Wednesday, February 23, 2011

Olam concerns (SGX)

Decided to write a post on this firm after a CLSA analyst wrote up on it. 
Many have known that I have expressed concerns with this firm since 2005 and amazingly it is a market darling and still garners much support from the market especially institutions. (Just look at its credit ratings).
  1. Firm has pretty weak cash flows (see diagram below) and high leverage (Net debt/equity is over 1.8x, gross over 3x) due to using leverage to plug the shortfall in FCF
  2. Firm is an acquisition machine, adding that to capex will mean free cash is ..literally not there
  3. Heres the funky part, the firm uses GC/NC or gross/net contribution (approx 300% of NPAT) to measure firm performance. Net profit is what it is, no 2 ways about it. You do not hold a weight loss competition by measuring volume changes.
    1. GC = Sales less COGS (ex all exceptional, interest income and change in FV of convertible)
    2. NC = GC less finance costs (ex finance cost for capital investments)
    3. It may be argued GC/NC are used for segmental measurement, however capital cost are still costs that needs to be matched to revenues, as well as changes in FV of derivatives. Especially so when a bulk of acquisition of companies and their fixed assets are from taking on more debt.
    4. The funky stuff are for firm strategy, probably for performance measurement and remuneration of the senior management. 
  4. Compensation is relatively high to speak the least for the performance they are showing
  5. Complex business - I only vaguely understand the business after repeated reading of the annuals
  6. Margin accounts is (of 2010 figures) 10% of revenues, 1.5x of profits, 33% of derivatives held, 19% of inventory and 89% of cash. Given we do not know the margin split attributable to whichever assets, rising commodity prices will nevertheless mean more cash needed in margin accounts which already has a high level of working capital tied in it.
  7. Company management was sensitive to questions on risks, performance measurements etc
  8. Valuation wise, Olam is US$ 5 billion, smaller than peers of US$ 9- 20 billion. Putting faith in their figures, Olams PE and EV/EBITDA is about 30x/15x vs peers of 17x / 13x (From CLSA report). This is despite ROA and ROE not being significantly higher. That is pricey!
  9. Export incentives are substantial - read below. Do note that governments can remove it.
Source: CLSA report, my comments in red 
CLSA also recently did an negative opinion report, I was curious and took a read. Surprisingly, the management replied back in a tone that was very similar to what we saw in 2000 where many tech firms rebutted. 
  1. Olam said Nigeria government incentives are not 30-40% of profits but 15-20% of total export sales revenue and that it does not directly flow to profits.
    • 2 things come to mind - Firstly, Olam bases the figures all on revenues and not profits. Secondly 15-20% of revenue is still substantial isnt it, and on a profit basis will be even larger?
    •  The incentive is equivalent to a direct cash profit that adds on to gross profits (sets off expenses). Incentives are on a FOB sales value basis. Olam claims it passes a bulk of the incentives back to the suppliers and farmers. The validity of the claim in terms of amount and proportion is beyond me to check.
    • For 2010, incentives receivables are added to income statement is S$104m / 95m and on balance sheet S$ 96m / 133m . To give you an idea, net profit for 2009/10 is S$252m / 359m.
    • Nigeria contribution to revenue is 5% small yet to profit is larger,so it backs up the above point.
  2. Differences between unaudited and annuals for inventory, cash, capex, COGS and margin accounts.
    • Olam mentioned in the rebuttal 
      • For incentives, cash accounting instead of cash accounting which CLSA claims should be used and therefore annual reported figures should not have differences. That also means the incentives can be applied with discretion
      • Differences in capex / PPE was reclassification (Acquisition to business combinations)
      • Differences in comprehensive income due to reclassification (Subsidiaries in various jurisdictions and/or between line accounts within group account). 
      • Did not explain the differences in interest expenses 
    • It seems like although numbers are likely to be correct and accurate as claimed by Olam, the figural changes may hint at loss of information between the auditors and the firm itself as well as the firm strong reliance on short term funding and acquisitions to fund growth.
While the CLSA analyst may seem to have not have been precisely accurate, a majority of the hinted discussions do shed some light on the firm and raises many points to think about. Kudos to the analyst.

Disclaimer: Author does not hold any position in the above related counter.


Anonymous said...

This issue is not new. I used to cover Olam and over 2 years ago this issue was brought up before the company. A lunch meeting was also hosted on this issue. If the incentives are taken off then farmers will just shut down in the country of operations and Olam will source from elsewhere. Given Olam has given a point by point rebuttal (unlike in 2000, where the answer was you a general "don't get it"), the CLSA analyst has to give a point by point rejoinder. Otherwise he/she is accepting she was mistaken

Mervyn Teo (MT&Co) said...

Yes i agree with you, generally they are touchy on this issue. However it is good that shes approximately accurate on some facts than precisely wrong on accounting principles. The fact is the numbers do not tie in when they should and not how much incentives flow through. But I guess analyst are paid to be right on everything.

I am surprised by the point by point reply. Think the company credit ratings may be jolted if this turns up negative. It is funny I just read the papers and saw the founder's picture advertised by ANZ as funding Asia's growth :)

The crowd is pretty much focusing on the wrong things. The incentives are: if right, affects earnings but is probably 10-20% but if wrong then theres no case for arguments. A stronger case would to seriously look at the earnings quality and the operations and decide if the premium is justified.

Asia needs more shorts, or shots..

PS: If you wish to discuss more with a non professional researcher like me, feel free to drop me an email. Ill be honored and more than happy to respond.


Theirs always surprises when you owna stock.

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