Olam @ 1.39 ( Supply Chain / Singapore ) 13 comments
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1.High valuation risk at >26X trailing PE
2.Considerable operational risks, given fluctuating commodities prices and lack of hedging options for many
3.Considerable and continuous borrowing to fund working capital
4. Low dividend yield
I had been watching this stock for some time and wondering when its upward momentum would stall. It seemed to me there were quite a few risk factors involved and I don't understand how it can be trading at >26 times trailing PE, based on the latest results just released in late August (which means forward PE is not that relevant here since we're just at the start of a new financial year).
Firstly there is valuation risk. The nearest comparable would be Noble which is trading at 7-8 times PE, and whose revenue base and track record as a listed company is better established than Olam's. Here of course the comparison is not quite apple to apple, since they are supply chain managers dealing in different commodities: Noble in primarily industrial, Olam in food. One may classify the former's business as being driven by countries' investment needs, the latter's business as being driven by their consumption needs. At this stage of the global business cycle, however, I would think both sectors are generally buoyant. So why the pricing discrepancy?
Secondly, there are a few key business risks to consider. As listed down in Olam's prospectus, a key risk is price fluctuations in the commodities they deal in. Hedging options are not available for a number of commodities, such as cashews, rice, dairy products. Weather risks would have to be incorporated for agricultural-linked stocks such as this; just look at how Zhongguo Powerplus's price was affected by the floods in China. And how about interest rate risk? Olam's business runs on short-term credit and about 40-50% of its operating profit goes to interest payments, which could escalate and limit growth if global rates rise as they are likely to do over the coming year. Not to mention developing country risk, where Olam mostly source their food products from, although the diversified scale of their operations mitigates this risk.
Thirdly, there is balance sheet risk. It is interesting to note that for the last three years (2003-2005) Olam has been incurring negative operating cash flows, and these are substantial too: S$74M, S$188M, S$713M in 2003, 2004 and 2005 respectively. For a trading company this may be acceptable since it is clear that the company re-invests the profits into new inventory on an on-going basis. But nevertheless watching inventory double while full-year revenue only grows 30% must be a negative sign under any circumstances. Its S$200M cash from the IPO has all been spent and it even borrowed an additional S$500M to finance its ballooning S$800M working capital (increase in receivables, inventory). That was really aggressive and one has to worry about its huge short-term debt of S$1.2B. One may compare it with Noble's capital structure which takes in a considerably lower proportion of short-term bank debt (being able to establish credit terms, probably interest-free, with suppliers) and also keeps substantial cash reserves.
And of course, since Olam's management seems keen to re-invest profits, it has only declared a miserly dividend of 2 cents for the year, or less than 1.5% yield. Not particularly rewarding for a stock trading at such high multiples.
I mentioned at the start that I was wondering when the stock's recent momentum would stall. Let me do a bit of market timing and stick my neck out to say it is now. Fund managers, in particular Newton Investment Management, have been buying up the stock these few months, providing the price impetus. It has reversed its position and started to sell recently. Newton, if I remember correctly, were also buying into Noble earlier this year driving its price up to 1.80, and when their buying stopped the stock sank and settled at 1.40-1.50. I'm thinking the fall could be worse for Olam.