Upstream windfalls, downstream shields

IOI Corp Bhd is not your typical plantation play.

While many investors chase pure upstream companies that fully capitalise on crude palm oil (CPO) price rallies, IOI is building a business that buffers such volatility by straddling the entire palm oil value chain, from plantations to oleochemicals and now, palm wood.

But is this diversification a dilution of value or a strategic hedge that offers long-term resilience?

At first glance, IOI's strategy to maintain a vertically integrated model might seem counterintuitive.

The upstream plantation segment, though generating only 30% to 40% of group revenue, contributes as much as 79% of lOI's profit in a good year.

By contrast, the downstream and resource-based manufacturing segment contributes up to 70% of revenue but only around 21% of group profits in financial year 2024 (FY24).

This imbalance raises a fundamental concern: During CPO upcycles, IOI is unlikely to reap the full windfall that pure upstream players enjoy.

In boom times, the downstream segment drags overall profitability due to its thinner margins and time lag in passing on higher input costs.

Critics argue that IOI is effectively "muting" its own earnings during commodity bull runs.

But IOI defends its strategy on multiple grounds. For one, the downstream operations serve as a natural hedge.

And the numbers speak for themselves. Despite the downstream business contributing up to 70% of lOI's revenue, the upstream plantation segment remains the major profit generator.

"Last year, we reported that our upstream contributed 79% of the profit of IOI in FY24," IOI deputy group chief executive officer Tan Kean Hua tells StarBiz 7 in an interview.

In contrast, he points out that the downstream segment brought in just 21% of profits.

The margin disparity is stark, but there's a strategic rationale.

"This is sort of a natural hedge," he adds.

"When palm oil prices are low, that means that the input cost for the downstream is lower. So the profit margin for the downstream will be bigger," he explains.

This cushioning effect was evident in FY23 when downstream profits rose to 37.5% of group earnings.

However, this approach can be frustrating for investors expecting to ride the full wave of a CPO rally.

"When it becomes 90%, then people say, why are you downstream? But it's a cycle... If the situation flips, you don't have that opportunity to earn more downstream," Tan adds.

Oleochemicals adds value

IOI's downstream oleochemical operations, spanning Malaysia and Germany serve multiple high-value sectors, pharmaceuticals, cosmetics and nutrition.

The company has also gained traction supplying essential ingredients to multinational clients like Bunge Loders Croklaan for infant milk formula and cocoa butter equivalents.

Its edge? ESG compliance and quality assurance.

"We pride ourselves as we actually produce lower (levels of 3-MCPD and GE) contaminants and there are customers actually asking for it. Mostly European customers and also the animal feed industry," Tan says.

Furthermore, about 20% to 25% of lOI's refined palm products sold to third parties are certified sustainable. But more than just certification, IOI touts product quality and traceability.

"Because we are integrated, we say that we have security of supply and it comes from our own mill, it doesn't sit in the tank for too long. That's why we are able to produce such good quality," he adds.

The EU Deforestation Regulation, viewed by many industry players as a threat, is seen by IOI as an opportunity.

"If we are integrated, we can tell the customer that we can provide you whatever information you want, and that meets that requirement. So actually from a threat, it's turned into an opportunity for us," Tan explains.

Palm wood: A risky diversification?

Perhaps the most surprising pivot in lOI's strategy is its entry into the palm wood panel business, a venture the group has positioned as part of its "circular economy" and net-zero roadmap.

"This is really where we have to walk the talk. We talk about the circular economy. We have our carbon neutral target by 2030, we have our net zero (target) even (by) 2040," Tan explains.

"And this type of project is supposed to help in achieving this."

Built with a hefty RM120mil investment, the palm wood plant is equipped with German and Italian machinery and is currently running at just 20% to 30% capacity.

Tan concedes this is a long-term play.

"When you talk about a start-up, it takes a few years, probably another few more years before we can see profit," he adds.

The company is not competing on price alone.

"We try not to talk about price. We try to talk about other aspects. This is sustainable green material. We say that, can you imagine, this is a waste material that we convert into something useful?"

The product is formaldehyde-free, lightweight, and can be used in furniture, flooring, decorative panels, and even acoustic solutions for auditoriums.

Yet mass commercialisation remains a hurdle, as buyers compare it to conventional timber.

"Customers will say 'What's the price? To them, the price benchmark is timber. So that would be our reference price," Tan shares.

Still, IOI is optimistic.

"We are convinced that we will reach there. The world is moving on," he said, adding that some global brands have already expressed interest in sustainable materials for their stores.

For investors seeking immediate leverage to CPO prices, IOI's integrated model may not appeal.

"If you take a long-term view; it's not wrong for analysts to say when it's high, why are you downstream? I mean, it's normal for a human."

Yet the benefits, resilience, traceability, premium pricing, and ESG positioning, paint a different picture for long-term shareholders.

The palm wood venture, while a slow burn, aligns with global trends and regulatory shifts.

And as IOI positions itself as a premium, integrated, and sustainable palm player, the company may well become a preferred partner for global buyers seeking not just oil, but trust and traceability.

In the words of Tan: "This is not just about making money. This is about making a difference, and the returns, we believe, will follow."