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Olam's Amazon-style cash burn lacks the payoff promise: Gadfly

[SYDNEY] Here's one of those undisputed facts that happens not to be true: No large company can survive long without gaining a significant return on its investments.

You need only to look at the early growth of Uber or Facebook to see that investors will happily pour money into fast-growing businesses in the pursuit of scale that can be monetized at a later date.

Olam unsecured borrowings due within 12 months S$5.49 billion That helps explain the remarkable stock-market performance of agricultural commodities trader Olam International. Despite a commodities crash that drove rice to a nine-year trough last year and pushed cotton futures to their lowest level since 2009 last week, the stock has fallen just 0.6 per cent since short- seller Muddy Waters rated it as worthless more than three years ago.

Investors, including Singapore's government-owned investment fund Temasek, Japanese trading house Mitsubishi Corp., and the owners of Olam's S$12.3 billion in borrowings, have funneled cash into the business in the hope that it will attain a scale to take on the big four "ABCD" traders, Archer-Daniels-Midland, Bunge, Cargill, and Louis Dreyfus.

That generous financing explains the Bizarro World nature of Olam's balance sheet. While ADM and Bunge have cut net debt over the past three years by, respectively, 37 per cent and 48 per cent, Olam has added an extra 31 per cent. That's not something many commodity traders have been doing in this environment.

There's method in this madness. Compare the free cash flow performance of Olam and Amazon over the past decade and you'd be tempted to think they were little different: Let's try zooming out a little, though, to see what's happened to Amazon over the past 12 months: That line where Amazon leaves Olam in the dust is actually the bull case for the Asian business. If years of top-heavy investment can pay off so spectacularly for a company distributing books and electronics, why can't the same thing happen for one distributing nuts and grains? Temasek and Mitsubishi have the capital to ride out weak patches in the commodities market, so seem happy to support Olam strategically in the pursuit of long-term advantage.

You get a good picture of this comparing Olam's bonds to those of a couple of other commodity traders. Olam has a higher debt-to-equity ratio than either Glencore or Noble, suggesting it should be considered a weaker credit. Far from it: Olam bond yields are pretty much the same as they were 18 months ago, while Glencore's and Noble's have soared: Is any of this a problem? Surely it's good to have some rich patrons who've put their faith in you? Well, up to a point.

Following its US$1.2 billion acquisition of ADM's cocoa business in December, Olam now has about S$5.49 billion of unsecured borrowings coming due in the next 12 months.  If the company generated enough cash to match its 10 best quarters since listing in 2005,  it would still come out a billion Singapore dollars short. Include all the quarters of negative operating cash as well and the total cash outflow from operations comes to minus S$3.09 billion. If Olam wants to get over that maturity hurdle, it will either need a miraculous operational turnaround or the continued equanimity of its lenders.

That's the key difference with Amazon. Jeff Bezos is famously averse to debt - his company has held net cash for more than a decade - so whereas Olam's rise has been fueled by bonds and loans, Amazon's has run on earnings. If optimistic shareholders change their minds about Bezos's high-risk strategy, the worst that can happen is a slump in Amazon's share price. If Olam's lenders do the same thing, the company will have to start producing some cash, and fast.

One significant difference is that Amazon consistently kept free cash flow positive whereas Olam was mostly eating into its balance sheet with negative free cash flows. Still, neither company was generating a lot of cash until recently.