Is Olam a victim of fair value accounting?
Has fair valued accounting muddied the waters?
The 133-page Muddy Waters (MW) report on Olam claims that Olam faces a high risk of failure and criticizes the company in a number of areas, including the following:
- Aggressive capital expenditure and acquisitions, involving low quality assets, which are badly managed and which may even be tainted by significant misconduct
- Questionable accounting practices and poor internal controls over financial reporting, which could be attributable to incompetent or even dishonest accounting functions
- Questionable risk management capabilities
- Over-leverage
- Complex, or “black box”, business model
In my view, the report has not provided clear evidence to support its allegations of possible misconduct and dishonesty.
Olam fired back quickly with its own 45-page response, dismissing MW’s claims. Olam said that it has no risk of solvency, its accounting is in accordance with Singapore financial reporting standards, its business model is working, and its capital expenditure and acquisitions are paying off. However, its CEO, Sunny Verghese, was more reflective a few days later, when he said that “the firm might have to tone down the very thing that defines it - its hard-driving expansion - …[and that the company] will take stock and see whether we need to slow down, decelerate, recalibrate." (Business Times, November 30).
So, putting aside the mud-slinging and unsubstantiated allegations, is there any basis for concern about Olam?
Accounting issues
MW has raised questions over accounting issues, such as the valuation of biological assets and the “negative goodwill” associated with Olam’s acquisitions, and how they impact Olam’s profitability. Olam’s response has been largely on target in terms of refuting the intentional use of inappropriate accounting practices to boost its profits.
However, the nature of Olam’s business and its business strategy exposes it to many of the vagaries of today’s accounting framework, which is heavily reliant on fair values. Under this accounting framework, most changes in the value of assets and liabilities have to be reported as part of Olam’s income, either in operating profit or comprehensive income (“below the line”). The application of fair value accounting in many cases requires considerable exercise of managerial judgment, internal (managerial) forecasts of future cash flows, and reliance on other assumptions which can have a big impact on a company’s profitability and financial position.
Some of the items that affect Olam’s financials and which are highly dependent on fair values include those relating to its biological assets, derivative instruments and intangible assets. For instance, gains from fair value changes relating Olam’s biological assets accounted for 25 percent of Olam’s profit before tax for FY2012. On its latest balance sheet, Olam has derivative financial assets and derivative financial liabilities amounting to about 9.5% and 8% respectively of its total assets, with about half of them having to be valued without the benefit of quoted prices in active markets for identical instruments. In some cases – so-called Level 3 financial instruments – they have to be valued without observable market data, and are therefore based on valuation models.
There has also been a debate between MW and Olam about negative goodwill versus positive goodwill in its acquisitions. In a way, this has masked a more important issue – the inherent subjectivity in accounting for goodwill and other similar intangible assets.
Basically, intangible assets are classified into those with indefinite lives and those with finite lives. Today, only intangible assets with finite useful lives are amortised over their estimated useful lives. In Olam’s case, these include customer relationships, software and concession rights.
Other intangible assets, such as goodwill, are not amortised but are instead assessed at least annually to determine if they have been impaired, and therefore, whether any impairment charges should be made in the profit and loss account. In addition to goodwill, Olam has trademarks and water rights which are not amortised. One issue is whether Olam has been sufficiently robust in assessing for impairment of these intangible assets. Over the past few years, Olam has made few impairment charges for such assets. Given some of the challenging markets that Olam operate, have the fair value of these assets remained largely intact? To be fair, only 3.5 percent of Olam’s total assets on its latest balance sheet are made up of intangible assets which are not amortised.
Indeed, impairment is relevant for many other assets, including property, plant and equipment, investments in subsidiaries and associates, and other financial and non-financial assets. There is a great deal of subjectivity involved in determining whether an asset has been impaired.
Financial risk
Olam is undoubtedly a relatively risky company. According to Reuters, Olam has a beta of 1.21, compared to Wilmar’s 1.03 and Noble’s 1.28. So, Olam’s stock is more volatile than the market and Wilmar’s, but not as much as Noble.
The chart below shows the cash flow from operations for the most recent five years for Olam, Noble and Wilmar as reported in their cash flow statements (Note: Noble and Wilmar reports in US dollars. For simplicity, this and the following analysis of profitability are presented using common Singapore dollars, based on exchange rates at the end of each calendar year).
[Image: olam1.gif?1354673227]
In terms of volatility of operating cash flows, the three companies look remarkably similar based on their peaks and troughs – and they are certainly much more volatile than your typical company. However, Olam’s operating cash flows tend to be negative or just barely positive over the last 5 years. It also has consistently large negative cash flows from investing activities. Together, these are consistent with Olam being in the “growth” phase rather than flows from investing activities. Together, these are consistent with Olam being in the “growth” phase rather than the “harvesting” phase of its business cycle.
In its response to MW, Olam has produced adjusted operating cash flows data, with adjustments made for inventories and receivables that are considered “near cash”. While this may be defensible for commodity players, “near cash” is nevertheless not cash, and will carry some risk of non-realisation. In any case, these adjusted numbers are still rather volatile.
The chart below shows that Olam’s profit before tax appears less volatile than Noble, and particularly, Wilmar. Ironically, when companies are in inherently volatile industries, but their profit trend appears smooth, there may be concerns that management has “managed” the profits using the application of accounting standards. For example, they may reduce the amount provided for uncollectible accounts or rejig their internal cash flow forecasts used in valuing certain assets, within the boundaries of generally accepted accounting principles.
[Image: olam2.gif?1354673240]
Finally, when we do a simple comparison of leverage, using the ratio of total liabilities to shareholders’ equity, Noble turns out to be much more highly levered than Olam. Olam is more highly levered than Wilmar, but there is some convergence with Olam’s ratio coming down and Wilmar’s going up. Olam and Wilmar also report adjusted leverage ratios. In Olam’s case, it has made adjustments for liquid hedged inventories, citing Standard & Poor’s as an authority. As mentioned earlier, while there are good reasons for such adjustments, there will nevertheless be some risk in terms of realisability.
Internal controls and corporate governance
According to Olam, 80% of the 65 countries in which it operates “are emerging markets which are poised to grow faster”. This provides opportunity but also comes with risks. Some of the countries that Olam operate in suffer from a lack of good management capacity, and in some cases, high risk of fraud and corruption. Systems and processes that we take for granted here may be lacking. The concern in these cases may not be so much with subjectivity in values, but with even more fundamental issues of internal controls over assets and proper record-keeping. For example, fixed asset management and inventory control can be challenging. It is not uncommon in some countries for assets to be in the books, but when auditors visit the premises, there is no sign of them. These issues affect the financial statements. Olam may need to get better assurances over these controls especially from their internal auditors and provide better assurances to investors.
Governance and management are also complicated by the very business model which Olam touts as a key source of its competitive advantage. In particular, it claims a “differentiated core supply chain business” which enables it to “out-origin” its competitors by “sourcing directly from the farm gate”. This is a contributor to Olam being seen to be a “black box” because its network of suppliers is truly mind-boggling.
Olam’s latest annual report disclosed that its total sourcing volume was 10.675 million metric tonnes (MTs), made up of 24%, 48%, 18% and 10% respectively from the Americas, Asia and Middle East (A&ME), Africa and Europe. It sourced from 3.4 million farmers in Africa! This compares with 7,400 and 111,300 farmers in the Americas and A&ME. Average sourcing volume for Africa per farmer was about 0.5 MT, compared to about 309 and 42 MTs for the Americas and A&ME respectively. In terms of per hectare, it was 0.53 compared to 1.51 and 26.1 respectively. Olam has to deal with a huge number of relatively small suppliers in Africa. In a way, Olam adopts a contrarian supplier strategy compared to many other companies in other businesses – which is to reduce the number of suppliers it deals with directly in order to improve supplier management and relationships.
Therefore, a fair question to ask is this: how does Olam manage such a complex supplier network? Is the so-called competitive advantage truly translatable in the long run into better performance than its competitors?
Olam clearly puts a lot of emphasis on risk management, and it has to because it has to deal with many risks, including those relating to the nature of its business (commodities), extensive use of derivatives, high leverage, aggressive expansion, accounting, its “differentiation strategy”, and doing business in emerging markets.
It has also adopted many of the “best practices” in the Singapore Code of Corporate Governance. However, the most important corporate governance (and management) issues for Olam have to do with its subsidiaries and operations overseas, and with its supply chain. The robustness of its process in evaluating capital expenditure and acquisitions, including post-implementation reviews of such expenditures, would also be an important part of its corporate governance and management. Other issues that are important include how it deals with fraud and corruption risks, and risks associated with environmental and social issues, especially in emerging markets. Indeed, the MW report cites some news reports criticizing Olam for its practices in certain markets and questions its dealings in some of these markets.
The crisis faced by Olam should also serve as a warning to other Singapore companies which are expanding overseas into challenging markets. They will need to pay attention to corporate governance of their foreign operations and along their supply chain.
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