Olam International: will the demand for food drive bond prices up?

Olam’s ability to service interest is decent. EBITDA over interest expense was 2.5x in 2019, up from 2.3x in 2018. Gearing, measured by net debt over EBITDA, stayed relatively high but dropped from 7.9x to 6.7x in the same period. Free cash flows, defined as net operating cash flow (“CFO”) minus capital expenditures, remained positive at S$756.4m in 2018 and S$108.9m in 2019.

To put the performance in the perspective of its peers, Olam’s credit profile is somewhat weaker than other agricultural merchants, with a higher gearing and lower interest servicing ability (Table 3). Bunge Limited and Archer Daniels Midland Company (“ADM”) are publicly traded firms in the US, while Louis Dreyfus Company (“LDC”) is an established agricultural trader with a portfolio covering the entire food value chain. ADM and Bunge are larger companies in terms of revenue as compared to LDC and Olam.

Like Olam, LDC has a high gearing metric, but has better debt and interest coverage ratios. However, LDC may be affected by the company’s exposure to Luckin Coffee after the two parties signed an alliance last year. In 2019, LDC recognized fair value gains of USD 63m from its investments in Chinese coffee chain, which could be written down this year.

ADM has the strongest credit strength among the four companies, with a 7.4x interest multiple and low 31.6% debt-to-total capital ratio. Bunge, on the other hand, reported negative EBITDA as the company made a loss of USD 1.3 billion during 2019, as a result of lower operating profit primarily in its sugar and bioenergy businesses, where a charge of USD 1.7 billion was recognized associated with the sale of sugar and bioenergy operations in Brazil.

Table 3: 2019 credit performance vs peers

First quarter outlook

We expect sales to fall during the first quarter of 2020 as prices of agricultural commodities have generally weakened across the board (Table 4). Sugar and cotton prices decreased significantly by 22.4% and 26% respectively in the first quarter. Cotton futures decreased due to a meaningful drop in retail textiles sales. Olam has announced that the company will be divesting its sugar business with the sale of the remaining 50% stake in Indonesian sugar joint venture, Far East Agri.

Food staples and packaged food revenue could witness a large pullback in 1Q20 as the underlying agriculture benchmarks in rice, sugar, corn, soybean meal (which is mainly used in animal feed), palm oil and milk have declined. Restaurant closures and the lower demand for cheese have brought down milk prices, forcing farmers to liquidate excess inventory. Country lockdowns have lowered demand for corn and ethanol, which led to a fall in corn futures.

While some countries like China and the US are starting to reopen their economies, others such as India remain in lockdown. Reopening the economy will lift consumption, but these demand-and-supply imbalances are likely to persist for at least some time, leaving supply chains in disarray. Until we have a clear outlook for long-term predictable demand, farmers will have a difficult time forecasting crop demand for the next season and agriculture prices may remain volatile.

Table 4: Agriculture commodity prices

High cash conversion cycle

Due to the inherent nature of the agricultural business, Olam has a high albeit improving cash conversion cycle of 70 days (Table 5). The firm alluded the improvement to the increase in bulk trading volumes and better access to supplier credit.

Agriculture traders face specific risks linked to biological- and weather-related factors, commodity price volatility, rural area infrastructure, and government trade policies, which may have a meaningful impact on profitability. With a significant customer base in frontier markets, striving for low counterparty risk, well-developed logistics and good working capital management are crucial to Olam’s credit outlook. The group’s ability to convert working capital to cash has been improving, but we will continue to monitor its cash-conversion ability as an indicator of potential credit weakness.

Table 5: Cash conversion cycle

Bond valuation

Given its easy access to liquidity and good cash-flow generating ability, we think that Olam’s bonds are attractively priced among global agribusiness credits. We like the OLAMSP 4.500% 12Apr2021 Corp (USD), OLAMSP 5.350% Perpetual Corp (USD), OLAMSP 5.500% Perpetual Corp (SGD) and OLAMSP 6.000% 25Oct2022 Corp (SGD) for their comparatively higher yields (Figure 4).

OLAMSP 5.5% SGD perpetual has a first call date of 11 Jul 22 with an indicative ask yield to call (“YTC”) of 9.6% on 29 Apr 20. If not redeemed, the distribution rate would reset to the sum of the prevailing SGD five-year swap rate, the initial spread of 368.5 basis points, and a step-up margin of 200 basis points. Although the reset benchmark is at a low level now, we hold the opinion that the extension risk is low given the step-up component and the issuer has good access to multiple funding channels.

We also recommend the OLAMSP 6% ‘22s for their appealing high yield of ~6.0%. Both the 6% ‘22s and 4.5% ‘21s are ranked senior unsecured, which are above the junior subordinated ranking of the perpetual notes. The Olam notes follow the terms and conditions of the company’s Euro medium term note program dated 15 Aug 15. The 4.5% 2021 bond had a yield to maturity of 14.6% as of 29 April.

USD investors may consider the OLAMSP 5.35% perp and OLAMSP 4.5% ‘21s following the significant decline in their prices. Recent quotes for the 5.35% perp indicated an ask YTC of 13.5%. If not redeemed on 20 Jul 21, the OLAMSP 5.35% perpetual note is resettable to the sum of the prevailing 5-year US Treasury yields, the initial spread of 4.29% and step-up margin of 2%.

Olam’s USD bonds are trading significantly wider than those of LDC. Last year, LDC delivered a better credit performance than Olam. But we would still prefer Olam’s bonds given their relative valuation and as LDC is still a private family-owned business with limited disclosures.   

ADM and Bunge have stronger credit profiles and this is reflected in their respective yield curves. (On a side note: the lower yields may also be a consequence of the pledge by the US Fed to buy US corporate bonds including fallen angels.) ADM is rated A2/A/A, while Bunge has credit ratings of Baa3/BBB/BBB-. All three rating agencies have stable outlooks on the two companies’ credit ratings. Regardless, we are more inclined towards Olam’s bonds as they provide a higher risk-reward in our view.

Figure 4: Relative valuation

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a principal interest in the OLAMSP 6.000% 25Oct2022 Corp (SGD). The analyst who produces this report owns none of the abovementioned securities.