Plantation review in Malaysia

7/28/2019 Plantation review in Malaysia

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MARCH 2012 | MALAYSIAN RATING CORPORATION BERHAD

MARC

RATING

METHODOLOGY

Contact:

Francis Xaviour Pereira Cruz JoeAssistant Vice President, Ratings

[email protected]

+603 2082 2200

www.marc.com.my

MALAYSIAN PLANTATION

COMPANIES

OVERVIEW

The oil palm plantation sector is currently the second largestexport revenue earner for Malaysia after the electrical andelectronics (E&E) sector. Presently, Malaysia remains the

worlds top exporter of palm oil, accounting for 47% of globalexports, and is second after Indonesia in palm oil production,

accounting for 41% of global production. In fiscal year 2008,palm oil contributed approximately 3.2% of the countrys realgross domestic product (GDP), with more than 90% of thecountrys total production exported to countries such asChina, India, the European Union (EU) and Pakistan.

The largest local commercial plantation companies are SimeDarby Berhad, ranked the largest globally based on size ofland bank, followed by Kuala Lumpur Kepong Berhad and

IOI Corporation Berhad. About one-third of Malaysian palmoil output is produced by smallholders, which are defined asthe owners or legal occupiers of any land that is 40.5hectares (or less) in area, while the rest come fromcommercially operated estates.

The players operating in the industry can generally becategorised into three different types: upstream, downstreamand integrated players. Upstream involves the cultivation ofoil palm, production of fresh fruit bunches (FFB) andprocessing them into crude palm oil (CPO) and palm kernel

oil. Downstream refers to palm oil refiners, palm kernelcrushers, manufacturers of palm-based edible products andspecialty oils and fats. Based on MARCs observations,

MARC RATING METHODOLOGY 1 |

CORPORATE DEBT


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Rating Approach To Plantation Companies

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integrated players involved in both upstream and downstream

activities have the strongest credit profiles as evident from their greaterearnings stability, notwithstanding the volatility of CPO prices.

Among oil seeds, palm oil is viewed as one of the most important oilseeds globally due to its diverse and widespread use ranging from food

preparation to oleochemicals and, recently, bio-fuels. Soybean is itsclosest competitor. Additionally, it has the lowest cost of productionwhile yielding the highest oil yield per hectare, typically 3.5 to 5.0tonnes per hectare, which is about five to ten times greater than anycommercially known oil seed crops. However, as an actively tradedcommodity, CPO is subject to price volatility, being a function of both

fundamental developments in the industry and the speculative tradingactivity of palm oil traders. This causes revenues and earnings ofplantation companies to vary from year to year, reflecting the vagariesof CPO prices. Supported by growing demand for palm oil as food orfuel, long-term growth prospects are good with CPO prices trending

upwards since 2000, except in late 2008 when there was a suddendecline in prices due to the global financial and economic crisis.

ANALYTICAL FRAMEWORK

MARC currently rates five plantation issuers, with a total facility size of

RM6.22 billion. Rating considerations are classified into the followingcategories:

Industry risk analysis;

Business risk analysis;

Financial risk analysis;

Management and other qualitative factors risk analysis; and

Issue structure and terms analysis (applicable for plantation-backed securities programmes)

Among the rated universe of plantation companies, there is aprevalence for plantation-backed rated issuers, where cash flows arering-fenced, securitised and held by a special purpose vehicle (SPV).The similarity between the different types of programmes is theassessment of the originator whose rating is derived from themethodology described here but only forms part of the rating factorsfor a plantation-backed issue. The methodology for plantation-backed

securities programmes incorporates, additionally, an analysis of theissue structure and terms analysis. In both cases, CPO prices remain theprimary rating consideration as it is the most sensitive to cash flowgeneration, which is a key rating factor in determining ability to honour

commitments to bondholders.


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INDUSTRY OVERVIEW

Plantation companies in Malaysia are exposed to a number of similarindustry fundamentals, key of which are as follows:

Supply and Demand

The global supply of palm oil has been on a steady upward trend overthe past decade, supported by productivity improvements in Malaysiaand Indonesia, the top two global producers. A key risk factor affectingsupply is adverse weather patterns such as that caused by El-Nino.MARC notes that local planters have demonstrated an ability tomitigate such adverse effects by managing inventory levels andreplanting schedules.

The global demand for palm oil is expected to continue to rise, fuelledmainly by increasing demand in Asia and Europe. In Asia, China is thetop importer of palm oil, with demand underpinned by a rapidlyexpanding economy and household income, while consumption inEurope will be supported by increasing use of palm oil as bio-fuel tomeet their commitment to significantly decrease greenhouse gas(GHG) emissions to address the issues of climate change. However, inthe near term, intense lobbying by environmental groups has curtailedstrong take-up of palm oil as the preferred feedstock for bio-fuels.Notwithstanding the pressure on using palm oil as feedstock for bio-fuel,MARC is of the view that the diversity and importance of palm oil for

food and industrial use will continue to bolster demand, particularlyfrom the Asian region, coupled with the underlying increase in worldpopulation which is projected to grow to over 9 billion in 2046 from 6.8billion in 2009.

Cost Structure

The biggest operating cost constituents of plantation companies arefertiliser and labour costs. Fertiliser prices tend to rise in tandem withCPO prices but are downward sticky when CPO prices drop. As such,during periods of high CPO prices, when the cost of fertilisers would also

increase, planters tend to respond by cutting back on its usage tomanage profit margins. In terms of labour, the main issue facing localplanters is the shortage of fruit harvesters where availability of locallabour is scarce as the job is considered by locals as menial and lowlypaid. Thus far the government has shown restraint by continuing toallow employment of foreign labour in the plantation sector. MARCopines that this issue would remain a key concern until a firm solution isagreed on, formulated and strictly adhered to by all partiesconcerned.


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Environmental and Public Concerns

Environmental lobby groups or non-governmental organisations (NGOs)such as Greenpeace and Friends of the Earth have been intensifying

their opposition of palm oil on the grounds of environmentaldegradation and unsustainable planting practices, which is perceivedas a campaign to weaken palm oils increasing foothold in the worldsoil and fats market. The effects of such campaigns can be seen inMalaysias palm-based biodiesel exports which, despite rising 20% in

2009, was significantly lower compared to the increase in generaldemand due to more stringent requirements under the EUs renewableenergy directive which has limited palm-based biodiesel access to theEU market. Additionally, some multinational corporations, such asCadbury, have stopped using palm oil in their products due to public

pressure from these NGOs. MARC expects continued negative publicityaround this issue would affect both the edible consumer productsmarket as well as palm-based biodiesel demand prospects in theimmediate to near term.

Capital Intensity and Return Period

The setting up of a commercial plantation business is capital-intensiveas it requires high initial investments for acquisition of land, landclearing, construction of basic infrastructure, set-up of productionfacilities and other plantation-related expenditures. Typically, there is a30-month no-return period between initial planting and the start of the

fruit harvesting period; during this period, agronomic-relatedexpenditures would still need to be incurred. Even after the immaturepalm trees begin bearing fruits, their yields in the first few years are lowand unprofitable. The lifecycle of a new plantation is relatively long(approximately 25 years) and generate profitable returns providedmanagement adheres to professional estate management practices.Overall, MARC views the initial set-up cost as the biggest barrier to entry

as the actual planting know-how is relatively straightforward and easyto acquire.


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BUSINESS RISK ANALYSIS

Industry risk analysis is generally standard across all types of companieswithin the oil palm plantation sector; however, business risk isdependent on the credit risk profile of individual companies.

Key company-specific rating factors are as follows:

Maturity profile of palm trees and land bank

Production and yield

Oil extraction rate

Estate management

Maturity Profile and Land Bank

The maturity profile of a plantation depicts the age of the planted

trees. A normal oil palm tree starts bearing fruits 30 months after

planting and continues to be productive for about 20 to 30 years. An oilpalms fruit-bearing prime age is between 8 to 20 years. Plantationcompanies typically start replanting once the palm trees cross the 25-year threshold as older trees begin to bear less fruit and harvestingbecomes more costly due to the taller height of the trees. The desiredmaturity profile for estates is one which has a higher percentage of

young and prime aged trees. By analysing the maturity profile of anestate(s), the analyst would be able to make an assessment of thecompanys production capacity, revenue, cash flow, and capital

requirements for replanting. Meanwhile, the size of a companys

plantation land bank enables the analyst to assess the companysfuture growth prospects.

Production and Yield

The fruits produced by oil palm trees are referred to as FFB. FFB ismeasured in tonnes, and its yield is the ratio of FFB tonnes per hectare

of planted area. The average FFB yield of a company is computed andbenchmarked against other plantation companies as well as industryaverages to assess its productivity. MARC notes that the main reasons

for different yields among planters are poor estate managementpractices, higher proportion of young planted areas which pushesdown the overall average yield computation, poor quality seedlingsand/or weather conditions. Generally, variations of FFB production andyields against industry and peer benchmarks should not be too

material, otherwise, the analyst would need to ascertain its cause(s)and identify the reasons.


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Oil Extraction Rate (OER)

OER is the percentage of weight of oil that can be physically recoveredfrom a known weight of FFB processed. The OER is an important tool inassessing the performance of a companys mill and plantation as

higher extraction rates contribute to improved profitability and providesan indication of palm tree quality and estate management practices.Just like FFB yield, the OER is benchmarked against industry and peeraverages. Major factors affecting OER are management practicessuch as adherence to optimum fruit ripeness standards, supervision of

harvesting process, extent of harvesting mechanisation and loose fruitcollection. Other factors include, but are not limited to, propermaintenance of processing machineries, quality of planted seedlings,climate, seasonal and geographical disparity.

Estate ManagementEstate management involves day-to-day decisions on how to efficientlymanage and maintain an estate to ensure optimum production, yieldand oil extraction rates. Good estate management practices include,

but are not limited to, complying with agreed fertilisation and weedingprogrammes, maintenance of transport infrastructure, speedytransportation of FFB to processing mills, security of estate perimeters,labour supervision and sourcing, harvesting practices and the rate ofmechanisation. These factors are not as straightforward to evaluate

compared to quantitative factors such as OER and FFB yields. For a

proper evaluation, the analyst would normally request for a site/plantvisit to verify the practices adopted at the estates.

FINANCIAL RISK ANALYSIS

Profitability

Profit potential is a critical determinant of credit protection, asplantation companies with high operating margins and returns oncapital have greater ability to generate equity capital, attractadditional investors/borrowers and withstand periods of cyclical

adversity. Significant measures of profitability used by MARC are theoperating profit margin and return on equity. Historical comparisons onprofitability ratios can be analysed on a per company basis, but asthese ratios are also affected by economic cycles, a peer comparison based on publicly available information is used to gauge a firms

competitive strengths and operating efficiency, and forms the basis for

an assessment of the credibility of the companys assumption of futureprofitability.

Based on MARCs observation, upstream plantation companiesgenerally register double digit margins whilst further downstream or

diversified plantation companies tend to enjoy stable albeit single-digitmargins. The integrated players, meanwhile, display better credit


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profiles by virtue of their ability to generate more stable margins

through the business cycle.

Besides the margin analysis, performance would also be evaluated byrelating profits to assets, permanent capital and equity. Return onassets is computed both before and after taxes to measure the

productivity of all asset classes. Other ratios used to gauge thecontribution of profits to the companys financial profile include theretained earnings ratio, dividend payout ratio and return on equity. Theretained earnings ratio indicates the extent to which profits reinvestedin the business have contributed to the funding of the companysassets over a period of time. A stable or rising ratio would indicate that

the company is able to rely more on internally generated funds for itsgrowth. It has been noted that during periods of high CPO prices,upstream plantation companies are likely to display rising ratios orimproving profitability in the absence of any major new planting orreplanting exercises.

Earnings are also viewed in relation to the companys debt obligations,as aggressive debt financing will adversely affect earnings due tohigher financing costs. The operating profit before interest and taxes(OPBIT) interest coverage (number of times OPBIT covers gross interest)

is used to draw distinctions between companies whose profitability isattributable to its competitive position or capital structure.

Cash Flow Protection/Debt Servicing Capability

An evaluation of a companys cash flow is important as it representsthe predominant source of repayment for its debt obligations. Cashflow from operations (CFO), which are cash flows incurred in the dayto-day operations of a company, should ideally be positive and alignwith historical trends and performance at the time of evaluation. Onthe other hand, non-operating cash flows such as that arising from saleof non-current assets or investments are evaluated as and whenincurred. Additionally, free cash flows (CFO less net capital expenditureand dividend) are also considered, particularly for companies with highreplanting and/or new planting commitments as persistent negativefree cash flow would likely lead to the need for additional borrowings tomeet its financial and business commitments.Dividend payouts aboveindustry norms may be a source of concern, especially if the firm facesa large capital investment programme. The issue structure maysometimes impose certain dividend covenants or restrictions tosafeguard the interest of bondholders.

For liquidity, plantation companies would experience cyclical as well asseasonal flows with temporary boosts of cash balances during periodsof economic booms and peak seasons and vice versa. Importantinformation can be compiled from turnover ratios for inventory andreceivables (asset category), and for trade payables (liabilitycategory). These turnover ratios can be used to gauge the level offunds tied up in these activities and used to ascertain if companies are


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stretching out or expediting payments to creditors. Liquidity ratios are

compared against historical trends as well the performance of otherplantation players/peers.

A companys debt servicing capabilities are captured by cash flowfrom operations (CFO) interest coverage and CFO debt coverage.

CFO interest coverage is a variation of OPBIT interest coverage. CFOdebt coverage is an indication of the availability of funds to honourupcoming debt obligations and flexibility in changing a companysdebt structure through early debt repayments.

MARC notes that cash flow movements of more established or growing

plantation companies are heavily influenced by business cycles,unplanned working capital changes and sometimes opportunistictransactions. Thus, in gauging the reasonableness of a companysfuture cash flow projections, the analyst would seek to understand theunderlying assumptions, how these relate to what the company has

previously accomplished and the outlook for the industry and overalleconomy. When conducting sensitivity analyses on a plantationcompanys cash flow projections, good risk scores would notautomatically be given to companies whose forecasts, even whenstressed, indicate future cash flow surpluses. The cash flow surplus would

be analysed against the companys requirements and capacity toservice its debt obligations and, to a certain extent, its competitivenessshould the surplus be utilised to reduce debt rather than reinvested. Ithas been noted that single- A rated plantation companies haveconsistently demonstrated interest coverage of above three times.

Capital Structure

Plantation companies, particularly ones in the midst of expansion ofplanted areas, will typically rely on medium- to long-term borrowings to

finance their capital expenditures due to the nature of a newplantations return period and capital intensity. Working capitalrequirements are usually met by short-term borrowings as plantationcompanies with prime yielding areas would typically have sufficientcash flows to cover those short-term obligations as they fall due. The

analyst would also consider and understand the companys financialpolicies and capital structure before drawing any conclusions.

The assessment of the capital structure of a company would take intoconsideration the extent of debt versus equity financing compared to

historical tolerance levels. The universal standard leverage measure isthe total debt-to-equity (DE) ratio, which considers all on-balance sheetdebt obligations relative to equity. Further segregation of the DE ratio toshort-term and long-term DE ratios enables an evaluation of theaggressiveness of the capital structure.

MARC notes that single-A rated plantation companies haveconsistently demonstrated DE ratios of below one time. Additionally, thedebt amortisation schedule will also be considered as part of the


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evaluation of debt protection measures and debt leverage position.Bullet maturities may indicate that the debt may have to be refinancedat maturity with new debt or other forms of external capital, leading tohigher refinancing risk. Companies that are able to address these debt

spikes well in advance are certainly preferable to those that wait untilnearer to maturity date.

Financial Flexibility

The analysis of financial flexibility evaluates the options available to thecompany under financial stress and/or refinancing ability. These wouldinclude an assessment of access to capital markets, available bankingfacilities, affiliations with other entities within the group, likely proceedsfrom disposal of assets and/or availability of unencumbered assets to

pledge as security to obtain additional borrowings. The analyst takes

cognisance that most banking facilities have a material adversechange clause which pre-emptively releases the bank(s) from anyobligation to lend or withdraw the facilities, which could impair/limit thecompanys financial flexibility.

MANAGEMENT AND OTHER QUALITATIVE FACTORS

ANALYSIS

Management is evaluated for its role in determining the operationalsuccess and risk tolerance level of the company. This involvesunderstanding their key business decisions and strategic directions,

manner of implementation and monitoring of initiatives, tracking ofperformance, corporate governance, succession planning and capitalmanagement, amongst others. Ideally, a companys business goalsand financial policies should be clear, consistently pursued andrealistic, taking into account the surrounding risk elements andeconomic conditions. This would then translate into an assessment of

the credibility, track record and experience of the management team.

Issue Structure and Terms Analysis

Important terms under the issue structure include priority of payments,

security, positive and negative covenants, underwriting requirements,sinking funds, repayment schedule, etc. The tenure of the instrumentbeing rated should preferably be related to the assets or activitiesfinanced by the instrument. This consideration diminishes in importanceas the issuing entity becomes stronger or in cases where the issuers

standalone rating is very strong and hence repayment of the instrumentwould typically be less directly reliant on cash flows attributable to theinvestment financed by the debt issue proceeds. Given thebusiness/group structure and financial profile, key considerationsinclude the priority or rank of cash flow utilisation to service the debt

obligations of the particular issue vis--vis any other concurrent or futureborrowings and other financial covenants attached. Considerations onsecurity also cover priority wherein senior secured debt has priority over


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senior unsecured debt which has priority over subordinated debt andso on and forth. Each of these different classes of debt securities canbe issued by a subsidiary or by a holding company. Typically, all

borrowings undertaken by a subsidiary have priority with respect tothat subsidiarys assets over any claims of the holding company.

Priority comes into play upon a default. Theoretically, those with higherpriority are fully paid before other claims are considered. It is alsorecognised that tax authorities and possibly othergovernment/statutory bodies have higher priority than anydebtholders.

In respect of the plantation companies rated by MARC, bondholderstypically have the comfort of legal charge over reserve funds ordesignated accounts for assignments of revenue. This will facilitate theaccumulation of funds for debt service on a timely basis. To beconsidered positively in the rating process, accounts established have

to be separately managed by responsible parties and mechanismsmust be established to assure that the pledged revenues are in factcaptured. In addition, for plantation companies, it is common toestablish a Commodity Reserve Account as a means to provide anadditional liquidity buffer (during bumper crop seasons or high prices)over and above the normal reserve fund and sinking fund set up toservice the debt obligations. The covenants that the analyst wouldassess (even if the issue being rated is expected to be bank-guaranteed) include, inter-alia, the maximum debt leverage ratio,events of default which spell out the conditions under which abondholder has the right to accelerate repayment and cross default

provisions, limits on distributions (such as controls on dividends,advances or loans upstream or downstream and utilisation ofproceeds from disposals, etc) and other positive and negativepledges. The inclusion of covenants, even in bank-guaranteed issues, isa statement by management that it is willing to operate within certainboundaries, and as such will be viewed positively. Of course, a

company agreeing to abide by indenture covenants does notguarantee that it will be able to fully comply if events beyond itscontrol occur. MARC would express concern if covenants imposed aretoo tight that only a small variation from the covenanted terms wouldcause an event of default.


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MARC has refined its methodology for its Plantation Companies rating approach, and

should be read in relation to its "Corporate Debt Ratings" methodology which is

available on the website at www.marc.com.my. This methodology partly amends and

supersedes MARCs "Rating Approach to Plantation Companies" published in 2006.


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Ratings are solely statements of opinion based on information gathered and available in public and information obtained fromratees and other sources which MARC believes to be reliable and therefore, shall not be taken as a statement of fact under anycircumstance. MARC does not and is in no position to independently audit or verify the truth and accuracy of the informationcontained in the report and shall not be responsible for any error or omission or for the loss or damage caused by, resulting from orrelating to the use of such information. NEITHER MARC NOR ITS AFFILIATES, SUBSIDIARIES AND EMPLOYEES, GIVE ANY EXPRESS ORIMPLIED WARRANTY, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTY AS TO THE ACCURACY, COMPLETENESS, MERCHANTABILITY ORFITNESS FOR ANY PARTICULAR PURPOSE OR USE OF ANY SUCH INFORMATION.

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