Indonesia Palm Oil: Cash flows set to surge but show me the money

Disclosures & Disclaimer This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it. Issuer of report: The Hongkong and Shanghai Banking Corporation Limited View HSBC Global Research at: https://www.research.hsbc.com   Palm oil demand is inversely related to animal feed growth in China; as the latter slows, palm oil prices should continue to rise  Rising CPO prices and falling capex to offer FCFE yields of 11-13% by 2017-18e, but investors won’t buy the story until they see cash flows go toward higher dividends and deleveraging  Reiterate Buy on GGR (SGD0.49) & First Resources (SGD2.45) with TPs based on 1-yr fwd EV/EBITDA (1SD above 5-yr avg.) It has been a volatile year for crude palm oil (CPO): After a 32% rally in 1Q due to El Niño and a weak South American soybean harvest, the sector gave back half its gains in 2Q. A surge in hog prices and animal feed (soymeal) demand created a surplus of soy oil (by-product of soy crush). Not only did soy oil crowd CPO out of the Chinese market in 2Q but the value conscious Indian demand also fell as soy oil’s premium over CPO shrunk. This trend reversed in 3Q – falling hog and soymeal prices reduced the need to crush soy into meal and oil, lifting soy oil and CPO prices to 2016 highs. Trends in 2016 point to an upturn for palm oil: The prospects of CPO and soy oil, palm oil’s biggest competitor, are closely tied to animal feed demand in China, which has accounted for half the growth in global soymeal consumption since 2008. The greater the demand for soymeal, the greater the supply of soy oil and lower the demand (and price) of CPO. But, after years of strong growth in soy meal consumption, China’s feed protein intake per unit of meat production is approaching saturation levels seen in the US and the EU. Going forward, potentially lower growth in soymeal demand is likely to leave a greater share of the vegetable oils market for CPO. But, earnings growth alone won’t move share prices: After the supply contraction in 2016, we see a balanced market in 2017 with relatively thin inventories. We raise our 2017 EBITDA estimates by 1-9% to 19-40% above consensus. CPO price recovery to above USD700/MT and lower capex at GGR and FR should push FCFE yields into double digits by 2018, but investors need to see evidence of the cash flows being used to cut debt and raise dividends to get excited. Neither FR nor GGR has done so in the past. The former has been in an expansionary phase through the downcycle and the latter has a history of opaque investments. Both now have a chance to change course and reverse years of share price underperformance. 26 October 2016 Shishir Singh* Analyst, ASEAN Materials The Hongkong and Shanghai Banking Corporation Limited shishirkumarsingh@hsbc.com.hk +852 2822 4292 *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations. Indonesia Palm Oil EQUITIES MATERIALS Indonesia Summary of valuations & ratings – Indonesia upstream palm oil stocks Company Ticker Old TP New TP % TP Old New Price Upside Mkt cap Daily vol. EV/EBITDA PE Div. Yld _ 2017e EBITDA __ SGD SGD change rating rating SGD % USDm USDm 2017e 2017e 2017e vs. prev. vs. Street First Resources FR SP 2.00 2.45 22.5 Buy Buy 1.77 38.4 2,011 3.6 5.7x 8.7x 2.9% 9.2% 39.5% Golden Agri GGR SP 0.44 0.49 11.4 Buy Buy 0.38 28.9 3,500 6.0 7.6x 14.7x 3.3% 1.3% 18.7% Source: Thomson Reuters Datastream, HSBC estimates. Valuations as at the close of 24 October 2016. Cash flows set to surge but show me the money  EQUITIES ● MATERIALS 26 October 2016 2 Weaker soymeal demand and prices drive CPO prices higher in 3Q16 Reversal in lean hog and soymeal prices since end June 2016... ...has reduced soy oil surplus and a rally in soy oil and palm oil prices (all in USD/MT) Source: Thomson Reuters Datastream, HSBC Source: Thomson Reuters Datastream, HSBC Biodiesel is driving Indonesian CPO demand India & China rebound hinges on Soy oil rally Source: Thomson Reuters Datastream, HSBC Source: Thomson Reuters Datastream, HSBC As structural case for higher Soymeal (animal protein) demand is weak in China... ...we remain bullish on the prospects of CPO recovery; marginal increase in 2017 forecast Source: USDA, Thomson Reuters Datastream, HSBC Source: Thomson Reuters Datastream, HSBC estimates 20025030035040045040.050.060.070.080.090.0100.0Jun-15Sep-15Dec-15Mar-16Jun-16Sep-16Lean Hogs (USDc/lbs, LHS)Soymeal (USD/MT, RHS)400450500550600650700750800850200250300350400450Jun-15Sep-15Dec-15Mar-16Jun-16Sep-16Soymeal (LHS)Soy oilCPO0.2%0.1%0.2%0.7%1.2%2.3%3.6%5.7%3.1%8.0%0.0%1.0%2.0%3.0%4.0%5.0%6.0%7.0%8.0%9.0%2007200820092010201120122013201420152016EIndonesia Biodiesel blending (% of diesel in transport)-30.0-25.0-20.0-15.0-10.0-5.00.05.010.015.020.025.030.0Dec-10Mar-11Jun-11Sep-11Dec-11Mar-12Jun-12Sep-12Dec-