IOI Corporation Berhad: RSPO Suspension Leads to Buyer Loss and Depressed Market Value
Greenhaven Road Capital commentary for the third quarter ended September 30, 2022. Q3 2022 hedge fund letters, conferences and more Dear Fellow Investors, The Fund is enduring its worst drawdown since inception. We were down again in the third quarter, bringing year -to-date returns to approximately -59%. Returns vary by . . . SORRY! This Read More
IOI Corporation Berhad, a palm oil producer with market capitalization $6.6 billion (MYR 28 billion), was suspended from the Roundtable on Sustainable Palm Oil (RSPO) for six months in 2016 for illegally clearing 11,750 hectares (45 square miles) of forest and peatland in Indonesia, and for failure to mitigate fire risk.
- IOI’s suspension meant that it was prohibited from selling crude sustainable palm oil, prompting 27 of its largest corporate buyers, including Unilever, Kellogg, Mars, Nestle, and Cargill, to suspend procurement contracts with IOI, and its competitors then purchased certified palm oil from competitors such as Kuala Lumpur Kepong. As a result, IOI reported a net income available to common shareholders of negative MYR 59 million in Q2 2016 compared to MYR 113 million gain in Q2 2015.
- Depressed equity valuation, and the risk of a debt ratings revision by Moody’s, made IOI’s equity and debt less attractive to investors. As shown in Figure 1 (below), IOI’s market capitalization dropped 17 percent, or MYR 3.2 billion. Two months into the suspension, on May 10, 2016, Moody’s stated it “expects IOI’s earnings and profitability will deteriorate…if the suspension is not resolved swiftly.” Moody’s reaffirmed its Negative Outlook on IOI August 11, 2016.
- By August 2016, IOI returned to RSPO with plans to improve its sustainability record, and the suspension was lifted. IOI’s shares rallied 5 percent to MYR 4.45 August 5, 2016 on the news. IOI’s suspension continues to impact it one year after its reinstatement, with some suppliers yet to resume purchases because of concerns about the company’s ability to enforce sustainability practices in its operations. In September 2017, IOI announced it had sold its Loders Croklaan –and Loders’ high-value palm oil products – to Bunge for $946 million.
FIGURE 1: IOI SHARE PRICE AND VOLUME (2016)
FIGURE 2: IOI IN THE PALM OIL SUPPLY CHAIN, CORPORATIONS WHO SUSPENDED PURCHASES, AND IOI'S RECENT PRODUCTION.
Palm oil is a staple of many consumer goods, biofuels, and plastic substitutes found in over half of all packaged products purchased by Americans. Because it achieves higher yields than other oilseeds, it is attractive for cultivation and highly profitable. It is the most actively traded vegetable oil globally.
Plantations, cooperatives, and smallholders grow oil palm trees (Figure 2). The fruit from oil palm trees yield about 4 to 5 metric tons of crude palm oil (CPO) and 0.5 metric tons of crude palm kernel oil (PKO) ha per year.
Demand for palm oil has tripled over the past fifteen years. In 2016, global palm oil production was 58.3 million metric tons. Malaysia and Indonesia produce 85 percent of global supply.
The rapid rise of palm oil production is a key driver of both global tropical deforestation and the draining and burning of peatlands in Malaysia and Indonesia. This has many serious environmental and social consequences:
- Peatland deforestation accounts for 5 percent of global GHG – the same level as the entire country of Japan. Thus, Indonesia is the 3rd largest GHG emitter globally.
- Burning peatlands creates a toxic haze of gasses and particles with serious health effects. In 2015, 100,000 deaths in SE Asia can be attributed to haze from landscape fires. Many of these fires occurred on peatlands.
- Deforestation endangers wildlife. Only 15 percent of flora and fauna survive when a primary forest transitions to an oil palm plantation. Tigers, orangutans, and other species are now critically endangered due to deforestation and peatland destruction.
The RSPO was established in 2004 to address these concerns. The RSPO promotes the growth and use of sustainable oil palm products through credible global standards and engagement of stakeholders. RSPO certification systems involve third-party audit. These systems are: Identity Preserved, Segregated, Mass Balance, and Book & Claim. CSPO is produced under these systems.
In 2017, CSPO accounted for about 21 percent of global palm oil production. CSPO may attract higher prices than CPO because it reduces deforestation and supply chain risks for palm oil consumers with transparency and sustainability commitments.
Many growers, traders, and buyers have made zero-deforestation commitments. For example, palm oil buyers such as Unilever have made public commitments to exclusively purchase No Deforestation, No Peat, No Exploitation (NDPE) palm oil. Midstream traders such as Wilmar and Cargill have also made NDPE commitments. As of July 2017, IOI has a NDPE commitment in place.
IOI Corporation Berhad (IOI:MK) is vertically integrated in two areas: plantations and resource-based manufacturing (Figures 2). In FY 2016, 91 percent of IOI’s MYR 1.9 billion revenues from its plantations segment accrued from sales to its resource-based manufacturing business units.
IOI became a founding member of the RSPO to develop and access the CSPO market. In 2015, IOI produced 5 percent of global CPO and 6 percent of global CSPO. Its products are exported to 85 countries. IOI engages in multiple activities across the palm oil supply chain. First, it leases over 300,000 ha over 90 estates. As shown in Figure 3 (above), the resulting production is 3.7 million metric tons of crude palm oil annually – 750,000 of which is CSPO. Second, it operates 15 mills to process the palm oil with a combined annual capacity of 4.75 million metric tons fresh fruit bunches (FFB). Additional to its own production, IOI buys CPO and PKO from pre-qualified suppliers. Third, IOI operates four large refineries that make palm oil into the goods we use each day.
Once the fresh fruit bunch is milled into CPO and PKO, the products are shipped globally to be manufactured into three commercial sub-segments: refined goods, oleochemical products, and specialty oils and fats. IOI refines palm oil, with an operating capacity of 3.3 million metric tons per year. Since 2012, IOI has grown production and improved yields (Figure 2). Both dipped in 2016.
IOI’s Suspension from RSPO
On March 25, 2016, RSPO announced its suspension of IOI taking effect April 1, 2016. The suspension was in response to allegations by Aidenvironment that IOI’s subsidiaries in West Kalimantan, Indonesia did not follow RSPO rules. IOI subsidiaries PT Berkat Nabati Sawit and PT Sukses Karya Sawit had allegedly illegally deforested 11,750 ha. This included 1,300 ha inside the Manis Mata Production Forest. They also lacked required government permits.
On August 5, 2016, RSPO announced it was lifting IOI’s suspension based on progress of its action plan to remedy complaints. IOI submitted various documents to RSPO on its action plans, including quarterly progress reports and endorsements by the IOI Board of Directors, as well as a joint statement between IOI and Aidenvironment related to the original complaint. However, RSPO has threatened re-suspension if deficiencies are not corrected.
The suspension from RSPO had both reputational and market impacts on IOI.
Reputational risk. As described in Engage the Chain Drivers of Financial Risk, reputational risk is the risk that adverse publicity regarding [a company’s] business practices and associations, whether accurate or not, will cause a loss of confidence in the integrity of the institution. As an early adopter of RSPO, the actions of its subsidiaries illustrated poor oversight and inconsistency in implementation of sustainable practices. Second, the reputational damage was compounded by the company’s legal action against RSPO for its decision to suspend IOI. IOI withdrew its lawsuit against RSPO two months after filing it in Zurich, Switzerland. Since then, IOI has improved its sustainability profile. It now reports that 51 percent of its palm oil can be traced from plantation to mill. IOI’s management needs to restore the peatlands and forests it destroyed, in violation of RSPO criteria, to further address the reputational risks it suffered as a result of its suspension from the certifying body.
Market risk. Within the agricultural supply chain, market risk refers to the potential that access to buyers’ markets and financial markets will be adversely affected. In the case of IOI, access to both markets were jeopardized.
Buyers’ markets. In terms of buyers’ markets, suspension from RSPO led 27 of IOI’s corporate buyers of CSPO to suspend their procurement contracts. The company was not only unable to retain future contracts, but for a period of time it was also unable to sell its existing CSPO inventory. Many of its customers had implemented sustainable sourcing policies prior to IOI’s RSPO suspension and would have suffered reputational damage if they did not suspend their contracts with the conglomerate.
IOIs suspension continues to impact it one year after its RSPO reinstatement. Some suppliers have yet to resume purchases from IOI because of concerns about the company’s ability to enforce sustainability practices in its operations. For example, Unilever did not announce that it resumed sourcing from IOI until August 2017. At the same time, IOI announced it intended to sell Loders Croklaan for $946 million to Bunge in September 2017.
IOIs competitors capitalized on this uncertainty in the CSPO market. IOI’s suspension denied it market access, temporarily reducing global CSPO supply by 6 percent. Kuala Lumpur Kepong reportedly raised its CSPO prices from MYR 85-MYR 107 to MYR 150-MYR 171.
Restoring access to buyers’ markets was stifled by IOI’s reputational risk and ongoing NGO scrutiny. For example, Greenpeace pressured IOI through April 2017 until a commitment to sustainability practices was negotiated.
The suspension hit the company’s bottom line. Net income available to common shareholders was negative MYR 59 million in Q2 2016, a decline from MYR 113 million income in Q2 2015 (see Figure 2).
Financial markets. IOI’s suspension also hurt the company’s access to financial markets. From a closing price of MYR 5.00 on March 14, 2016, IOI stock slid 17 percent to MYR 4.12 on May 16, 2016. During this period, IOI lost close to MYR 3.2 billion in market capitalization. Over the same period, IOI underperformed its competitor Kuala Lumpur Kepong by 6.5 percent. Although IOI’s stock price increased 5 percent after the August 5, 2016 news that its RSPO suspension would be lifted, the share price was still below pre-suspension levels. In calendar year 2016, IOI underperformed the FTSE Bursa Malaysia Asian Palm Oil Plantation Index MYR by 11.7 percent.
Debtholders were also affected by its suspension. In May 2016, Moody’s reviewed for downgrade IOI’s unsecured debt, citing its RSPO suspension and its loss of CSPO procurement contracts. As of August 2017, Moody’s rated IOI’s outlook as negative and its issuer rating as Baa2.
In the case of IOI, the failure to enforce sustainable practices and the subsequent suspension from RSPO tarnished its reputation, damaged its customer relationships, and depressed its market value. For palm oil producers such as IOI, managing material business risks from deforestation will be key to maintaining future profitability, due to the heightened scrutiny across an array of stakeholders, including customers, investors, and NGOs.