Market Overview

Olam Fights Back Against Muddy Waters' Ahead of Research Report Release

Olam International Ltd. (OTC: OLMIY), a Singapore-based agricultural commodity trading company, is fighting charges by Muddy Waters LLC, a Hong Kong-based investment research company, that Olam is misleading investors by overstating profits and is too highly leveraged. Muddy Waters disclosed that it has a short position in Olam shares, which are traded in Singapore.

Muddy Waters founder and research director, Carson Block, made his allegations in a speech given at the Ira Sohn investment conference in London last week. Following Block's remarks, Olam shares and corporate bonds were heavily sold.

Muddy Waters gained a reputation for sharp analysis when it criticized Sino-Forest Corp., a U.S.-listed Chinese tree plantation company that went bankrupt after Muddy Waters accused the company of cooking their books. Muddy Waters made a large profit on its short position in Sino-Forest.

Muddy Waters is scheduled to release its research report on Olam on Tuesday.

Block's key criticism of Olam is the company's ”aggressive” accounting for biologic assets. Under International Financial Reporting Standards (IFRS), which Olam is required to use as a Singapore company, Olam must estimate the fair value of its agricultural crops and animals. According to Bloomberg, “A global accounting standard introduced in 2003 forces companies every three months to value living things from wheat crops to cattle, or so-called biological assets. As Singapore-based Olam branched out from being the world's second-largest rice trader and acquired dairy farms and almond plantations, the company began to apply the rules that accountants themselves say are riddled with subjective assumptions on future prices, inflation, production and costs.”

To illustrate how difficult it is to value biologic assets, consider this: One of Olam's biggest investments is a greenfield oil palm plantation in Gabon, in Western Africa, which, according to a 2011 research report published by CLSA Asia-Pacific Securities, is expected to cost $236 million for the 50,000 ha (123,500 acres) of phase 1, much of it funded by debt.

New oil palm plantations are capital-intensive and do not yield any cash flow at all for four years. Oil palm seeds are started in nurseries where they grow for a year before the seedlings are planted in the field. Oil palms take three to four years to go from seed until they bear fruit and do not reach peak production until the sixth year after planting in the field. CLSA says that planting will be complete by 2016, which means that the last trees planted as part of phase 1 will not be at peak production until 2022.

To follow the IFRS rules, Olam must estimate the fair value of an oil palm seed in the nursery today based upon what the price of palm oil will be in 2019, when that seed will be a seven year-old tree entering peak production. While it is not as subjective as trying to figure out the winner of 2019 Kentucky Derby when that horse will not even be foaled for another four years, there is considerable room for differences of opinion.

IFRS then requires that Olam book any estimated gains or losses on the estimated fair value of its biologic assets to its profit and loss account. In the first quarter of fiscal 2013, ended September 30, 2012, Olam's net gain on the estimated value of its biologic assets came to about 24 percent of reported profit for the period, a relatively high figure but not necessarily a red flag.

Under U.S. GAAP, the Olam oil palm plantation would be valued at the lower of cost or market. In this case, the value of the greenfield plantation would be all of the costs associated with preparing the site, buying the seeds and the cost of labor needed to plant and tend the seedlings. There is no market price for an immature oil palm tree. Once the tree begins to produce fruit and yields palm oil, an actively traded commodity, then a market value can be assigned to the plantation based upon how much palm oil is produced per acre.

Although one could argue about the valuation assigned to the company's biologic assets, Olam's auditors, Ernst and Young, have issued a statement saying that they agree with the methodology used.

The other aspect of Muddy Waters' criticism of Olam is the amount of leverage on the balance sheet. This same criticism was lodged by CLSA in its 2011 report. “The February 2011 CLSA report, which raised far fewer concerns than we have identified internally, and that Olam itself made so controversial, should have caused you to work toward repairing what ails your business and your balance sheet,” Muddy Waters said in a statement posted on its website. “Instead, Olam has since increased its a) debt load by approximately S$900 million, b) cumulative investment cash burn by approximately S$2 billion, and c) cumulative operating cash burn by approximately S$500 million. In other words, you did the exact opposite of what you should have done. Your actions have been an abject failure of leadership.”

Olam responded by saying that its inventories consist of large amounts of agricultural products that have already been sold to customers but have not yet been delivered and commodities that have been hedged. The company considers these inventories that are “liquid, hedged or sold forward” to be near-cash assets that are a normal part of the company's business and uses these inventories to adjust the amount of net debt to equity in its investor presentation.

Given its track record, investors do listen to what Muddy Waters has to say. All eyes will be on tomorrow's release of their research report on Olam. Expect more news and more volatility in the share price tomorrow.

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