-year average of 7.91x to 5.87x over 2018E while Debt to Equity ratio is expected to spike to 12.6% over 2018E from 7% in FY 17.
• Catalysts: Further depreciation in the naira at the parallel market and uptrend in global CPO prices would drive CPO prices higher which is positive for Presco’s revenue.
• Valuation: Overall, on the heels of tamer CPO prices and higher interest expense we now look for a 17.5% YoY decline in 2018E PBT to N9.03 billion (excluding biological gains). However, based on the recent depreciation in the share price of Presco (-22% YTD) our FVE of N67.47 translate to a 26% upside on the stock and hence, we have a BUY rating on the stock. Presco trades at a P/E of 9.2x relative to 8.29x for Okomu and 13.65x for Bloomberg MENA peers.