Plantation companies are one of the first to suffer from the deepening global downturn. And, as the year end nears, it is plantations with scale of production, the right mix of tree maturity and a conservative balance sheet (low debt and high cash levels), that are best able to weather the storm.

It was only a few months back, that the sector's outlook still looked so bright. Crude palm oil (CPO) prices were on an unprecedented upward climb. Fueled by high economic growth in India and China CPO prices soared to reach a peak of US$1,200 per ton by mid-year, about double its historical prices in the $350 to $600 per ton range.

Reflecting this trend, the share price of Indonesia's three top listed plantation companies, PT Astra Agro Lestari (AALI), PT Bakrie Sumatera Plantations (UNSP) and PT London Sumatera (LSIP) also doubled in 2007, reaching respective peaks of Rp 28,000, Rp 2,275 and Rp 10,650 per share by early 2008.

However, with the consolidation of the global downturn in the second semester, these earlier gains disappeared in a couple of months. CPO prices began their steep decline after June, reaching a low of $500 per ton by November. Reflecting this drop, share prices of the above three companies also fell by more than 70 percent, to reach lows of Rp 8,550, Rp 340 and Rp 2,725 per share, respectively.

This has been a painful awakening for plantation managers after seeing margins and profitability levels rise. So what has been the impact? First, there has been the drop in revenue with falling commodity prices. Costs, on the other hand, are fairly fixed and not easy to adjust downward in this sector. This ultimately translates into narrowing margins and profitability.

For instance, Astra Agro Lestari, the largest of the three plantation companies, showed a steady decline in quarterly net income from Rp 827 billion in the first quarter of the year, to Rp 770 billion in the second and further down to Rp 532 billion in the third quarter.

How have they responded? In the short-term, the response has been on finding ways to control costs and push them downward. This is difficult in a business with a long business cycle. Palm oil tree crops take 3-4 years to plant and grow to first production level, during which time it is all cash outflow. This is then followed by another 6-7 years for a tree to reach its maturity and generate peak yields.

Interestingly, the plantation cost structure has undergone a fundamental change with the rise in oil prices. In 2006, the largest cost component was labor, accounting for 39 percent of total cost.

However, by 2008, with rising gas prices, fertilizer costs have rapidly grown to replace labor as the largest cost component. Fertilizer, which previously accounted for just 14 percent of total cost, now takes up 34 percent of the CPO cost structure.

As a result, it has become the major focus in the sector's cost cutting efforts. Efforts are underway to use fertilizers more efficiently and to look at replacing costly chemical-based fertilizers with natural organic compost waste. The drop in oil and gas prices should help bring down fertilizer prices, although companies have yet to notice and confirm this trend.

In the long term, there is a focus on improving tree crop yields by investing in higher yielding and disease resistant seeds. Currently Fresh Fruit Bunch or FFB yields are about 18.2 tons per year per hectare. This palm fruit is then further processed by mills yielding an average of about 4.2 tons of CPO per year per hectare.

Most Indonesian plantation companies limit their activity to the upstream part of the value chain, focusing on planting, harvesting and processing palm fruits into CPO. Rarely have they ventured further downstream to vertically integrate into the next phase of processing, for example, into cooking oil or cosmetics, where the value added and larger margins are to be found.

There is also little discussion thesedays about investing in biofuel processing plants, with the decline in oil prices.

Plantation owners explain that moving downstream would require extensive investment. This is not limited to large processing plants but also to building distribution networks and marketing capability, as well as investing in creating strong brand names. This, they argue, requires a different skill base.

Besides, they also say, there is much to do already at their end of the value chain. The argument is that it would be more prudent if they focused on what they are good at, which is expanding and investing in their existing processing mill capacity, improving efficiency in their planting phase and increasing yields and then further seeking additional land or acquiring other plantations to plant more hectares and expand their capacity.

Astra Agro operates some 235,000 hectares of tree crops across the islands of Sumatra, Kalimantan and Sulawesi. About 80 percent of its tree crops are mature, with the remaining 20 percent in the planting or immature phase. In a downturn cycle planters prefer to have a larger mature proportion in their tree crop mix as it minimizes the heavy cash outflow found in the initial phase.

With a large mature area, there is also more cash flow generation, even with lower prices. This is why plantation companies that are relatively new or have a larger immature proportion of tree crops are suffering more in this downturn cycle.

Another cost that needs to be managed well in a downturn is financing costs. All commodity companies that face volatile commodity prices tend to have conservative balance sheets, carrying low debt levels in proportion to their capital. Astra Agro, for example, has Rp 1.9 trillion in cash as of September 30, 2008, and practically no debt.

It is too early to tell whether the recession will be long enough to encourage consolidation in this sector. What is sure is that those with scale, an appropriate mix between mature and immature tree crops and a conservative balance sheet should be able to ride out the storm more comfortably than others.

Manggi Habir is Contributing Editor at The Jakarta Post

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