BMI View : Olam International's USD61mn investment to establish a new cocoa processing plant in Indonesia is consistent with the ongoing trend in both Olam and Indonesia's agribusiness sector to gain greater exposure to mid- and downstream operations. Olam itself is looking to expand further downstream in certain areas of Africa and Asia, in a bid for a more stable and less indebted business model.
Potential Seen In Indonesia
Olam's USD61mn investment into a new cocoa processing plant in Indonesia is consistent with the company's movement to more mid- and downstream focused activities, which it argues will increase profitability through more value-added products. Olam's belief that Asia will deliver strong confectionary sales growth is the primary driver behind their investment into Indonesia, which will also act as a regional trade hub. Indeed, our Food & Drink team believes that chocolate confectionery sales growth in countries such as Indonesia, India and China will be among the highest in the world.
|Selected Asian Countries - Chocolate Volume Sales Growth, 2013-2018 (% Chg Over Period)|
We believe that some key downside risks exist for Olam's performance in Indonesia. While we forecast cocoa production to grow 14.5% from 2012/13 to 2017/18 to 492,300 tonnes, we note that structural problems exist in the market which could limit output. The core of Indonesia's cocoa production problem lies in the fragmented nature of the country's cocoa growing. In 2003, 87% of land under harvest for cocoa was on smallholder farms with on average 0.5-1.5ha of land a farm. The dominance of smallholdings means that investment into inputs is limited, and inhibits the purchase of new plant stock which is more resistant to disease.
These potential output issues could be further exacerbated by the number of domestic and multinational companies who have entered the cocoa market. For example, Archer Daniels Midland (ADM) and Cargill are entering the market with installed capacity of 60,000 tonnes and 65,000 tonnes respectively. Barry Callebaut is tying up with domestic player PT Comextra Majora to set up crushing plants with an installed capacity of 30,000 tonnes. There exist real risks of a supply shortage in the coming years, as some operations in Indonesia already import some cocoa beans from Africa. Grinders are waiting for the government to reduce the import tax on cocoa beans, currently at 5%, which would improve profitability in the future.
|Indonesia - Cocoa Production, Grinding Capacity & Raw Cocoa Imports And Exports ('000 tonnes)|
Recent Move Downstream
Olam's business is split into four main areas, and until 2009, the company predominantly focused on its upstream operations, devoting most of its annual capital expenditure to the ' Industrial Raw Materials' segment as agricultural commodities prices rose. From 2009, however, Olam re-orientated its business towards mid- and downstream, seeking higher profitability from more value-added products. Relatively, Olam has invested more into its 'Food Staples and Packaged Foods' segment than any other business area for the past three financial years. Indeed, this segment is the only business area which grew in size, relative to the rest of the company, for the past two financial years up to FY2013.
|Staples & Packaged Food Expansion|
|Olam International - % Of Total Capital Expenditure/ % Of Total Assets By Sub-Sector|
Similarly, the company has increased its focus on its 'Confectionery & Beverage Ingredients' business, in line with its value-added strategy. In 9M14, Olam increased its capital expenditure (capex) in the segment by 35.3% y-o-y to SGD2.8bn, compared to average capex growth of an average of just 1.0% across the other three business areas. The 9.1% y-o-y capex decline in the company's 'Industrial Raw Materials' segment further showcases their shift in focus.
|Average Margins For Food & Confectionery|
|Olam International - Revenue Growth (LHC) & Operating Margin By Sub-Sector|
We believe that Olam's new strategy will result in less volatile results and will ultimately be more sustainable, but will limit both revenue and EBITDA growth. Though Olam argues that a move to more downstream activities is more value-added and therefore more profitable, both its 'Food Staples and Packaged Foods' and 'Confectionery and Beverage Ingredients' segments have recorded flat operating margins over the past 10 years since sales have increased in both these segments. This implies that no economies of scale have been achieved. In fact, until 2011 the company's 'Industrial Raw Materials' segment was more profitable than either of the other two business areas.
|Improving Cash Flow|
|Olam International - Free Cash Flow (SGDmn, LHS) & Debt/ T12M EBITDA|
In previous years, Olam's growth in its upstream businesses has come at high expense, as it came largely from fast-paced product and geography diversification via acquisitions. This meant that the company has historically been highly leveraged, with negative free cash flow. EBITDA growth has also been very volatile, as a result of fluctuating commodities prices and the business environment in countries in which it operates. We believe that Olam is focusing more downstream in order to reduce such volatility, to deleverage itself and to generate positive cash flow. However, in our view this will weigh on both revenue and EBITDA growth rates, though will ultimately result in a more sustainable business model. Furthermore, we believe that this is consistent with the strategy of Temasek, the Singaporean investment group which is in the process of purchasing Olam.