Suggestions to Olam in their fight against Muddy Waters

When Muddy Waters (MW) strikes, the immediate aftermath will be a double-digit percentage plunge in high volume in the share price of the stock being shorted. When MW strikes, it always provide lessons and entertainment for investors unless you happen to be vested in the company attacked by MW. MW sends shudders down the spine of CEOs of public-listed companies. Olam CEO Sunny Verghese must be cursing MW now. Why me? When he learnt of MW's first strike, it was fearsome enough to make him cancel his flight while waiting in the departure lounge.

Olam is a component stock of the Straits Times Index. As a Singaporean investor, I do not think this is a healthy development for our local stock market. On the other hand, shortists do play an important role in the stock market by knocking sense into an over-confident Mr Market who overlooks risks. For this, Singaporean investors (except Olam's of course) should thank Muddy Waters for opening our eyes to the risks of investing in Olam and in providing us keen investment lessons. Their Olam report is an interesting exercise in forensic accounting and due diligence.

In this battle between Olam and Muddy Waters, I hope to see Olam emerging as the final victor. Not through the court-room but by business savvy and creation of shareholder value. I would like to give some suggestions to Olam in their fight against Muddy Waters, although I am definitely not qualified to do so.

MW's main thrust of attack is that Olam is a complex business which is not only hard to understand but also easy to manipulate. MW contends that the biological gains and Level 3 derivatives in Olam's accounts allow management the discretion to manipulate profits to mislead investors. To counter this attack, Olam management needs to win investors' trust so that we trust their highly discretionary profit numbers. One way of doing this is substantial insider buying of Olam's stocks. Preferably, the insider buying should consist of multiple insider buying from executive management, starting from the CEO. Each insider should spend a substantial(>20%) portion of his net-worth or 2 years' salary to buy Olam's stocks. A few months' salary worth of buying is not sufficient. Buying too little and appearing too desperate may backfire if investors treat it as a public relations exercise to win confidence. While CEO Sunny Verghese share purchases a few days ago is to be applauded, his impatience to announce it even before the market closed is highly unusual and may be taken by investors as a desperate measure to win back confidence. Once investors are convinced by the insider buying action that top management's interests are aligned with theirs, then they will be less worried that the profits are being deceptively manipulated.

Please, no more company share buybacks. Don't use shareholders' money to prop up the share price, particularly when MW is alleging that senior management has pledged significant numbers of their own shares and could be facing margin calls. Management could be exposing themselves to shareholder lawsuits if they use shareholders' money to support the share price only to see it plunge later due to management's forced selling from margin calls.

Cumulative negative operating cashflow is a major bugbear for Olam investors. Profits are useless if they do not generate cash. In fact, it is worse than useless because it generates suspicion among investors. It was for this reason that I cease becoming an Olam shareholder a few years ago. I first became a shareholder because of the impressive profit growth. Initially, one can accept the argument that for a high-growth company, operating cashflow is negative in the beginning due to enormous upfront capital expenditure. However, investors lose patience if operating cashflow continue to remain negative over a multi-year period and the company keep asking for more money from shareholders and bondholders. This is the case for Olam. Operating cashflow has been cumulatively negative since FY2008. The poor operating cashflow also lends credence to MW's contention that Olam executes terribly in its acquisitions. Although Olam has rebutted MW on this point, no amount of clever persuasion is enough unless you can show me the money (cash, not accounting profits!). Good execution must show up in the numbers eventually. By numbers, I mean hard cash and not profits determined by opinions of accountants or management.

One suggestion to Olam's management is to, at least for the time being, base their staff's bonuses and promotion on cash-flow metrics, not profits. MW compared Olam to Enron for their shared appetite in acquiring companies to create fake profits through complicated accounting. By pegging staff incentives to real cashflow and not opinionated profits, investors need not fear Olam staff are motivated to practise Enron-like behavior of spending real $10 on acquisitions to create fake $5 of accounting profit.

I hope Olam will pause its capital-raising activity for the time being. Show us some cash first before you continue asking for more cash from us. Despite its impressive growth, Olam's Piotroski score is only 1 for FY2011. However, I am not sure if this is accurate as this was computed by a software I wrote early this year when I had plenty of time being unemployed.

MW is a tough opponent. Its latest move to pay for Olam's debt to be rated is cunning. It is an offer that Olam simply cannot accept. Even if the bonds are rated at better-than-expected ratings, it is useless because Olam's bonds are already trading near distressed levels. It is a lose-lose situation if Olam accepts. If Olam rejects, it appears as if Olam has chickened out. This offer by MW was designed to embarrass Olam.

I hope to see Olam emerge as the final victor. Not vested at the moment but enjoying the show. Will consider investing once Olam starts showing us some real money (cold, hard cash).