Is KLK an investment opportunity?

Value Investing Case Study 78-1: A fundamental analysis of Kuala Lumpur Kepong Bhd (KLK) to see whether it is a value trap or an investment opportunity.

Kuala Lumpur Kepong Berhad (KLK or the Group) has evolved from a plantation company into a multifaceted conglomerate with significant agriculture, manufacturing, and property development operations.

This diversification mitigates risks associated with the plantation sector's cyclical nature. It also positions KLK to capitalize on the growing global demand for sustainable palm oil and its derivatives.

Despite these advancements, the Group faces inherent challenges. These include fluctuations in commodity prices which could impact profitability.

This article aims to provide a comprehensive analysis of KLK's business model, financial performance, and market positioning. It also highlights the risks and limitations associated with the investment thesis.

Join me as I examine KLK's journey from a traditional plantation company to a diversified multinational. We can then better understand its current standing and prospects in a dynamic global landscape.

My analysis showed a fundamentally sound company with a significant margin of safety.

Should you go and buy it? Well, read my Disclaimer.

Company background

Operating performance

Financial position

Valuation

Conclusion

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Company background

KLK started as a plantation company in 1906 and until today, plantations remain the Group’s core business. However, over the years the Group had diversified into manufacturing and property development.

The Group currently has 3 major operations as follows:

Plantation. KLK presently has about 300,000 hectares of planted area of which 97% is for oil palm. The Group’s land bank is spread across Malaysia (Peninsular and Sabah), Indonesia (Belitung Island, Sumatra, as well as Kalimantan), and Liberia.

Manufacturing. KLK initially diversified into resource-based manufacturing (refinery and oleochemical) and vertically integrated its upstream, midstream, and downstream businesses. The Group has since expanded its manufacturing operations resulting in international oleochemicals operations in Malaysia, Indonesia, China, Switzerland, Germany, the Netherlands, Belgium, and Italy.

Property development. KLK's first foray into property development was in 1990 with the Sierramas project in Sungai Buloh, a joint venture with Tan & Tan Developments Berhad. The Group property projects are currently focused on Bandar Seri Coalfields, a 1,001-acre township in Sungai Buloh and Caledonia in Ijok, Selangor.

As can be seen from the left part of Chart 1, the manufacturing segment has grown over the years so in 2023, it was the biggest revenue contributor.

Note that in 2022, KLK reclassified the refineries and kernel crushing operations from the Plantation to the Manufacturing segment to better reflect their underlying business. Even if you ignore this reclassification, the Manufacturing segment was still the biggest revenue contributor in 2023.

From a geographical perspective, KLK serves the global market. In 2023, customers in Malaysia only accounted for about 15% of the Group’s revenue. Refer to the right part of Chart 1.

Chart 1: Revenue profile

Notes:

1) The Investment Holdings segment covers placement of deposits with licensed banks, investment in money market funds, investment in quoted and unquoted corporations, and specialty chemicals manufacturing by an associate.

2) The Others cover farming and management services.

3) In 2022, KLK reclassified the refineries and kernel crushing operations from the Plantation to the Manufacturing segment. It also restated the comparative figures for FY2018 to FY2021. To enable an apple-to-apple comparison, I estimated the “classification ratio” for the other years based on these 2018 and 2021 data.

Notwithstanding the growth of the Manufacturing segment, I would still consider KLK a plantation Group. This is because the bigger portion of its equity is still tied up in the plantation sector. Refer to Table 1.

Over the past 3 years, the average Ringgit operating profit and % return from the plantation operations were still better than the manufacturing operations. The property development operation is still a very small part of the Group’s business.

Note that the reclassification of the refinery and kernel operations from the Plantation segment to the Manufacturing segment boosted the Plantation segment performance. You can see this by comparing the 2018 to 2021 average profit margin:

Plantation - 11.3 % before reclassification to 37.1 % after reclassification.

Manufacturing – 4.8 % before reclassification to 3.7% after reclassification.

Nevertheless, it still showed that the Plantation segment had the better profit margin. I also estimated that the Plantation segment had better Ringgit operating profit and return before the reclassification. In other words, the reclassification did not change the general conclusions about the Plantation and Manufacturing segments.

Table 1: Sector returns

Note that the performances were based on the 2022 segment classification where the refinery and kernel operations were treated as part of the Manufacturing segment.

a) Average of 2021 to 2023.

b) Average of 2021 to 2023.

c) 2023 Equity.

The plantation sector is a cyclical one due to the cyclical nature of the palm oil prices as shown in the right part of Chart 2. There is also a significant link between oleochemical prices and palm oil prices. This relationship is primarily driven by the fact that oleochemicals are derived from palm oil and its derivatives.

This makes KLK a cyclical company.

From 2012 to 2023, there is a 0.75 correlation between KLK revenue and the average CPO prices.

Over the past 12 years, KLK average selling prices for crude palm oil (CPO) have experienced 2 peak-to-peak cycles as illustrated in the left part of Chart 2.

As a cyclical company, it is more realistic to look at its performance over the price cycle.

Chart 2: Plantation trends

Note: The left chart shows the trends for several KLK plantation metrics relative to the 2012 performance. The right chart shows the palm oil prices over the past 2 decades.

Note that KLK has its financial year end as Sep. As such in this article, unless stated otherwise, all the years related to the Group are for the financial year.

Operating performance

Over the past 12 years, revenue grew at 8.1 % CAGR. As can be seen from the right part of Chart 3, this growth was contributed by both the Plantation and Manufacturing segments.

Revenue growth was not continuous as there was a significant decline between 2017 and 2020.

The drop in revenue in 2018 and 2019 was due to lower palm oil prices. You can get a sense of this by looking at the CPO price trend in the left part of Chart 2. “Prices of palm products continued their downward trend throughout our financial year 2018.” 2018 Annual Report.

In 2020, we had COVID-19.

But as can be seen, revenue recovered in 2021 to continue on its growth path. Note that the jump in the Plantation segment revenue growth from 2020 to 2022 was due to acquisition and significant CPO price increase.

“…The production volume increased due to contributions from the recently acquired KLK Sawit Nusantara’s… total planted area of 61,336 hectares and PT Pinang Witmas Sejati… 14,000 hectares that were fully consolidated this year.” 2022 Annual Report.

Chart 3: Performance Index and Segment Revenue Index

Note: Segment performance was based on the 2022 reclassification.

While there was revenue growth, you could not say the same about profits. Both the PAT and PBT before unusual items in 2023 were lower than their respective 2012 values. As can be seen from the left part of Chart 2, profits were volatile.

Part of the reason for the declining profits was because of the declining gross profit margins. At the same time, there was no significant reduction in the Selling, General, and Administration (SGA) margin. Refer to the right part of Chart 4.

Gross profit margins averaged 21% in 2012/14 whereas it reduced to an average of 16% from 2021 to 2023. I suspect that this was due to the Manufacturing segment getting bigger over the years. As shown in Table 1, the Manufacturing segment had a lower profit margin.

If the Manufacturing segment continues to get bigger, we will continue to see declining profits unless the Group can improve its efficiency. In the context of efficiency improvement, the initial signs are not positive as gross profitability (gross profits/total assets) has been declining over the past 12 years. Refer to the left part of Chart 3.

Chart 4: Returns and Margins

Given the profit picture, you should not be surprised to see volatile and declining returns. Refer to the left part of Chart 4. Over the past 12 years, ROIC averaged 10% while ROE averaged 11%. Nevertheless, KLK managed to create shareholders’ value as these returns were greater than their respective cost of funds.

The ROE in 2021 was boosted by a fair value gain of RM 324 million arising from changes in equity interest in an associate.

There were also higher finance costs in 2022 and 2023 as new debt were issued. “With these acquisitions, our Group net debt to equity ratio has increased to 37.3% at the end of FY2021.”

Growth

Growth needs to be funded and one way to measure this is the Reinvestment rate defined as Reinvestment/NOPAT.

Reinvestment = CAPEX & Acquisitions – Depreciation & Amortization + increase in Net Working Capital.

Over the past 12 years, KLK had an average Reinvestment rate of 62%. This is high because of its acquisitions. Excluding the acquisitions, the average Reinvestment rate reduced to 41 %.

KLK did not provide a breakdown of its growth due to organic growth and acquisitions. But you can get a sense of this by looking at the amount spent on acquisition and CAPEX. Over the past 12 years, the Group incurred RM 3.4 billion for acquisitions compared to RM 10.7 billion on CAPEX.

I would posit that on a proportionate basis, acquisitions accounted for about ¼ of the Group’s growth.

Note that the bulk of the acquisitions took place between 2021 and 2023. If I assumed that the revenue growth from 2012 to 2019 (to exclude the COVID-19 impact) was all due to organic growth, we have an organic growth of 6.4 % CAGR.

Referring to the left part of Chart 2, you can infer that the Plantation segment growth was due to more mature areas coming onstream. The growth in the Manufacturing segment seemed to be from a combination of plant expansion and acquisitions.

“…new 165,000 mt per annum plant in Indonesia and the additional 100,000 mt per annum expansion in Germany…” 2013 Annual Report

“…by expanding into Belgium with the acquisition of TensaChem…” 2014 Annual Report

“… we acquired a fatty acid plant in…Germany… and also doubled the capacity in our China operations...” 2015 Annual Report.

“…the acquisitions of… Elementis Specialties Netherlands…expanding our product portfolio…” 2019 Annual Report

“Capital expenditure in Manufacturing segment included construction of ester plant in China…and conversion of Sulphonated Methyl Ester plant...” 2020 Annual Report.

“…capital expenditure…over 2 years an integrated oleochemicals plan for new capacities…” 2021 Annual Report.

Efficiencies

Efficiency improvements have been a recurring theme for the Group.

“The emphasis for the Group remains unchanged, that is to continuously drive for further cost efficiency…” 2014 Annual Report.

“The Group will mitigate the risks by focusing on raising efficiency and productivity and be prudent in managing costs…” 2017 Annual Report.

“Managing operational efficiency remains the key focus for the Oleochemical division to remain competitive…” 2020 Annual Report.

“The Group remains cautious and prudent on capital expenditure by focusing mainly on those related to productivity, efficiency…” 2023 Annual Report.

But as I have indicated earlier, gross profitability has been declining. To see whether there are other signs of improvement, I considered several operating and capital efficiency metrics as illustrated in Chart 5. The results were not so positive.

Operating efficiency. There were mixed results. While the operating expense ratio and inventory turnover seemed to have improved, we could not say the same for the operating profit margin and return on assets.

Capital efficiency. Of the 4 metrics, only the Reinvestment margin (Reinvestment/revenue) improved. The other 3 metrics remained unchanged at best.

I think there is still much work to be done in this area.

Chart 5: Operating and Capital Efficiency Tren

Peer comparison

I compared KLK's performance with 3 other Bursa plantation companies with the same level of revenue. Refer to Table 2. You can see that KLK had the largest revenue in 2023 with one of the better revenue growth rates.

Table 2: Peer revenue

Note: The comparison was from 2015 as this was the first year with readily public data from SDG.

I looked at the trends of 4 metrics to get a sense of how well KLK performed compared to its peers. Refer to Charts 6 and 7.

While KLK faces declining returns on capital and average operational margins, its superior EPS performance highlights its ability to generate profit effectively. Future strategies should focus on reversing the decline in capital returns while maintaining its EPS strength.

KLK had one of the better returns on capital initially but declined to average over the past few years.

It had an average EBIT margin and levered Free Cash Flow margin.

But its EPS is the best among its peers.

Chart 6: Bursa Peer Return on Capital and EBIT Margin

Chart 7: Bursa Peer Levered Free Cash Flow Margin and EPS

I also compared KLK performance based on several plantation metrics as shown in Table 3. KLK had the best FFB yield and % of mature areas. However, its oil extraction rate (OER) did not stand out.

Table 3: Plantation metrics

Financial position

I would rate KLK as financially sound.

As of Jun 2024, it had RM 2.6 billion cash. This is equal to 8 % of its total assets.

Over the past 12 years, it generated positive cash flow from operations every year. During this period, it generated RM 16.0 billion cash flow from operations compared to the total PAT of RM 14.9 billion. This is a very good cash flow conversion ratio.

I had already mentioned its Reinvestment rate of 41% excluding acquisitions.

It had a reasonable capital allocation plan. Refer to Table 4. The cash flow from operations was sufficient to fund its CAPEX. However, the company had to increase its debt to fund its acquisitions as well as pay dividends.

Table 4: Sources and Uses of Funds 2012 to 2023

The main negative point was its Debt Equity ratio of 0.72 as of Jun 2024, a 12-year high. But I would not worry too much as the Group generates a lot of cash from its operations. There is enough cash flow to reduce the debt although it would be at the expense of acquisitions. Its RM 2.6 billion cash would also offer some cushion for the high debt.

Valuation

I considered 2 scenarios in valuing KLK:

Scenario 1. This assumes that the company is a mature one that will grow at the long-term GDP growth rate of 4% in perpetuity via organic growth. Accordingly, the Reinvestment rate would be based on the one without acquisition.

Scenario 2. This assumes that the company would undertake another major acquisition next year that would boost its revenue by 8 %. Thereafter the revenue growth rate would reduce proportionately to the terminal rate of 4% in Year 6. Accordingly, the Reinvestment rate would start from the historical one with acquisition but reduce proportionately to one without acquisition by the terminal year.

For both scenarios, the base revenue was derived from the 2023 revenue based on the best fit logarithmic line for the past 12 years revenue. This will smoothen the “random” component of the annual revenue. Refer to the left part of Chart 8.

As KLK is a cyclical company, I assumed that the normalized margin would be the 2016 to 2023 average margin.

Chart 8: Projections

Note to Op Model. I broke down the operating profits into fixed costs and variable costs.

Fixed cost = SGA, Depreciation & Amortization and Others.
Variable cost = Cost of Sales that excluded Depreciation & Amortization.
Contribution = Revenue – Variable Cost.
Contribution margin = Contribution/Revenue.

On such a basis, I estimated the intrinsic value of KLK to be:

RM 27 per share under Scenario 1.

RM 36 per share under Scenario 2.

The market price of KLK as of 8 Nov 2024 was RM 22 per share. There is thus a 21 % margin of safety under Scenario 1 and 62 % under Scenario 2.

Valuation model – Scenario 1

In valuing KLK, I based it on the operating profit model shown in right part of Chart 8. I valued it based on the single-stage Free Cash Flow to the Firm model.

FCFF = EBIT(1 – t) - Reinvestment.

EBIT = Revenue X Contribution margin – Fixed cost.

Reinvestment was derived from the Reinvestment margin to give a 42% Reinvestment rate.

Value to the firm = FCFF X (1 + g) / (WACC – g).

Table 5 illustrates the calculation under Scenario 1. The WACC was based on the first-page result of a Google search for “KLK WACC” as shown in Table 6.

Table 5: Sample calculation – Scenario 1

Table 6: Estimating the cost of funds

Valuation model – Scenario 2

The valuation under Scenario 2 is based on a 2-stage valuation model as shown in Table 7. The key assumptions here are:

Revenue will grow so that the terminal revenue in Year 6 will be 42 % higher than that in 2024.

The terminal Reinvestment rate would be 42 %.

All the other parameters – Contribution margin, Fixed cost, WACC – followed those of Scenario 1.

Table 7: Sample calculation – Scenario 2

Notes

a) Straight-line reduction.

b) Pegged to growth rate.

c) Assumed no improvement.

d) Assumed growth at a terminal rate.

e) Revenue X Margin and after accounting for Fixed costs.

f) Assumed proportionate change.

g) b X f

h) FCFF for each year = e - g

j) Refer to the WACC table.

k) NPV for each year = (h X j)

l) Terminal for the year discounted at terminal growth rate.

m) 5 years NPV + terminal value.

n) Inclusive of any excess TCE. Non-operating assets, MI and Debt.

o) Based on the number of shares.

Case Notes

In my valuation of KLK, I have considered the cash flow from the various segments as one. In practice, the Plantation, Manufacturing, and Property development segments are affected by different economic forces. As such they would face different growth paths and risks.

Valuing KLK using a sum-of-the-parts (SOTP) approach can be particularly effective for a diversified company for the following reasons:

Segment differentiation. Different segments may have varying profit margins and capital requirements. Valuing them separately provides a clearer picture of where value is being created or destroyed.

Market comparisons. By valuing each segment against comparable companies in their respective industries, investors can gauge how KLK stands relative to its peers, leading to a more accurate valuation.

Flexibility in assumptions. A SOTP framework facilitates scenario analysis for each segment, allowing for better stress testing of different market conditions.

As you can see, fundamental analysis requires expertise and time. That is why I created the Fundamental Mapper to shortcut the process. You can see the position of KLK as of 7 Jan 2025 in the Fundamental Mapper chart below.

Download the Fundamental Mapper app now on Xifu to get investment insights into Bursa Malaysia companies.

PS: The Fundamental Mapper gives you a first-cut picture. You probably would not consider KLK looking at just the Fundamental Mapper. But you may think differently following a detailed analysis as shown in this article. Along this line, a stock falling into the Quicksand quadrant would clearly be worth considering if you carried out a detailed analysis.

Risks and limitations

Consider the following when looking at my valuation:

Normalized values.

Likelihood of Scenario 2.

Size of non-operating assets.

As is a cyclical company, the challenge is estimating its performance over the cycle. I have assumed that the 2016 to 2023 average contribution represents the normalized performance over the cycle.

You can argue that this included the 2021/22 CPO price spike. Refer to the right part of Chart 2. If I used the 2016 to 2020 values as the normalized values, the intrinsic value reduces to RM 15 per share and RM 22 per share under Scenarios 1 and 2 respectively. The choice of the years has an impact on the intrinsic value.

Secondly, looking at KLK's history, I think that Scenario 2 is more likely than Scenario 1. The challenge with Scenario 2 is that the trendline for the projected Free Cash Flow is more optimistic than then historical one. This is illustrated in Chart 9.

Furthermore, the projected operating profit as shown in the left part of Chart 8, shows a more aggressive revenue growth picture.

Chart 9: Sanity checks

But in mitigation, the projected revenue growth for Scenario 2 from the current to the terminal year is equivalent to a 6% CAGR. This is about what KLK had achieved in the past based on its organic growth.

Finally, from Table 5, you can see that the non-operating assets comprise the excess capital employed, cash, and other investments. I estimated that these amounted to about RM 9 per share. This is sizeable compared to the intrinsic value. In mitigation, the margin of safety under Scenario 2 is still there, but reduced, even if you ignored the non-operating assets.

Conclusion

KLK has successfully diversified into manufacturing and property development. As of 2023, the manufacturing segment has emerged as the largest revenue contributor. Despite this diversification, KLK is still a plantation Group.

The Plantation segment has consistently shown superior profit margins compared to the Manufacturing segment. However, the cyclical nature of the plantation sector, influenced by fluctuating palm oil prices and associated oleochemical markets, poses challenges.

Over the past decade, KLK has achieved a commendable revenue growth rate, yet profit margins were volatile. And the declining trend in gross profit margins raises questions about future profitability unless operational efficiencies can be improved.

Additionally, while KLK has maintained a strong financial position with consistent cash flow generation, the increase in debt levels needs monitoring.

KLK's strategic focus on efficiency improvements, alongside its potential for organic growth and further acquisitions, positions the Group well for future success. My valuation suggests a significant margin of safety based on the current market price.

Overall, KLK's ability to balance its historical strengths in plantation operations with its evolving business landscape will be critical as it seeks to enhance shareholder value.

Investment thesis

The Group's expertise and established operations in the plantation sector provided a stable foundation for revenue generation. Despite its cyclical nature, the Plantation segment has consistently shown superior profit margins compared to other segments.

The diversification to manufacturing, particularly in oleochemicals, has allowed KLK to capture additional value. This vertical integration enhances profitability and stabilizes revenue streams against the cyclical nature of the plantation business.

The Group is also financially sound. Furthermore, the current market price of KLK reflects a significant discount compared to estimated intrinsic values. This provides an ample margin of safety.

END

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I am not an investment adviser, security analyst, or stockbroker. The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies. Investments or strategies mentioned on this website may not be suitable for you and you should have your own independent decision regarding them.

The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such.

I may have equity interests in some of the companies featured.

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