Why Olam's new strategy is a winner

Positive free cash flow by next year.

HSBC Global Research noted that Olam's new strategy will not only help it achieve positive free cash flow by FY2014, or a year earlier than expected, it should also result in substantially lower gearing.

Here's the big picture impact analysis from HSBC:

More cash. Upfront. Olam’s latest strategic review aims to turn the group’s free cashflow (FCF) positive by FY14; a year ahead of the earlier plan. Capex has been reduced 27% for FY13-16 vs. earlier guidance to SGD1.2-1.6bn by foregoing long gestation opportunities for projects with faster delivery. Together with lower working capital (through closure of subscale profit centres etc), this will drive positive FCF in FY14. Sustainable growth of FCF from here on will be driven by increasingly focusing on high growth businesses (edible nuts, spices & ingredients, coffee, cocoa, and grains) while for other strong platforms (such as packaged foods) strategic partners will be involved to unlock value. Improving operating efficiencies by reducing overheads will further contribute to FCF generation.

Reducing balance sheet concerns. Olam will look to reduce fixed asset intensity by offbalance sheeting and securitisation of upstream and midstream assets. Olam will also look to further monetise its assets through JVs, alliances, divestments, and equity carve-outs. We saw a similar playbook being pursued by Noble Group (NOBL SP, SGD1.14, TP:SGD1.32, N(V)) as it moved its balance sheet to an investment grade credit rating. Management expects these strategies to cumulatively release SGD1.5bn of cash between FY14-16. To put this in context, 2Q13 net gearing (including inventories) would fall to 1.8x from 2.2x. Olam has also reduced its net gearing boundary to 2.0x by FY16 from 2.5x.

Positive steps to improve transparency. Olam will start disclosing EBITDA – as a gauge for operating cashflows – along with invested capital by business segment going forward. The group will also provide a project progress overview for upstream, midstream, and core investments. We believe these are positive steps towards transparency by allowing for better earnings visibility.

Improving visibility. Maintain OW. Delays in the fertiliser project as well as business restructuring will likely push back the FY16 USD1bn PAT target. Yet with a large part of investments already made yet to ramp up, medium term growth will remain robust, according to management. While changes to estimates at this stage would be premature, we believe Olam’s new strategy will improve visibility and result in better quality earnings growth. Our DCF (WACC of 9.9%, 3% terminal) and mid-cycle peer PE based target price of SGD2.35 implies 40.7% potential return. Maintain OW. Downside risks: execution risks on this strategy, rising funding costs and commodity pricing.