The CLSA analyst (Swati Chopra) had been following Olam for some time now, and had

previously issued negative assessments of Olam. In Chopras most recent report, a strong conviction to Sell finally had the media scrutinizing and publicizing the sell-sides analyst concerns about Olam, and forced Olams CEO Sunny Verghese to openly challenge Chopras claims, in a bid to re-instill investors confidence, after Olams share price dropped 9.5% about an hour after the market opened. The major concerns highlighted in the analyst report are: 1. Export Incentives in Nigeria, and whether Olams profit is over-reliant on such incentives 2. Reporting differences raise questions and doubts about Olams internal controls 3. How the concerns above have inflated the true economic value of Olams share Mispriced Risk. (Negative EVA) 1) The export incentive scheme was introduced to encourage exports of certain products from Nigeria, which will help Nigerias economy grow. The scheme was introduced in the form of an Export Expansion Grant (EEG), and CLSA estimates that a significant chunk of export incentives received are from Nigeria. CLSA concluded that the EEG ranges from 5-30% of the FOB value of an exporter, depending on the value of produce, and size of the exporter in Nigeria. Therefore, CLSA feels that since Olam is the largest Agricultural exporter in Nigeria, they will receive preferential EEG rates, which will contribute significantly to the profit of Olam. How? Because the grants are issued as Negotiable Duty Credit Certificate (NDCC), which can be used to pay off some of Olams import duties therefore, the grants serve as an alternative to cash payment and can be viewed as a form of cash inflow or cash equivalents. The accounting standards require grants to be recognized in 2 ways: 1) Credited to the P&L, and presented separately or under other comprehensive income. 2) Deducted in reporting the related expenses, which is COGS in Olams case. By deducting against COGS, expenses are lowered

and reported earnings for the current period are increased. Olam subscribes to this accounting treatment, so the more export incentives Olam receives; a larger portion of the reported earnings will be contributed by these incentives. So one major concern is how much of Olams reported earnings are attributable by these incentives? Also, are such incentives an industry norm? CLSA also showed that even if Olam passes some percentage of incentives e.g 20% to farmers (by paying farmers more) and to end consumers (by absorbing costs and selling at a lower price), it would still make up 35% of Olams profit, and if no incentives were passed on, then it would make up 30-40% of Olams profit, based on CLSA, the contributed margins are relatively high. Another major concern is how sustainable are these incentives, if incentive contributed earnings are acceptable due to industry norms? Well, the Nigerian government are bound to withdraw such incentives sooner or later (as seen by the lowering EEG rates over the years, the withdrawal of incentives on cotton export and suspension of export incentives in 2007 and 2008), thus by building such incentives into COGS, Olam will be able to report higher earnings in the short run, and will give investors a false sense of security. Because if Olams profit relies largely on these incentives, then a relative portion of reported profits are volatile and risky because it will depend on external factors which Olam cannot control. This is alarming for investors, as most investors look at a firms ability to control and sustain their earnings in the long run, if they are not guaranteed the firms reported earning power, they will quickly sell their shares, or demand higher risk premiums to offset the higher risk which they are now taking. To address the export incentives issue, Olam rebutted by showing that CLSAs estimate of 3040% was wrong, in fact, the amount of Nigerian incentives for FY2010 was only 0.8%, and this is because Olam had taken into account the overall consolidated revenue of the group. Also Olam argued that they are not the only exporter enjoying such favorable EEG rates, other

players like Cargill, ADM, Armajaro also receive similar rates, and more importantly, that even if Nigeria were to withdraw these export incentives, it will not impact Olams reported earnings significantly. This is because of Olam extensive presence in 65 countries, which will help diversify Olams income contribution, therefore they are not solely reliant on any particular market (they receive export incentives from only 5-6 countries). It was also historically shown, that even when India withdrew their export incentives, Olam was still able to produce stable margins. On such grounds, I am agreeable with Olam that they are definitely not over-reliant on the export incentives given by such emerging countries, because they would have income sources from mature markets where their earning power is much stronger, and given their strong presence in such markets, they have most likely gained economies of scale, strong supplier relationships, and sustainable earnings. 2) The second concern raised by Chopra, are the reporting differences. Chopra highlighted that there are significant differences between audited and unaudited statements. Firstly, the 2008 export incentive amount restated in 2009 annual report was lower by S$69.9m. Secondly, the realized loss on derivatives was also restated from S$134.9m in 2008 AR to S$125.9m in the 2009 report for the year 2008. Thirdly, the cash balance in the cash flow statement for FY08 and FY09 was different, and lastly, the audited expense of PPE was significantly higher than the unaudited AR. On the surface, it seems that Olam is trying to pose healthier reported earnings in 2009, how can Olam increase the COGS figure for 2008 in the 2009 AR and not adjust the reported earnings downwards? This just doesnt make accounting sense, but Olams reply was because in FY08 certain group companies sent through COGS net of export incentives to be consolidated without breaking it up and hence showed only S$2.17m, and since it was already netted off in the COGS for FY08, no adjustment was needed. I feel that Olams explanation

seems reasonable to justify why there is no need to adjust 2008 net income; but I would raise the question of why/how Olam could consolidate the groups accounts without standardizing the presentation? Was there not enough disclosure in the line items for FY08 and FY09 to make Chopra raise this concern? My view on the second issue relating to the difference of S$9m between realized loss on derivative figure reported, is that from a pure accounting perspective it is not possible to reclassify between realized and unrealized losses, once it is classified as realized, the losses are booked into that periods net income, and if Olam reclassifies a certain amount from realized to unrealized loss, then there should be disclosures and adjustments (which was not seen in 2009 AR), moreover, I feel that there is no basis that can justify such a reclassification. Assuming that it is justifiable to decrease the realized loss figure, then where is the retrospective adjustment to the beginning retained earnings for FY09? If the adjustments were made, it should increase FY09 beginning retained earnings by S$9m, which will perhaps show a healthier financial position to Olams stakeholders, but there was no impact on reported net profits after restatement. So where did the S$9m go? Olam attributed this accounting phenomenon to reclassification, calculation errors and the difficulties of collating data across multiple operations. I feel that Olam has not adequately addressed the problem and attributing it to calculation errors and collation difficulties is just not acceptable. Moreover, if Olam wants to attribute the difference to reclassification, then they should give more specific details, as to the reason for reclassification? From which accounts are the figures reclassified to? The third concern is about the cash balances for FY07 and FY08 being different between the audited and unaudited AR. This was attributed to the fact that in the unaudited AR, overdrafts were presented under short term Loans from Banks, but in the audited AR, the bank overdraft was netted off against cash equivalent of A/R to show S$187.64m for FY07. The same treatment was done for

FY08; the reason was due to the differential treatment at subsidiary level and at consolidated level, and the effect on the financial statements is that it will decrease the cash and short-term payables equally for both financial years, thus it will not affect financial ratios such as the current ratio and quick ratio which investors look at to measure a firms liquidity and financial health (i.e. the firms ability to meet their debts). I feel that Olams explanation is reasonable and since the treatment has no major impact on the financial statements as a whole, investors need not be too worried about it. The last concern is about the audited expenses on PPE being significantly higher than the Unaudited AR. Olam claims that as they were integrating new acquisitions they are required to conduct a purchase price allocation, which from my understanding is to split the purchase price paid for an asset into various classes e.g. such as the assets balance sheet value, fair market value and any goodwill associated with the asset, so that Olam can calculate the depreciation on value excluding for example purchased goodwill attributed to the price of the asset. However, Olam only finished the purchase price allocation after the unaudited AR was released; therefore, they claimed that they have made the appropriate final adjustments, which was basically a reclassification between Purchase of PPE and Acquisition of assets as a business combination. Olam also mentioned that the reclassification has no impact on depreciation and/or profits, which means to say that the assets were depreciated all along, and this is important to ensure the matching of revenue earned from such assets. So if what Olam claims is true, then investors do not need to be concern, because the revenues earned from such assets are properly matched to the relevant expenses incurred in that period. Also the reclassification is only a shift of numbers within the Cash Flows from Investing Activities section, thus it will not adversely impact investors analysis of the Cash Flow Statement.

In Summary of the reporting difference issues, I feel that only the S$9m difference between realized losses on derivative for FY08 has not been properly addressed by Olam. Also, another point to note is that for Singapore listed companies, any material changes in financial statements between the unaudited and audited version need to be signed off by Olams auditors (Ernst & Young) and a public disclosure via Exchange must be made. Thus if investors trust these control policies put in place, then there is no cause for worry over the reporting difference, as Olam and Ernst & Young were not required to take any actions regarding the reporting differences. 3) The last major concern raised by Chopra, is regarding Olams negative EVA, and Mispriced Risks. Chopra mentioned that with all the issues highlighted, Olams share price warrants a significantly higher risk premium and consequently a lower multiple, thus CLSA cut their target price to S$1.6/share, a 46% downside with conviction to Sell. Chopra claimed that Olams ROIC is lower than WACC (even if using a Singapore cost of capital), this is contrary to what was reported by Olam which showed a positive capital spread from FY2008 to FY2010, so how can the results be so different? Olam and CLSA did not disclose the cost of capital used to calculate the WACC, and to break in down further, the Cost of Debt and Cost of Equity and Beta figures are also not shown, therefore the difference in the WACC figure calculated by Olam and CLSA could be due to these 3 components. Generally, investors use the capital spread as an indication of a firms value creation and if the firms capital spread is positive, it means that the investors are getting back higher returns on their invested capital as compared to the minimum rate of return (adjusted for risk) that a company must earn to create value for its shareholders. Given that EVA is calculated by taking the Capital Spread (ROIC% - WACC%) multiplied by the Invested Operating Capital (or Total invested capital), then the discrepancy in EVA value calculated by both companies is definitely attributable to the calculation of Capital Spread, as the

Invested Operating Capital can be calculated from the items on the Balance Sheet, which would be available to the public through Olams audited or unaudited AR. The difference in the calculated capital spread could be attributable to different assumptions used by Olam and CLSA, sample size of data used, and information asymmetry. Generally, I feel that Olams EVA and Capital Spread are within the positive range because given the current situation Olam would not want to provide inaccurate figures to avoid further scrutiny. Another reason is because other analysts covering Olam, e.g. CIMB and HSBC did not question the Capital Spread calculation. While Olam has adequately addressed most of the concerns raised, I believe Olam can take some additional actions to prevent future misunderstandings. Firstly, given the complexity of Olams operations, the group needs to strengthen its consolidation process, in order to eliminate changes between unaudited and audited AR e.g. standardizing across subsidiaries how to report figures (net or shown separately in line items) and secondly, more detailed disclosure is needed to help the public understand Olams business and industry better. Also geographical contributions data is important to help the public determine the firms value, earnings sustainability and identify possible areas of risk, for example, a detailed disclosure on Nigerian export incentives, and contributions from such incentives would help the public come to a better conclusion of Olams firm value. Lastly, transparency in choice of accounting treatment of certain accounts is necessary; this will help users of their AR understand why certain figures need to be reclassified. Given these recommendations, Olam will need to weight the cost and benefit of additional disclosure. Is it proprietary information? Will it erode Olams competitive advantage? Based on the efficient market theory and investors rationality, investors constantly look for more information to help them revise their assessment of Olams value, however, this takes time, effort and a great deal of understanding in finance, which not every investors have. Therefore,

sell-side analysts serve their clients by analyzing information about the company and giving their opinion about the firms value. Analyst play a very important role in the capital markets (e.g evidence show that top companies bid for star analyst to have them cover their more important stocks) as the public is likely to give more weight to what an analyst says compared to other sources of information, simply because they are 1) trained in finance 2) more experience in valuing companies 3) have a good understanding of the industry which they cover 4) have access to better information, thus they can do a more in-depth analysis. But are analyst forecasts actually unbiased and accurate? Here are several factors that can impact an analysts forecast, 1) New analysts prefer to follow the crowd due to their lack of experience and fear of being scrutinized by the public/media. 2) Studies also showed that analysts are systematically rewarded for being optimistic in their forecast, because they are a) less likely to be fired, b) more likely to be hired by a better house and c) more likely to be assigned to cover reputable companys stock. 3) Stickel (1992) showed that an analysts forecast accuracy is related to the analysts reputation, highly reputable star analysts were more pressured to outperform their untitled peers. 4) The Underwriting effect suggests that analysts pay are affected by the amount of underwriting revenue he helps his house generate, and underwriting revenue is earned when analysts are able to satisfy the underwriting firms with more optimistic forecasts. However, it is interesting to note that point 3 can help mitigate the underwriting effect. 5) Conflict of interest exists between analysts compensation and the accuracy of their forecasts 6) Fear of being left out, most analysts whom did not accept the companys data/forecasts/explanations, where are either replaced by another analyst or firm altogether or excluded from analysts meetings, interestingly, if you visit Olams website today, CLSA is no longer under the list of analyst covering Olam stocks, this is a direct example of the punishment for giving a less optimistic assessment.