About Golden Agri-Resources Ltd
Golden Agri-Resources Limited (“GAR”) is one of the world’s largest palm oil plantation companies. GAR manages 500,345 hectares (as at 31 Mar 18) of palm oil plantations (including smallholder farmers) in Indonesia—almost seven times the size of Singapore. The firm is listed on the SGX since 1999 and has a market cap of S$4.2 billion at today’s market close.
GAR’s businesses span four segments, namely plantation and palm oil mills, palm and laurics, oilseeds, and “others”. The last division on that list produces and distributes food and consumer products (e.g. refined edible oil products, noodles) in China, India and Indonesia. The company’s primary activities range from upstream operations in cultivating and harvesting oil palm trees; crude palm oil (“CPO”) and palm kernel processing; to downstream operations such as refining CPO into value-added products such as cooking oil, margarine, biodiesel and oleo-chemicals.
Despite generating most of the revenue (see Chart 1), GAR’s downstream businesses (palm and laurics, oilseeds and others) have yet to show satisfactory profitability. In 2017, the firm’s downstream operations made up 81.6% (USD 7.4 billion) of gross revenue (including inter-segment sales), but they contributed just 25.2% (USD168m) of EBITDA. The returns of GAR’s downstream business as measured by its EBITDA margin were thus weak at 2%, versus 30% at its upstream division.
Chart 1: GAR’s operating segment information (2017)
The Widjaja family, among Indonesia’s wealthiest, is GAR’s largest shareholder and owns about 50.4% of the company’s shares via Flambo International Limited. The institutional investor Silchester International Investors LLP is the second largest shareholder with an 11% stake.
The Widjaja brothers Mr Franky Oesman Widjaja and Mr Muktar Widjaja lead GAR’s executive team as CEO and executive director respectively. In April, Mr Frankle (Djafar) Widjaja retired from his non-executive role on the company’s board of directors. To our knowledge, there are two other Widjaja family members—daughters of Mr Franky Widjaja; Ms Jesslyne Widjaja and Ms Emmeline Widjaja—working at GAR as director (corporate strategy and business development) and legal counsel.
Weak start in 2018 due to soft CPO prices and lower fruit production
GAR recorded a decline in revenue of 11% YoY to USD 1.8 billion in 1Q18 (1Q17: USD2.0 billion). The softer results were primarily due to weaknesses in GAR’s upstream business, which saw decreases in both palm production and CPO prices. The firm’s palm product yield deteriorated by 14% YoY to 1.2 tonnes/ha in 1Q18 (1Q17: 1.4 tonnes/ha). At the same time, average CPO FOB price dropped 12% YoY to USD645 per tonne versus USD734/MT in 1Q17.
According to the company, the lower production yield in 1Q18 was attributable to tree-stress effect after the high production last year following the recovery from El Niño weather conditions. In addition, several GAR plantations in the southern part of Kalimantan and Sumatra were hit by prolonged drought condition. As a result, GAR’s reported EBITDA fell 34% to USD121m in 1Q18 from USD183m a year ago.
A quick fact check of other palm oil producers operating mainly in Indonesia agrees with GAR’s assessment. As a reference, Wilmar International’s tropical oils division suffered a decline of 34% YoY in its profit before tax during the same period. First Resources and Indofood Agri Resources (“Indo Agri”) saw their EBITDA declined 32% and 36% respectively.
Business outlook
Earnings likely to improve as output increases
We expect GAR to produce better results for the remaining nine months in 2018, as its palm oil production improve from the seasonal weakness in 1Q18. Industry observers are generally predicting for palm oil output to continue growing this year, albeit at a slower pace than 2017. In a February report, the commodity research firm Hightower Report forecast world palm oil production to grow 3-4% in 2018.
The poor palm oil yields early this year have led to a reduction in world palm oil stocks. Statistics from the Malaysian Palm Oil Board (“MPOB”) and United States Department of Agriculture (“USDA”) show that total palm oil inventories at Malaysia and Indonesia fell to 5.6m tonnes in April from 6.3m tonnes at the end of 2017. The reduction of palm oil stocks should support CPO prices in the near term, although we note the expected pickup in output later in the year is bearish for the market.
While CPO prices have trended lower in the second quarter of 2018, GAR’s performance should benefit from easier YoY comparison. Average 2Q prices through 21 Jun 18 was just 4.6% lower than 2Q17 (see Chart 2), in contrast to the 11% YoY decline in 1Q18.
Chart 2: CPO prices have continued to stay soft in 2018
Furthermore, GAR’s downstream business should benefit from the surge in fossil oil prices this year (see Chart 3). If oil prices remain at current levels or rise higher, the prospects for palm-oil based diesel will be much brighter as domestic usage and exports increase.
On this regard, GAR’s Director of Investor Relations Mr Richard Fung in the firm’s 1Q18 earnings call said that Indonesia’s target of around 3.5m tons biodiesel consumption is achievable, given the rise in crude price. Reuters reported in April that Indonesia’s Energy and Mineral Resources Ministry intends to allocate 3.46m kilolitres for biodiesel in 2018, up from 2.54m kilolitres last year. The additional biodiesel consumption should support demand for palm oil and provide a floor to CPO pricing.
Chart 3: Biodiesel has become more competitive vs fossil oil
EU palm oil ban
A major downside risk in palm oil prices is the European Union’s current review of its legislation on renewable energy. In January, the European Parliament voted to reduce “the contribution from biofuels and bioliquids produced from palm oil...for the purpose of calculating Member State's gross final consumption of energy from renewable energy sources,” to zero by 2021. Mr Vincent Guérend, the EU Ambassador to Indonesia, said that the vote “aims at progressively replacing food-based biofuels by more advanced ones.”
Data from the USDA shows EU palm oil imports totalled 6.5m metric tonnes in 2017, making the EU the second-largest importer after India. Based on some industry reports and EU biodiesel production statistics we have seen, we think close to half of the European palm oil imports is used to make biofuel. As such, the proposed ban in biofuels could lead to a significant fall in overall demand for palm oil.
Although the ban will only start in 2021, market participants may price in the potential fall in palm oil demand. To ease the transition, fuel producers in Europe will also likely start phasing out palm oil soon and seek other alternatives like soya bean oil, which could lead to a reduction in palm oil consumption earlier than 2021.
Nonetheless, the palm oil phase-out process may take a few years to be implemented. First, the European Council of Ministers and the European Commission have to approve the proposed ban. Then, each of the 27 EU member states will have to ratify the final law before the ban becomes effective.
Furthermore, even if the proposal to ban palm oil in biofuels become EU law, we think the negative impact on GAR’s credit profile is likely to be manageable, given the company’s diversified revenue base. In 2017, around 13.7% (USD 1.03 billion) of GAR’s total revenue was earned from European customers. If we assume 50% of these European sales was used for biofuel production, it might mean that ~6.9% of GAR’s earnings would be affected. The impact is certainly meaningful but far from disastrous, especially for creditors, who do not participate in the company’s profitability upside.
Credit highlights
Leverage is stable
Despite the headline fall in revenue, GAR’s financial position remained good with its net gearing (net debt/equity) at 0.73x as of 31 Mar 18, up slightly from 0.69x three months earlier. We note the firm has USD250.4m of short-term investments (compared to its cash position of USD118.0m), comprising of debt and equity securities and time deposits. Including these potential sources of liquidity, we find adjusted net gearing at 0.67x (4Q17: 0.63x).
GAR’s total borrowings increased USD118.0m to USD 3.11 billion in the three months ended March, mainly due to the S$150m issuance of the GGRSP 4.750% 25Jan2021 Corp (SGD). The firm should have received cash proceeds of USD111m in April after completing the disposal of its oilseed crushing plant in Tianjin. Assuming that GAR apply the sale proceeds toward the repayment of its S$200m (~USD150m) that also matured in April, we estimate net gearing to have fallen slightly to 0.70x on a pro forma basis (pro forma adjusted net gearing: 0.64x).
At the end of last year, GAR recorded USD433.0m of corporate guarantees provided on the borrowings of joint ventures (4Q17: USD268.1m). Adding this off-balance sheet item into the company’s debt, we estimate its net gearing would have been around 0.86x in March (4Q17: 0.79x).
Interest coverage and cash flow weakened
Due to the soft earnings, GAR’s interest coverage as measured by its reported EBITDA/interest expense fell to 3.3x in 1Q18 from 5.2x in 1Q17 (FY17: 4.8x). Nonetheless, net financial expenses actually dropped somewhat to USD28.0m (1Q17: USD28.8m) due to higher interest income from time deposit and financial products (USD9.2m versus USD6.7m).
GAR swung to net cash outflow for its operating activities—after payment of interest expenses and tax—of USD13.2m in 1Q18, compared to a USD232.3m inflow in the previous corresponding period. The deterioration in cash flow was due to lower earnings and higher working capital needs for the firm’s downstream activities. We note GAR’s advances to suppliers jumped to USD301.4m at the end of March from USD189.0m three months earlier.
During the quarter, GAR spent a net USD138.4m in investing activities, of which USD101.4m went into additional investments in financial assets. The latter was mostly technology-related investments, which increased by USD81.1m during the period.
While investments in technology and R&D are important for companies to sustain productivity improvements, we think GAR’s more pressing need is to replenish its diminishing pipeline of immature and young trees (see next section), given its high proportion of old trees. The increased investments in technology divert important capital expenditure dollars from replanting, and could strain the firm’s balance sheet.
GAR projected its 2018 capex needs at USD220m, to be divided equally between its upstream and downstream businesses. The firm spent only USD44.5m in PPE and bearer plants in 1Q18, so we should see larger capex spending in the months ahead.
Old plantation age profile poses threat
From its peak of 23.2% in 2009, GAR’s oil extraction rate has gradually come down to 22.5% in 1Q18 (FY17: 22.2%). Similarly, the company’s fresh fruit bunch yield declined from 23.1 metric tonnes per hectare in 2009 to 20.5 tonnes/ha last year.
The falling productivity seems to have coincided with a lack in replanting, as the proportion of older trees on GAR’s plantations has quadrupled since 2009 (see Chart 4). With old trees—age above 18 years—constituting 48% of its planted area at the end of March, GAR has one of the highest percentage of old trees in the industry. According to their latest filings, the proportion of old trees at Wilmar, Indo Agri, and First Resources stood at 19%, 35%, and 26%.
Chart 4: The age profile of GAR’s oil palm plantations has deteriorated over the years
Given its weak pipeline of young and immature trees (11%), GAR will need to start replanting aggressively to reverse the rising proportion of old trees and improve crop yields. The company probably needs to at least double its replanting rate to 20,000 hectares per year for the foreseeable future, from 9,900 hectares in 2017. That might still be insufficient to stave off a decline in crop yield, as GAR’s old and past-peak trees totalled 243,248 hectares in March (4Q17: 226,231 hectares).
The replanting cost of aged oil palm tree is around RM12,000 per hectare (~USD4k/ha) according to estimates by Federal Land Development Authority of Malaysia. Based on that figure and assuming USD1,000 per year in lost income in the first five years, GAR needs to spend around USD180m to replant 20,000 hectares every year. That would represent ~27% of the firm’s EBITDA last year, and is much higher than the USD110m budget it has allocated to upstream activities in 2018.
Thus GAR faces a difficult dilemma between aggressive replanting, which would hurt cash flows immediately and raise indebtedness, or dawdle on the matter and see its crop yield and profitability deteriorate further. Should the firm decide to start replanting rapidly, we think its net gearing might climb gradually to approach 0.9x in a few years.
On the other hand, GAR launched two new planting materials—Eka 1 and Eka 2—last year that have a potential CPO yield of more than 10 tonnes/ha per year (versus its palm product yield of 5.7 tonnes/ha in 2017). The firm said it will focus on using these and other higher-yielding seeds in its replanting programmes. The newer generation seeds may help to mitigate the negative impact from GAR’s aging trees. Finally, we note that despite its poorer tree-age profile, GAR’s oil palm productivity was still higher than its peers (see Chart 5) in 2017.
Chart 5: GAR’s production yields are ahead of its competitors
We like the GGRSP 4.75% ‘21s
Overall, although GAR’s increasing replanting need and the potential EU palm oil ban may pressure its balance sheet, we think the firm’s credit profile should stay steady, supported by its diversified revenue base and industry-leading efficiency. Also, GAR’s results should improve from the weak start in 1Q18, as crop yields rebound and its downstream business benefit from higher fossil oil prices.
Due to the combination of disappointing earnings and weaker market environment—both interest rates and credit spreads have risen this year—the performance of GGRSP 4.750% 25Jan2021 Corp (SGD) has been sluggish since its issuance in January. At its indicative ask price of 98.673, the GGRSP 4.75% ‘21s are yielding 5.30%, 315bps above SGD swap offer rate.
We think the GGRSP 4.75% ‘21s provide a decent return relative to their credit risk. They also offer good value against the existing bonds of Olam International Ltd, such as the OLAMSP 5.800% 17Jul2019 Corp (SGD) and OLAMSP 4.250% 22Jul2019 Corp (SGD). The two aforementioned bonds are trading at YTMs (ask) of 2.86% and 2.98%, which translate to spreads of 97-108bps over SGD swaps.
Therefore, a switch to the GGRSP 4.75% ‘21s would provide a spread pickup north of 200bps, which more than compensates for their longer tenor (about 18 months). We acknowledge that Olam is a Temasek-linked company—it is 54% owned by the Singapore state investment arm Temasek Holdings—and therefore enjoys stronger access to capital markets. But we think this is offset by Olam’s significantly more levered credit profile, with its net gearing at 1.49x at the end of March.
Declaration:
For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) has a principal position in GGRSP 5.350% 05Aug2019 Corp (MYR). The analyst who produced this report holds a NIL position in the abovementioned securities.