Tug-of-Fools: Olam – The Bear Argument

Commodities trader Olam (SGX: O32) got thrust into the financial-media spotlight last November when short-seller Muddy Waters denounced the company. There will be many on both sides of the fence, but, I’ll like to share why I’m on the side of the bears.

Let’s Make Some Money

Olam ended 2007 with S$5.48b in sales and S$109m in earnings. Since then, those figures have increased by more than 2.5 times, with sales and earnings for the last 12 months (LTM) clocking in at S$19.5b and S$415m. That’s fantastic growth, isn’t it?

But, a different picture emerges when we focus on Olam’s Return on Equity (ROE).

Needing A LOT more money to make money

Olam’s ROE has been falling steadily since 2008, as seen in the graph below. It means that Olam required increasing amounts of shareholder capital for each incremental dollar of earnings over the years, and even more capital is needed going forward if the downward ROE trend persists.


For Olam to maintain earnings growth, it needs more money. There are only three sources that Olam can tap; retain more earnings in the company; asking for more equity from investors or increasing debt.

Retention of earnings would mean smaller dividends. That, in and of itself, is not an issue. The crux here is the falling returns that each retained dollar is earning. As a shareholder, I’m being done a disservice if dividends, that are supposed to be accrued to me in search of better returns, are being retained to earn smaller returns over time.

The same argument holds with asking for more shareholder equity – why should an investor pick Olam over better alternatives? Investors don’t really have much say over the amount of earnings being retained by management, but they (meaning investors) certainly have a choice when it comes to ponying up more cash.

And, that leaves us with debt.

Needing Borrowed Money to Make Money

There’s nothing inherently wrong with debt. But investors need to bear in mind that debt creates risks for companies that take on too much of it with the most glaring one being bankruptcy-risk.

Olam’s balance sheet already carries net-debt of S$8b while carrying only shareholder’s equity of S$3.6b. That’s high and in a credit crunch, Olam will have a lot of trouble finding ways to pay-off any due-debt, especially when it’s struggling to generate cash from its operating activities (between 2007 to 2012, Olam consumed a total of S$2.09b in cash).

This does not make taking on debt to grow earnings a palatable choice.

So what does all this mean, going forward? It means that Olam’s earnings might fall. And falling earnings do not generally lead to happy endings for shareholders.

Foolish Bottom Line

In short, Olam’s balance sheet, bloated with debt, carries with it too much risk. Couple that with the risk of falling earnings, and I find myself scowling at it in the bear’s den.

That was the bear argument. You can read the bull argument here.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.