Olam announced a partnership with a Russian Dairy Company RUSMOLCO

Target Price S$2.98

Initiative in Russian upstream milk & grains RUSMOLCO partnership a positive for Olam’s long term earnings. Olam announced a partnership with a Russian Dairy Company RUSMOLCO for the development of dairy and grains farming in the Penza region of Russia. Olam will invest US$75m and take a 75% equity stake in RUSMOLCO – with acquisition P/B of ~1x. Over the next 4-5 years, RUSMOLCO will require CAPEX of US$320m to expand the number of dairy farms to 11 (from 7), and double land cultivated to 106k ha. Olam sees potential in the Russian dairy business given the large demand-supply gap, and low farm land cost creating room for excess returns in grains. The net profit potential will contribute to Olam’s FY16 net profit target of US$1b. We maintain our earnings forecast and BUY recommendation, with our S$2.98 target price derived from a 3-stage DCF valuation model. Current P/E of 14x is low versus historical average of 18x.

No further equity investment required from Olam besides the initial US$75m. Olam will initially invest up to US$75m in exchange for 75% equity of RUSMOLCO, which translates into RUSMOLCO enterprise value of up to US$130m. For phase 1 over the next 4-5 years, RUSMOLCO will double the area under grains cultivation from the current 52k ha to 106k ha. Four new modern dairy farms will also be constructed, taking the total milking cow population from the current 3.6k heads to 20k heads. Further CAPEX of US$320m in phase 1 will come from additional debt, government cash subsidy and operating cash flow. US$170m of the CAPEX will be made over the first 2.5 years.

By steady state in 2019, Olam expects EBITDA margin of 35-40%, net margin of 15-20% and equity IRR of 28%. Whilst the current RUSMOLCO operations are not profitable due to the gestation of the business, Olam expects the expansion to lead to positive RUSMOLCO cash flow by FY13, and positive earnings by FY14. This upstream initiative will help widen Olam’s EBITDA margin from FY12F’s 5.5%.

Other Key Highlights

The founder of RUSMOLCO, Naum Babeav, will continue as Chairman of RUSMOLCO’s Board of Directors, which will also comprise five Olam nominees and one independent Director. We see this continuity as important.

RUSMOLCO balance sheet will be strengthened post injection by Olam. Of the US$75m investment by Olam, US$35m will remain within RUSMOLCO, US$32m given to the existing owners, and the balance for working capital. This will help to strengthen the balance sheet, which currently has US$65m of gross debt.

In phase 2, Olam and RUSMOLCO envisage further investments, which could include increasing area under cultivation to 130k hectares, and raising milking cow population to 50k heads of cattle.

The partnership is in line with Olam’s dairy strategy of upstream dairy farming in geographies with potential for profitable growth. Olam sees the Russian dairy sector as attractive due to (a) high demand for milk and a large and growing demand-supply gap, which led to Russia being one of the largest importers of milk in the world; (b) low cattle-feed cost due to availability of fertile agricultural land at competitive prices.

Grain farming in Russia can potentially generate excess returns due to (a) low cost of farm land – yield adjusted agricultural land cost in the US/Western Europe if 14-15x more expensive than in Russia; (b) soil and agro conditions are favourable for grain cultivation; and (c) inland and port logistics are well developed, which facilitates grain exports from Russia.