The commodities sector can be notoriously volatile, as prices of commodities such as coffee, palm oil and sugar may experience rapid fluctuations in response to supply and demand issues. Aside from crop-specific issues, there are also cyclical swings in each commodity based on the supply-demand situation at any point in time.
For investors who plan to invest in the commodities sector, a key aspect to look out for is whether companies are still caught in the downcycle, as this means that they will suffer from a combination of low demand and high cost prices. One way to analyse this is to look at a group of such companies to ascertain if conditions are indeed better for all players, or if there is still significant stress within the system.
In order to determine if commodity companies are seeing better days ahead, I took a look at three aspects – revenue growth, gross margins and net profit growth. I selected a group of four companies which are representative of the sector – Wilmar International Limited (SGX: F34), Golden Agri-Resources Limited (SGX: E5H), First Resources Limited (SGX: EB5) and Bumitama Agri Ltd (SGX: P8Z).
All four companies saw year-on-year top-line declines, and this sends the signal that the commodity cycle probably has not run its full course yet and that companies within the sector are still subject to weak demand and falling prices. The average decline in revenue was 17.7%, but investors need to find out if the main contributing factor (for each company) was due to volumes, prices, or a combination of both.
In terms of gross margin, all companies also experienced a decline in gross margins, with two of the companies (First Resources and Bumitama) seeing a more than 10 percentage point plunge in gross margin. Notably, Wilmar is the largest and most established player, reported just a small decline in gross margins of less than 1 percentage point. The gross margin compression means that cost of goods sold is staying high while pricing may be pressured, or that the cost of acquiring the commodities is rising (due to lower supply) while selling prices stay constant.
Net profit growth
All companies saw a deterioration in net profit, with declines of between 50% and 70% being the norm. Note that Golden Agri reported a loss in Q2 2018, but the loss has worsened considerably for Q2 2019. The problem here is that the high operating leverage for such companies negatively impacts net profit when revenue takes a tumble.
Still mired in trouble
The above shows that commodity companies are still mired in trouble and are far from being out of the woods yet. Though larger players may have multiple divisions and diversification to mitigate some of the revenue and margin declines, the high operating leverage will still result in a significant decline in net profits.
Investors will do well knowing that commodities are an inherently cyclical industry, and this makes it a tough industry to both monitor and invest in unless one is intimately familiar with the cycle.
The information provided is for general information purposes only and is not intended to be personalized investment or financial advice. Motley Fool Singapore contributor Royston Yang does not own shares in any of the companies mentioned.