Description

Note: All numbers are in Singapore dollars unless mentioned otherwise.

I recommend Olam International Ltd. as a short. Olam is a highly levered company that is generating returns below its cost of financing but is trading at approx. 1.4x its book value. The tied is slowing receding and the Company will soon be seen swimming naked.

In the last 10 years, the Company has grown its revenues by 650%+ and its assets by 1,200%+ (the disproportionate increase in revenue and asset is due to that the fact that the Company has transitioned from 100% asset-light supply-chain business to adding asset-heavy upstream and downstream business segments). The growth has mainly been achieved by taking on excessive leverage and aggressive acquisitions. While the business economics have not improved (actually have deteriorated), the Company is taking advantage of its complex business model to inflate revenue and earnings numbers. Investors dazzled by the growth of the Company have lent more money over the years, only for the management to gamble it away.

The Company made headlines multiple times in 2012-2013 post Muddy Waters’ short pitch at the Ira Sohn conference in London on November 19, 2012 and its subsequent write-ups, including the 133page initiation write-up posted on November 26, 2012. Reports on Olam by Muddy water can be found Here. While the stock tanked almost 20% after Muddy Waters’ initial short recommendation and then traded range bound for a year, the stock recovered strongly post Temasek’s tender offer in March 2014 to purchase Olam shares for $2.32 (12% premium to previous day closing price and approx. 65% above the lows experienced after Muddy Waters’ short report). Post the tender offer, Temasek via its investment arms Breedens and Aranda owns 58.5% of the Company (excluding shares received from convertible bond held). The tender offer boosted not just equity investor but also credit investor sentiment as the Company was subsequently able to secure $2.2 billion of bank loan from 12 banks in May 2014 and raise $700 million of long-term senior unsecured debt at 4.0-4.5% rate in July 2014, a ridiculous rate for a Company levered approx. 9x EBITDA.

While the Company was able to survive Muddy Waters’ short recommendation, the Company came under investor pressure to show real cash flows, which made the Company switch gears – stop new acquisitions/investments and target lower leverage and increased profitability. In the last year and half, the Company has applied breaks on acquisitions but this has taken the firepower from the Company to cook revenue and earnings. Despite the damaged vocal chords, the Company is still singing the same songs but from a different book as the management is trying to demonstrate that the Company is profitable and that the business is growing.

The hypothetical revenues and inflated earnings have come at the expense of the Company spending real cash on poor acquisitions and investments. Cracks have now begun to show in the growth and earnings numbers; quarterly results since CQ3 2013 have shown deteriorating sales and adjusted ROE has been less than 5% for FY2014. This coupled with the excess leverage (9.3x debt / EBITDA, 11.5x debt/EBIT) and high interest expense (approx. $520mm or 1.9x interest coverage ratio sales) is quickly catching on to the Company. In the short-term, Olam can manage to survive as long as banks and investors are willing to lend the Company money to refinance its debt, especially if the debt is refinanced close to its latest refinancing rate of sub 5%. But in the medium to long-term, Olam is a sinking ship. Why? Couple of reasons, i) in a macro environment where the chances of interest rate increasing is more than decreasing, if the average cost of debt increases by 1%, interest expense will increase by approx. $100mm, reducing profits before taxes by about one-third the estimated amount for FY2015, ii) the Company operates in a commodity industry that is tied to inflation and high competition (inflation is high especially in developing countries where Olam mostly services). 1% increase in working capital (increase due to inflation and no growth scenario) would imply approx. $50mm of capital required that can either come from cash flows from operations (at the expense of reduced cash for investments) or additional debt, and iii) with limited to no cash flows remaining after paying interest and necessary capex and with no capacity to raise additional debt, the Company has limited room to growth its business.

Olam’s Ways of Fooling Some People All the Time:

1) Inflated Revenues are Supported by Other Income and Non-Cash Accounting Gains - But with Other Income and Non-Cash Accounting Gains Even Pigs Can Fly

Olam relies on Other Income to exhibit revenue growth and positive earnings. Since 2009, Olam has used a total of $1.1bln of non-cash income to boost revenues and demonstrate increase in earnings, but over the years, the type of non-cash income recorded has changed:

• In 2009 – 2011, when olam was acquisitive, the Company used Negative Goodwill and FV Change to Biological Assets (both non-cash items) to boost revenue and earnings
• More recently (FY2013 – 2014), Olam has relied on Sale and Leaseback of assets and Remeasurement of Investments to boost revenues

Sale and Leaseback of Assets: Sale and leaseback is a nice way to reduce assets (leases are recorded as operating leases and not financial leases) and generate day-1 cash, but the Company will be required to make yearly lease payments (Olam will face approx. $13mm of additional expenses going forward) that will reduce earnings

• In 2013, $36.3mm of gains from sale of USA Olam Orchid Almond plantation (1,940 hectares); lease expense of $3.5mm per year
• In 2014, $124.4mm of gains from sale of Australia Olam Orchid Almond plantation; estimated lease of $10mm per year (($309mm cash received from financing – non-cash gain) / est. years)
• The initial term of the lease agreements is for approx. 6.5 years and so approx. $85mm of lease expense should be capitalized and added to the long-term liability

Remeasurement of Investments: In 2014, Olam reclassified PureCircle Limited investment from an Associate to Available-for-Sale asset and remeasured the value of the asset to book a non-cash gain of $271mm. The investment is not publicly listed (i.e., unquoated equity share) and so the valuation done by the Company has room for substantial manipulation.

Negative Goodwill: Since 2007, Olam has booked approx. $210.4mm of negative goodwill to increase revenues. Assets at the time of acquisition are measured by Olam to come up with the fair value, leaving room for manipulation. Apart from the non-cash benefit that Olam releases to boost revenue and earnings, the negative goodwill helps reduce asset value and increase return on assets.

Biological Assets: Since 2007, Olam has booked approx. $374.7mm to other income/operating expense benefit from change in fair value of the biological assets.

2) Other Expenses – Undisclosed Number a Plug for Everything Unexplainable and Way to Hide Losses

Other Operating Expenses is a convenient place to shove any unexplainable expenses and to hide losses incurred during the fiscal year. Footnote(7) in the annual reports provide details for the Other Operating Expenses / Other Expense number specified in the income statement. Olam provides only partial breakdown for the Other Expense number, leaving about one-third of the expense ($299mm for FY2014) undisclosed. While most of the items disclosed in the Other Expense footnote have remained fixed, some items like rental expense have been deleted and other items have moved between Other Income and Operating Expenses

• Forex gain / loss used to be a separate line item until 2010 but since has been looped into Other Expenses

• In FY 2014, Olam started including Employee Expenses (a $470+ mm number) in the Other Expense number

• When a big number in the range of $250 - $300mm goes undisclosed, it automatically affords the Company a lot of room to include any expense or loss that it wants to hide from investors. What is strange is the fact that Olam in some instances takes the liberty to disclose details on sub $5mm expenses but at the same time is not willing to provide clarity for the remaining $250-$300mm of expenses.

Other indirect expenses such as expenses/benefits from changes to forex, remeasurement of derivative investments and gain/loss from jointly controlled entities have been included in operating expenses and have contributed to reducing the total expenses, thereby increasing operating margins. In 7 of the last 11 years, indirect expenses have helped reduce operating expenses

• In 2010 and 2011, indirect benefits helped reduces operating expense / increase earnings by $111mm and $120mm, respectively

• In 2014, indirect benefits helped increase earnings before taxes by $47.8mm

3) Capital Expenditure - $4.1bln Investment Since 2010 that is Vaguely Disclosed

Olam’s capital expenditure is a black hole as Muddy Waters rightly points out. Capex is Olam’s #2 expenditure item (when compared on a cumulative basis), only after COGS. Even though the Company has spent a total of approx. $4.1bln on capex since 2010, the Company has provided limited details on where and how the cash is spent. Depreciation and amortization for the period on the other hand has been only been $660mm, implying that more than 85% of the capex should have increased the invested capital. To check whether the capex has actually increased the investment capital, we calculated the YOY change in the investment capital from the financial statements with the investment capital disclosed in Olam’s 2014 Annual Report. In the last 4 years, Olam has added $4.1bln of fixed capital (capex + acquisitions – disposal) but according to the latest Annual Report, investment capital has only increased by $3.5bln and so approx. $0.6bln of capital deployed is not being reflected in the investment capital

4) Biological Assets – Net Additions and Capitalization of Expenses Increase Assets but Do Not Have a Counter Balance on the Financial Statements

While the net change to FV of biological assets and gains from business combination have been widely discussed by Muddy Waters and other research analysts, additions to the biological assets and capitalization of expenses have not been analyzed closely.

Since 2010, Olam’s assets have increased by $459mm from addition of biological assets. Olam defines these additions as “Net additions include purchases, growths and harvests in the various biological assets categories”. Until 2013, Olam included capitalization of expense number in the net addition to biological assets number but in FY2014 the Company started bifurcating the two and reported capitalization of expense as a separate line item.

Additions to the biological assets are generated from hypothetical valuation of the harvest made and so this is a non-cash number. While the additions increase the non-current assets on the balance sheet, Olam does not report a counter line item in the income statement or the cash flow statement that balances the increased value. I presume that the increase in assets are added to the income number or reduced from the other operating expense number thereby increasing the earnings in the income statement and surplus retained in the shareholder equity. Apart from the increase in earnings, the higher assets lets Olam report a higher debt/equity ratio, a number that is currently the major focus of investors.

Olam on the other hand is capitalizing the expenses incurred to harvest and grow the plantations and so not including the expense in the income statement. The capitalization of expense is a real cash expense but Olam does not report the expense as reduction to cash flows from operations in the cash flow statement.

But is Olam a Good Business and Can it Generate Adequate Returns to Investors?

1) Adjusted Operating Margins and Investment Returns Do Not Justify the Stock Trading at 1.4x Book Value

Based on the previously mentioned adjustments to revenue and operating expenses, the adjusted operating profits (after adjusting for non-cash income and indirect benefits) reveal a very different story about the operating profits and the health of the business. My numbers are on the conservative side as the adjusted operating profits exclude expenses to grow the biological assets that Olam is currently capitalizing (approx. $60mm and $75mm for FY2013 and FY2014; other years not disclosed), implying that even adjusted operating profits are higher than actual profits. Some of the variations in the Company stated and adjusted numbers include:

• For FY2014, adjusted EBIT and PBT was only 4.2% and 1.5% compared to the stated 6.7% and 3.7%; 250bps and 220bps inside the stated numbers

• Adjusted PAT for FY2014 was below 1.0%

Similarly, adjusted ROA, ROIC and ROE are way lower than what Olam states in its financial highlights

• Real ROA is below 5% for FY2014

• ROIC has dropped from 10-12% range in 2005 – 2008 to below 7% in FY2014 and is modestly above the cost of debt and certainly below the cost of equity

• In 2010, adjusted ROIC was 6.6% versus non-adjusted number of 12.8% (6.2% difference)

• Non-adjusted number for FY2014 is improving from 2013 (10.5% vs. 8.9%) but in reality ROIC has dropped 150bps from (8.0% to 6.5%)

Adjusted ROE has achieved a max of 25.9% in 2008 (mainly due to high leverage; Asset / Equity ratio of 9.2x) and has been as low as 3.8% in 2014

• Since 2009, adjusted ROE has never been above 10% and has been dropping steadily

• ROE has been lower than ROIC mainly because of the heavy interest expense burden and lower asset turnover

With Olam trading at 1.4x Book Value, investors investing at current stock price are essentially capturing a return of 4.5% (assuming Olam’s average ROE of 6.5% since 2010)

Note: Direct = Adjusted numbers to reflect income/expenses from continuous operations; Total = Numbers as stated by Olam

2) But Despite the Low Investment Returns, the Company can Remain Solvent in the Short-term as the Relationship Banks and Debt Capital Markets can Provide Liquidity to keep the Company Floating

From a short term perspective, I estimate (based on conservative assumptions) that Olam will be required to issue $2.3bln of additional capital in the next 9months to fund operations through 2015. I assume no change in working capital from FY2014; to the extent working capital increases (as observed in Q1 2015 despite lower revenues), Olam will be required to source additional capital.

Olam has historically been able to keep operations running by tapping the debt market and drawing from its bank facility. From a business operational perspective, three areas are highly important to keep the Company functional: i) generate CFO before interest, tax and WC, ii) pay interest expense, iii) fund change in WC. But an estimated $1bln of CFO before interest and working capital changes for FY2015 is just sufficient to fund the Company’s annual net interest expense of approx. $0.43bln and capex requirement of approx. $0.5bln. The limited free cash flows to the firm leave no room for expanding working capital or increase in interest expense:

• 1% increase in interest rate would imply approx. $100mm of additional expense at current debt level

• 1% increase in WC would imply approx. $50mm of additional cash required to run the business

Olam clearly realizes the crisis and is taking steps to address the short term liquidity issue, but is dressing the steps taken as transformational / turnaround projects that are increasing the earnings and cash flows and reducing debt levels. Some of the steps in this direction include:

• Sale of assets, subsidiaries, and ownership interest – Olam’s messaging is that the Company is trying to get out of non-core business

• Sale and Leaseback – classic example of monetizing assets to generate near term liquidity

Olam has an existing bank facility of approx. $5.2bln and so is able to run its operations even though the Company is not generating sufficient cash to solve long term leverage issues. With limited free cash flows, maxed out leverage capacity and high interest expense, the Company is trapped in a corner and will not be able to reinvest or acquire more businesses without drastically hurting its balance sheet.

3) But in the Long-run, Leverage is a Time Bomb That is Slowing Ticking

Olam’s current leverage is 8.1x Net Debt/ Direct EBITDA and 10.0x Net Debt / Direct EBIT, implying that leverage is high by any stretch of imagination. Olam has historically operated at high leverage levels but previously most of the debt was short-term that was used to fund working capital and interest expense was low as the debt was short term. In recent years, with more long-term debt added to finance fixed assets, interest expense has increased resulting in lower interest coverage ratio. Leverage numbers derived from financial statements based on how Olam reports the liabilities does not depicts the true state of the Company’s balance sheet. Couple of items that should adjusted to get the right leverage numbers:

1. Overdraft is currently in the current liability and so increases cash balance. Adjusting cash for overdraft will reduce current asset to current liability ratio

2. Capitalised leases are only $53mm but operating leases are $481mm, a clear sign that Olam is using aggressive accounting and trying to avoid inclusion of certain leases in its balance sheet

3. Olam strips out capital lease interest expense from its interest expense number and so this needs to be added back to the total interest expense number

4. Due to the recent sale and leaseback activities, operating lease expenses will increase going forward and this is not included in the below interest coverage number

• 4) Checking for the Quality of the Investment Assets in a Liquidation Event - $1.5bln of Investments are Loans with No fixed Repayment Date and are Mostly Non-Interest Bearing

Approx. 34% of the fixed tangible assets are loans to subsidiaries, jointly controlled entities and associates with no fixed repayment date and about 60% of the loans made are non-interest bearing. As a part of its investments in jointly controlled entities and associates, Olam lends money to the companies. Loans provided are booked as assets on the balance sheet. In 2014, Olam had $1.48bln of loans to subsidiaries, jointly controlled entities and associates. Olam classifies the Loans to subsidiaries, jointly controlled entities and associates as “Loans to subsidiary companies, loans to jointly controlled entities and loan to associate have no fixed terms of repayment and are repayable only when the cash flow of the entities permits. Accordingly, the fair value of these amounts is not determinable as the timing of the future cash flow arising from these balances cannot be estimated reliably.”

Loans to Subsidiaries: Loans to subsidiaries are unsecured and not repayable within the next 12 months. Almost half of the loans made to subsidiaries are non-interest bearing and so while Olam is raising debt capital at 4-6% interest rate; the money invested is generating no returns

Loans to Jointly Controlled entities and associates: Loans to jointly controlled entities and associates are again unsecured, non-interest bearing and not repayable within the next 12 months

5) Finally, the Cracks are Starting to Show

Since H2 CY2013, with Olam putting the brakes on acquisitions, the Company has run out of firepower to demonstrate growth in volumes and revenues. We see the ground beginning to crack in a couple of places:

1. Direct revenues and volumes handled for FY2014 dropped by 6.6% YOY; first negative growth since IPO

2. Adjusted cash flow from operations dropped to $151mm for FY2014 from $253mm for FY2013 and $291.3mm for FY2012. Limited cash flows imply limited amount of cash available for reinvestment and to pay down debt while leaving the Company exposed to increase in interest rate and working capital changes due to inflation

3. With no more capacity to add debt, the Company has started to monetize existing assets via divestitures and sales and lease back. Sale and lease back of assets ($124.4mm benefit for FY2014), is a smart way of accelerate earnings but at the expense of increasing fixed expenses. Leased back assets are not included as capital expenses, another sign to reduce interest expense and liabilities on the books

4. Company raised $2.2bln of 1year bank facility to pay down short-term as well as long-term debt. While Olam is able to reduce interest expense for FY2015, refinancing the bank facility next year again exposes the Company to interest rate risk and banks appetite to lend to the Company, especially in a risk-off market environment

5. Confectionary and Beverages Segment is showing major signs of weakness. Volume has dropped by 170tons for FY2014 and FY2013; volume is down again in Q12015 compared to Q12014. Working capital on the other hand has drastically increased.

• WC for FY2014 increased drastically by $1bln from $1.6 to $2.6bln mainly due to increase in inventory and higher commodity prices

  • WC increased again in Q12015 by 100mm from end of FY2014

  • Commodity prices in the confectionary segment have increased in the last year or so Olam’s operating margins should typically benefit from FIFO accounting but this has not been the case

Catalyst

 weak quarterly earnings and pressure on Company to sell more equity to finance ongoing business and delever balance sheet