Muddy Olam Call Spurred by Rule Seen as Ambiguous

Muddy Waters LLC Carson Block
Carson Block, research director and founder of Muddy Waters LLC. Photographer: David Paul Morris/Bloomberg

Short-seller Carson Block’s Muddy Waters LLC says that believing commodity trader Olam International Ltd.’s accounting requires a “leap of faith.” The ambiguity lies with the rules as much as the company.

A global accounting standard introduced in 2003 forces companies every three months to value living things from wheat crops to cattle, or so-called biological assets. As Singapore-based Olam branched out from being the world’s second-largest rice trader and acquired dairy farms and almond plantations, the company began to apply the rules that accountants themselves say are riddled with subjective assumptions on future prices, inflation, production and costs.

“It’s an accounting method that inherently introduces uncertainty,” said Ray Ball, an accounting professor at the University of Chicago Booth School of Business. “Some of these numbers are difficult to estimate. When there’s subjectivity, there’s always doubt in people’s minds.”

Block’s questioning of Olam’s accounting practices at a London conference on Nov. 19 prompted the company to sue Muddy Waters and Block after its shares dropped 7 percent, erasing $254 million in market value, and its benchmark bond lost as much as 8.5 cents on the dollar. Muddy Waters has yet to release the research report detailing its concerns over Olam’s accounting and operations.

Aggressive Approach

According to Block, Olam uses an “aggressive” approach to reporting gains on biological assets, a valuation required by the more than 85 countries that adhere to the guidelines of the London-based International Financial Reporting Standards Foundation.

“It’s a leap of faith to think the company is being honest with its valuation” gains, Block told the Ira Sohn Investment Conference in London. Block said he had “shorted” Olam, seeking to profit by selling borrowed shares now and buying them back later at a lower price. Block’s doubts over Olam were echoed by John Armitage, co-founder of London-based Egerton Capital Ltd., who said at the conference that he is also betting against the company.

The IFRS rule on biological assets that Singapore and Olam follow are mandatory. The rule makes agriculture companies book earnings earlier than they would otherwise, said Chicago professor Ball, who owns Olam shares.

It means a wheat producer needs to estimate the value of a crop before harvest and a cattle rancher the worth of a herd before slaughter. While the method does help to get a “best estimate of value” on partially grown plants and animals, its subjective aspect leaves companies open to questions on their appraisals, Ball said.

‘Terrible’ Standard

“It’s a terrible accounting standard, it shouldn’t be used at all,” said David Fergusson, a fund manager at Woodside Holdings Investment Management in Singapore, who doesn’t own Olam stock. “But, it’s not like the company has a choice.”

Reporting profits on living things came into effect in 2003, and the rules were amended twice since then, according to Deloitte Touche Tohmatsu Ltd.’s website.

A company or its auditor picks an appraiser to estimate the worth of its plants and animals. The value is determined by subtracting the cost to sell the asset at the point of maturity from its so-called fair value, according to Deloitte. Gains and losses must be recorded in a company’s income statement.

For example, a cow bought at a cost of $200 and fattened after a year may be valued at $500, which would result in a biological asset gain of $300. That gain is added to the profit and loss statement of that period and feeds into net income.

Subjective Nature

In Australia, companies are responsible for making the initial estimate of their assets, a process much harder in some agricultural commodities such as young trees and orchards than cattle close to slaughter, said Clark Jarrold, a partner with BDO (Australia) Ltd. accounting firm, based in Brisbane.

“A valuation is an opinion on a price,” Jarrold said. While using fair value to account for plants and animals has been used in Australia for many years, “I imagine that in some jurisdictions some people may find it controversial.”

Olam reported that biological gains represented 27 percent of net income, or S$110.9 million ($90.7 million) of the S$403.8 million in profits for the year ending June 30. That’s up from 18 percent, or S$80.4 million in biological gains of the S$444.6 million profit, in the previous year.

Olam splits biological gains on the value of an asset into two. It records operating gains, for example from improved yields from an orchard. And it records non-operating gains from changes to fair value assumptions that relate to factors such as the long-term outlook on the price of a commodity.

Being Conservative

The company adds both gains to the profit statement, but takes out non-operating gains when presenting “core” profit to show investors what is “core to the business,” Hung Hoeng Chow, Olam’s associate general manager of investor relations, said by phone.

In financial statements, Olam lists “recorded” earnings per share and “operational” earnings per share. The former was 14.95 Singapore cents on a fully diluted basis for the year ended June 30. The latter was 14.32 Singapore cents.

“You can accuse us of being conservative, but being aggressive on fair valuation of biological assets is a figment of someone’s imagination,” Olam Chief Executive Officer Sunny Verghese said on a conference call for investors and analysts on Nov. 20.

U.S. companies don’t measure fair value of biological assets as the Generally Accepted Accounting Principles they use are more conservative, said Shane Dikolli, a professor of accounting at Duke University’s Fuqua School of Business in Durham, North Carolina.

‘Pretty Transparent’

Bunge Ltd., the world’s second-largest oilseed processor, instead shows the lower of the historical cost or market value of an asset, said Susan Burns, a company spokeswoman. Bunge is based in White Plains, New York.

Under IFRS rules, companies including Olam describe the method and assumptions made in valuing biological assets in their income statements, Dikolli said.

“It’s pretty transparent from what I can tell,” Dikolli said of Olam’s notes in its latest financial statement. “The problem is, fair value is so vague and it’s not clear how that should be done, and it can be very subjective.”

While companies in Australia, Singapore and Ukraine report the value of their biological assets, the U.K., where the IFRS Foundation is based, has relaxed the rules for some farmers. The practice of stating biological assets is available on a “voluntary basis” and may be an “unnecessary distraction” for some farms, according to an Aug. 1 statement by the U.K. accountancy body ICAEW.

Causes Volatility

“To do a valuation of biological assets you need to make a myriad of long-term assumptions,” said Fergusson of Woodside Holdings. “The question is, do you make so many assumptions in valuing these biological assets as to make the reliability of the entire calculation questionable? In my view, generally, yes.”

Takemura Mitsuhiro, a representative of IFRS at its Tokyo office, said that neither the IFRS Foundation nor its standard-setting body, the International Accounting Standards Board, are able to comment on specific companies. Questions sent to the Accounting Standards Council of Singapore weren’t immediately answered.

The IFRS’s board this year approved a project to look at amending the IAS41 rules on biological assets, according to the Foundation’s website. Michelle Fisher, an IFRS senior technical manager listed as the project contract, said by e-mail that she couldn’t immediately comment.

Malaysia Delays

Rather than ease comparisons across companies, the use of biological asset rules has caused volatility in income statements and been “misleading on taxation-related decisions,” according to a 2011 report by Yohanes Handoko Aryanto, who was an associate researcher at the Indonesian Institute of Accountants at the time.

Malaysia, the world’s second-biggest palm oil producer and also a follower of IFRS rules, has deferred the introduction of biological asset accounting until at least 2014 because of the complexity of the issue and expected changes to the rule by the IASB, according to a June 30 statement on the Malaysia Accounting Standards Board website.

At about a quarter of pretax profit, Olam’s proportion of income arising from biological gains as opposed to sales of products and services is “exceptionally big” compared with other companies, said James Koh, an analyst with Maybank Kim Eng in Singapore.

‘Valuation Subjectivity’

While biological assets “may mean some level of valuation subjectivity,” they only represent 5 percent of Olam’s assets and 19 percent of its equity, Citigroup Inc. analyst Patrick Yau said in a report. Even if the assets lost half their value, Olam’s debt covenants shouldn’t be breached, he said.

Analysts covering Olam’s stock, including Deutsche Bank AG’s Eltricia Foong and UBS AG’s Andreas Bokkenheuser, mostly dismissed the issue, saying it’s already been scrutinized.

“Most analysts and investors already exclude such gains when analyzing core profits and underlying trends,” Foong said in a note to investors. Seven of 10 analysts covering Olam surveyed by Bloomberg said they strip out biological gains from their reporting of the company’s results to investors.

Stock Slide

Olam’s stock has slumped in the past five years, even as the trader completed at least 43 acquisitions for a total of $1.83 billion, according to data compiled by Bloomberg. To fund the acquisitions, it turned to equity and debt markets, making at least three share offerings and 30 debt sales since 2007, data compiled by Bloomberg show.

Olam’s $500 million of 5.75 percent bonds due in September 2017 dropped to 88.5 cents on the dollar on Nov. 20 from 97 cents the day before, according to BNP Paribas SA prices. They closed at 91 cents on Nov. 23. Its shares rose 0.3 percent to S$1.66 today in Singapore, down from a May. 4, 2007, peak of S$3.64. Olam fell 1.5 percent to $1.32 in over-the-counter trading in New York.

Some analysts covering Olam even turned the criticism back onto Muddy Waters, saying the research company has not always made correct calls since the 2011 assertion that China’s Sino-Forest Corp. had exaggerated revenue that resulted in a police investigation, the company’s bankruptcy and delisting.

‘Mixed’ Record

“We note that Muddy Waters has had a mixed track record,” said Eugene Ng, a Singapore-based analyst at UOB Kay Hian. “While its call on Sino-Forest was correct, its recent calls on New Oriental Education & Technology Group and Focus Media have been less accurate so far.”

Muddy Waters founder and research director Block said last month that he is “more convinced than ever” that New Oriental Education is misleading investors after the Beijing-based company said a probe found no evidence to support his allegations.

Olam isn’t the only company to show higher profits based on a rise in valuations from biological assets.

Agriculture Australia Co., a beef-cattle breeder since 1824, reports growth in fair value based on fatter cows, calves being born and other adjustments as part of its continuing operations, citing the biological assets accounting standard.

The Australian company reported an 85 percent jump in profit from continuing operations, before finance costs and tax to A$4.4 million (US$4.6 million) in the six months ending June 30, helped by a 58 percent surge in cattle fair value adjustments to A$35.5 million. In contrast, margins on the company’s wholesale beef sales almost halved and its general operating expenses rose 32 percent in the period.

Other Companies

Wilmar International Ltd., the world’s biggest palm oil processor, also records net gains from biological assets in its income statement under “other items of income,” meaning it eventually flows down to net profit.

Wilmar’s biological assets include oil palm plantations. Their fair value is estimated by independent appraisers using market prices and estimated yields, minus the costs required to bring the trees to maturity, according to the 2011 report from Singapore-based Wilmar.

A spokeswoman for Wilmar said the company has never encountered issues raised by analysts and investors about its accounting treatment of biological assets.

Fair Value

“The accountant standard setters would say that it is part of your operations and therefore part of your profit and loss,” BDO’s Jarrold said. “The fair value change is a real change for you.”

This contrasts with treatment of the value of assets such as plant and equipment, an increase in which is not registered as part of the profit and loss statement from which net income is derived, Jarrold said.

Concerns over Olam’s accounting practices have been aired before. CLSA Asia Pacific Markets queried its accounting of subsidies from Nigeria in a February 2011 report, prompting a 9.3 percent slump in Olam shares. Olam responded by saying Nigerian incentives accounted for less than 1 percent of consolidated revenue, although CEO Verghese said the company made “some mistakes” in how it classified hedges and that while none of its numbers were inaccurate, elements needed “reclassification.”

Splitting Gains

Where Olam may have added to confusion and drawn criticism from Muddy Waters is in splitting its biological gains into two categories, the operational and the non-operational, and adding the former to recurring net profit, Maybank’s Koh said.

Not only is the practice of splitting the gains into two sets unusual, the company also has S$1 billion net profit goal for 2016 that includes gains from biological assets, Koh said. This creates “some ambiguity” and thus not all analysts strip the biological assets out of their calculations, he said.

For Olam CEO Verghese the separation is an attempt to give more clarity, not less. The non-operational biological assets are treated with different assumptions on price, yield and discount rate, Verghese said on the conference call. Moreover, Olam will report losses on the assets as they mature, he said.

“Analysts can do what they want, they can take out the biological asset gains” from their calculations, Olam’s Chow said. “In the entire life cycle of the plantation the net result will be zero. But by the time we report losses, will you also take out the losses?”

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