United Plantations (UP for the sake of brevity) is an integrated palm oil plantation, milling and refining company (plus a small coconut plantation). It’s currently too expensive for me to buy but it is a company that I would like to own if the price ever drops to an acceptable level.
Superficially, there are a lot of reasons why palm oil companies look like a bad investment. Like all agricultural commodities, the price of palm oil fluctuates a lot. There’s the risk of pests, disease or unfavourable weather events. A significant amount of palm oil is used for biofuel so there is some regulatory risk associated with reduction of biofuel subsidies or an outright ban of biofuel. Many people have concerns about the health impact of consuming palm oil. And the industry has had a lot of bad press regarding forest clearing, peat fires and loss of wildlife habitat.
I have some pretty strong views on these areas. For full disclosure I previously worked in the vegetable oil industry (including palm oil milling) and still do a small amount of work for a palm fruit milling machinery company. So you could say that I’m biased but I have at least seen what goes on at well managed mills in Malaysia, Indonesia and PNG. My opinion is that most of the bad publicity is undeserved and that unless people everywhere decide to accept a major downgrade in their diet and standard of living, palm oil is going to be part of our diet for the foreseeable future.
Previously, most of the hard fats in our diet came from animal fats such as tallow, lard and milk fat. Vegetarianism (and also halal and kosher requirements) made the first of those two unacceptable for many consumer products and veganism reduced the addressable market for the third. For a period, hydrogenated seed oil (mostly soy) provided an acceptable alternative. Unfortunately, health concerns regarding trans fat meant that hydrogenated oils became unpopular. That left palm. For a large food manufacturer or restaurant chain seeking an oil which makes baked goods fatty (but not oily) or fried food crispy, the oil which will offend the least number of customers from a dietary and religious point of view is palm.
Palm oil (and palm kernel oil) are also very versatile (compared to the main industrial oils) in terms of producing specialty products. The oil can be fractionated simply by chilling it until part of the fat solidifies and filtering the solids out from the liquid. The wide range of fatty acids in the oil make it useful for oleochemicals such as soaps and emulsifiers. It’s currently a very cheap oil - that might not continue in the future. But it will probably always be the easiest oil to manufacture many specialty products from.
In terms of the environmental impact, palm has much less impact than other oils when managed correctly. Palm oil uses a fraction of the area of land per tonne compared to soy, canola and sunflower oils. It also uses a fraction of the fertiliser, pesticide and herbicide per tonne compared to seed oils. Biomass from the pressed palm fruit is used to provide nearly all of the electricity and heat for processing. The main waste product is wastewater which is treated to a high standard (often by recovering biogas for combustion) before release. Based on the numbers alone, palm oil is the oil with the lowest environmental impact by a substantial margin.
Obviously the quantitative inputs aren’t the full story. A small proportion of the industry engages in unethical practices such as illegal clearing, burning etc. There is evidence that shows this is a very small part of the industry and that many of the more visible incidents (such as smoke emissions) that are blamed on the palm oil industry are actually caused by other sources. What I do know is that I haven’t seen anything like that in the (relatively old) plantations I have visited. UP has committed to exceed industry (RSPO) standards and has indicated that any future plantation purchases will only be for pre-2005 brownfield projects. UP’s management isn’t incented to grow the company at any cost. The company has set aside 11% of their land as forest reserve. If you add up the qualitative and quantitative environmental impacts of palm oil it is way ahead of the seed oils - which ironically have received very little bad publicity. The palm oil industry really could do with a well executed public relations campaign or two.
Compared to other crops, palm is pretty good in terms of agricultural risk. It’s not like soy or canola where you could lose an entire crop if the weather is poor. Permanent tree damage is rare. There are weather events such as El Nino which cause water shortages but usually when this happens production declines throughout the industry and the price of oil rises to compensate. There is still a risk that a new type of pest or disease could decimate the industry. I have no way of putting a probability on that except to say that it would be a similar risk to that faced by timber plantations all over the world.
That leaves the commodity price risk concern. All vegetable oil producers are subject to fluctuations in selling prices. The market for commodity oils such as crude or refined palm oil is very competitive and spot prices have fluctuated by +/- 40% over the last 30 years. However, UP’s KLSE listed peers have mostly been continuously profitable during this period. UP’s profitability has been especially stable. ROE has been between 11% and 17% whilst the best of its peers has rarely exceeded single digits. There is something unusual going on here - the bulk of the rest of this write-up is about the reasons for UP’s unusual profitability.
There are three main reasons why I think UP is unusually profitable - infrastructure, management and a special customer relationship.
UP’s infrastructure can be broken down into plantations/milling and refineries/downstream. One complex of 11 plantations with four mills and one refinery/packing plant is located in Perak, Malaysia. There is also a plantation and mill in Kalimantan, Indonesia and a bulk terminal near Penang in northern Malaysia. It probably sounds odd but I would say that UP’s infrastructure advantage is due to a lack of built-in mistakes rather than a special advantage. UP doesn’t have any infrastructure that couldn’t be replicated by other companies. What it does have is restraint and a lack of short-termism which has allowed the company to correct previous mistakes. UP could become a much larger company by buying plantations and other infrastructure at a rapid rate. But by being very selective about the quality of plantations that they have bought and the way they are developed, UP has stayed relatively small and avoided mistakes which would have significantly eroded shareholder value.
There are a lot of ways a palm oil company can bake long-lasting mistakes into their infrastructure. You really only get one chance to build a mill or set out a plantation - once it is built the cost of rectifying individual mistakes often exceeds the benefit. What often happens is that rectification projects that have less than a three year payback time or are difficult to quantify usually don’t get approved. That means management teams tend to reject projects with an IRR which is less than an arbitrary hurdle rate but significantly greater than their whole-company ROA. In contrast, UP will replant newly purchased plantations even if the existing palms aren’t that old - just because the standard of planting won’t provide the yields they require. By paying attention to a lot of small, boring capital reinvestment details a palm oil company like UP can accumulate a spectacular asset-driven advantage over a long period of time.
The most obvious example of an infrastructure mistake is in the purchase of plantation land and planting of palms. You can certainly grow oil palms on cheaper land which is susceptible to flooding or on the side of a steep hill. But oil palms are difficult to harvest - the fruit bunches are like a 30 kg pine cone stuffed with large olives. These need to be cut down without the bunch landing on the harvester’s head and somehow transported to the mill. You somehow need to get a tractor between the trees in order to broadcast fertiliser. So during good weather your cheap plantation may yield similarly to good quality land but wet weather will prevent access for harvesting and fertilising and so yields will decrease. If the plantation wasn’t properly managed during infancy then the palms may have permanent problems that will persist for another 20 years until they are replanted.
UP have avoided purchasing anything but relatively flat, good quality land and they manage their plantations so meticulously that employees of their competitors will tell you about it. Another example - in Malaysia at least one of UP’s mills loads the fruit into rail cars close to where it is harvested. These rail cars then transport the fruit to the mill and are used to hold the fruit inside the sterilisers which are the first step in the milling process. This sounds a bit boring and obvious but it cuts out a lot of labour cost and fruit damage related yield losses. Strangely, I haven’t heard of another company which does this - probably because hilly topography makes it too expensive.
UP also has its own tissue culture and seed production facilities. This not only means that they likely pay less for their seedlings, it also gives them control of the quality of the seedlings they plant. Given that it takes more than three years before the first harvest, it’s a big problem if mistakes are made in seedling selection.
One other capital expenditure issue specific to the industry is replanting. Oil palms must be replanted every 20 to 25 years or so, otherwise yields decline. If a company falls behind in its replanting schedule then future yields are compromised. Just being frugal doesn’t work - replant and maintenance capex must be spent at just the right time to maintain profitability.
Also, all of the above is not to say that UP have never made infrastructure mistakes. In the past the company has tried to grow by acquiring or setting up agricultural operations in South America and Australia and by investing in a Norwegian fish oil producer. Some of the existing plantations originally had flooding problems. But these mistakes have been divested, shut down or improved and the focus in recent decades seems to be on sticking to activities that UP has been successful at for a long time.
Survival of the Fittest, Not the Fattest
In terms of scale economies, I’m not worried about a competitor gaining an advantage over UP. Palm oil mills tend to max out in capacity at around 120 t/h - larger than this and the distance to the furthest plantation it services combined with the need to process fruit on the day it is harvested makes it more economical to build another mill elsewhere. UP’s Malaysian mills are between 40 and 60 t/h capacity. There are no companies with scale advantages at plantation/mill level. By comparison, soy and canola oil crush plants grow ever larger as the incoming material logistics and shelf life permit silo storage and long-distance transport by rail - fixed costs tend to drive smaller soy and canola mills out of the market.
At refinery level there are scale advantages in the production of commodity products but these are largely negated by changeover and batch size considerations for companies that produce higher-margin specialty products. UP’s two refineries are relatively small and produce mainly specialty products. They are highly integrated - by that I mean that they interact with the company’s mills to make their most of their inputs. For example, biogas from the palm mill effluent is used to fire the refinery boiler. Pipelines allow oil to be sent to the refinery from the mill without using trucks. When companies talk about synergies to justify making overpriced mergers it is often hard to see if the synergies are real. For palm oil businesses the synergies are obvious - you can see most of them from Google maps. In the oil milling industries in general, assuming the absence of scale issues, the company which is best integrated and makes the fewest infrastructure mistakes is the lowest cost producer. In the palm oil industry, that company is UP.
The only way I am comfortable investing in a commodity company is if I am confident that it can remain profitable during a period of depressed commodity prices.
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