Olam: risk management system in place

Prices of most inventories are hedged. Olam’s business model is to earn a margin from providing the supply chain management service to its clients, and Olam does not speculate on soft commodity prices to get its margin. Olam typically hedges 80-85% of its inventories with futures contracts (futures contract exist for cotton, coffee, cocoa and sugar) and forward agreements. Price volatility for these hedged commodities will therefore not impact on Olam’s profitability. However, there remains a 15-20% of its inventory which is unhedged, and this is estimated at S$269-358m (based on Jun 08 inventories of S$1.79b). Management indicated that the price volatility of these unhedged commodities is typically less than that for commodities with futures contracts. If the prices of these unhedged positions were to hypothetically fall 10%, then PBT could fall S$27-36m. However, we note that the impact is only one-time and the situation will normalize when commodity prices stabilize.

Olam controls its customer exposure according to some grading system. For the larger customers, Olam deals with them on a cash-against-documents basis. For the next level of customers (which are the smaller ones), the price exposure is limited to 3-6 months and not more than US$200k per invoice. Lastly, for some African customers, sales is done on the spot. This management system helps Olam control its counter-party risk.

Balance sheet strength remains comfortable. Olam has a net debt to equity ratio of 3.17x. After adjustments for stocks and debtors (which are liquid and cash-like in nature), the ratio falls to 0.74x. As of Jun 08, Olam has S$1.86b of working capital loans repayable by Jun 09. Management sees continued support from banks for its working capital financing, as these are rolling in nature (upon delivery of commodities to customers, Olam receives payment and pays off the working capital loans, and takes another loan when customers give new orders). Besides these working capital loans, Olam’s next refinancing obligation is US$200m at the end of FY10.

Olam has guided volume growth of 16-20% pa for FY09 and FY10. However, we have cut our revenue forecasts to factor in lower commodity prices. We have also cut our FY09 and FY10 net profit forecasts by 9% and 6% respectively to factor in losses from unhedged positions and slower demand growth given the global economic downturn.

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