Plantations & Commodities (CIMB)

• Glencore’s listing arouses interest in supply-chain managers; maintain Overweight with Noble as our top pick. Glencore’s recent listing has stirred interest in supply-chain managers with several investors comparing Glencore with Noble and questioning the former’s lower valuations and business model. We revisit their business models briefly and compare their historical valuations. We view Glencore as a complement to rather than substitute for Noble. Maintain Overweight on the Plantations and Commodities sector, with Noble as our preferred supplychain manager. No changes to our earnings estimates or stock ratings. We anticipate re-rating catalysts for locally-listed supply-chain managers from volume growth and earnings contributions from recent investments. Noble remains an Outperform while Olam remains a Neutral.

• Differences in business models justify valuation gap. Glencore trades at 8.8x CY12 P/E, a discount to Noble’s 12.0x and Olam’s 16.7x. Its lower valuations may, however, be justified by its portfolio which comprises mainly hard commodities, whereas 21% of Noble’s portfolio consists of agricultural products while 100% of Olam’s portfolio is made up of soft commodities. Hard commodities tend to command lower valuations due to more-pronounced cyclicality and companies’ heightened earnings volatility. In our view, the recent decline in metal prices could have a more adverse impact on Glencore than Noble given the former’s significant exposure to metals and minerals.

• Fundamentals remain positive. Recent commodity-price declines have also sparked fears of a fall in demand following a string of lacklustre economic indicators. We view the recent pullback as a temporary unwinding of speculative flows rather than a structural reversal of demand and supply fundamentals. While price weakness and recent events (e.g. Japan’s earthquake, Ivory Coast’s political events) may suggest muted performances from supply-chain managers in 2Q11, we remain confident in their medium-term prospects, buoyed by sound underlying demand and supply fundamentals.

Supply-chain managers at a glance

Different business models; different valuations. Noble’s shares were softer during Glencore’s listing, possibly due to portfolio reallocations, coupled with a broad sell-off of commodities amid fears of lower demand following a string of lacklustre global economic indicators. While Glencore’s valuations are lower than Noble’s, the two are not directly comparable due to differences in their business models. Glencore’s portfolio comprises 62% of energy products, 31% of metals and minerals and 7% of agricultural products. On top of that, it has a structurally long position in fleet chartering, exposing it to fluctuations in spot freight rates. Noble, on the other hand, is 66% concentrated on energy, 21% on agriculture and 13% on metals, minerals and ores. Its exposure to freight rates is insignificant. Glencore’s lower valuations could perhaps be justified by its exposure to freight markets and portfolio of hard commodities, which typically command lower valuations due to a higher degree of cyclicality, and therefore earnings volatility. As such, we view Glencore as a complement to rather than substitute for Noble.

Figure 1 provides an overview of supply-chain managers’ products and geographic segmentation, as well as historical valuations. Managers handling soft commodities, especially food-related products, historically command higher valuations (with the exception of ADM). This is in line with their greater earnings stability from fooddemand inelasticity vs. the demand for hard commodities such as metals.

Softer metal and mineral prices could deal a bigger blow to Glencore than Noble. Metals and minerals accounted for 48% of Glencore’s operating profit in FY10 and 19% of Noble’s. Softening metal prices could therefore have a more adverse impact on Glencore’s profits than Noble’s. Glencore’s portfolio is heavily skewed towards metals and minerals, including zinc, silver and iron ore, with significant upstream exposure via the ownership of mines. This exposes it to price fluctuations. The recent downturn in commodity prices could thus result in a devaluation of its inventories and hurt its profitability.

Noble is buffered by agriculture. Conversely, agriculture, for which demand is less elastic than metals, accounted for 47% of Noble’s operating profit in FY10 and 14% of Glencore’s. This suggests greater earnings stability for Noble than Glencore. Although agricultural commodity prices were recently rather volatile, we believe that the impact on volumes should be quite subdued.

Fundamentals intact

Glencore’s CEO Mr Ivan Glasenberg’s comments on the recent sell-off in commodities:
“A lot of it has been funds creating a bit of froth in the market, but the underlying fundamentals of the commodities market is relatively strong because of the tightening of supply… Asian demand should underpin growth in commodities as global producers strive to keep pace with booming appetite from the region.”

Underlying fundamentals remain positive. In our view, the recent pullback in commodity prices is more likely the result of a temporary unwinding of speculative flows rather than a structural reversal of demand and supply fundamentals. We remain sanguine over commodity fundamentals, on the basis of: 1) the global economic recovery; 2) continued growth in China and India; and 3) the massive reconstruction in Japan which should drive demand for various commodities. Residual effects from global events such as Japan’s earthquake and the Ivory Coast’s political events may disrupt trade flows in the near term, but these headwinds should ease by 3Q11, paving the way for firmer flows in 2H11. Other headwinds may, nevertheless, arise from: 1) the faster-than-expected cooling of emerging economies such as China and India, which may weaken the demand for commodities; and 2) an unwinding of QE2 by the Fed as it prepares the market for rate hikes in 2012. This would reduce the excess liquidity that has been financing speculative investment in commodities.

Valuation and recommendation
Maintain Overweight; Noble remains our preferred supply-chain manager. Locally listed supply-chain managers are on track to deliver earnings growth, helped by: 1) larger pipeline capacities, which should support volume growth; 2) margin improvements as they integrate their networks and exploit profit points along the chain; and 3) the resumption of global trade after disruptions caused by Japan’s disasters, Ivory Coast’s embargo and Australia’s floods.

We maintain our Outperform rating on Noble with an unchanged target price of S$2.70 (based on 15x CY12 P/E), and Neutral rating on Olam with an unchanged target price of S$3.34 (based on 18.7x CY12 P/E). Noble remains our preferred supply-chain manager for its more attractive valuations than peers, stronger balance sheet, product diversification across hard and soft commodities, and superior working-capital efficiency. Against Glencore, we believe that its earnings should be more resilient to the recent decline in the prices of hard commodities given its lower exposure to this product segment.