What Happened
Sentiment at the Asia Mining/ Commodities Trade and Finance World Asia Conference was distinctly less exuberant than a few years ago. Experts warned of moderating growth in commodities demand owing to slowing global economic growth and China’s soft landing, while insiders warned that demand-supply imbalances among certain commodities such as steel and iron ore could send prices
lower. Locally-listed supply chain managers have survived the European credit crunch relatively unscathed, but questions about Basel III implications continue to cast a shadow over trade finance, especially among smaller players.
What We Think
Supply chain managers face a subdued outlook amid lingering Eurozone worries and slowing growth from heavyweight countries such as China. Amid such uncertainties, we prefer to seek refuge in soft commodities, especially edibles, where demand inelasticity and growing consumption buffer the economic headwinds. We have seen a resurgence of M&A activities, and expect further consolidation as players seek vertical and lateral integration.
What You Should Do
Olam remains our preferred stock within this space for its defensive portfolio which comprises mainly edibles. Valuations are compelling with the stock trading 1.5 standard deviations below its historical 7-year mean P/E. Mewah remains our key Underperform as execution risks remain elevated.
Highlighted Companies
Olam
Olam’s earnings are more resilient than its peers, supported by its defensive portfolio which comprises 80% edibles. We expect the stock to outperform its peers amid macroeconomic uncertainty.
Noble
Noble has survived the worst of the downturn. Earnings will climb from here, but we do not expect a strong rebound in profits as demand for economically-sensitive commodities remains weak.
Mewah
Mewah’s track record has been marred by declining volumes and margins. The group continues to face headwinds from intensifying competition from Indonesian refiners, who have an export tax advantage.
1. DEMAND OUTLOOK – MODERATING GROWTH
1.1 Is the party over?
Demand for hard commodities is no longer the rosy picture it used to be over the past four years. Commodity prices jumped in 2009 as China’s RMB4tr economic stimulus plan spurred demand for raw materials for housing, infrastructure and transportation. The economy today is no longer flush with liquidity. With China and India being the predominant consumers of hard commodities, moderating growth from these economies threatens to weigh on commodity demand. Coupled with a high base effect, experts warned that growth may moderate going forward.
In particular, China’s steel-making industry is facing structural problems stemming from overcapacity and low ASP, resulting in dangerously thin margins. Markets for steel-making ingredients iron ore and coking coal may languish as the industry struggles to regain its footing. Faltering demand for iron ore, coupled with additional supplies from Australia and Brazil coming on stream, led one of the panelists to predict that iron ore prices could be on a downward spiral that will last until 2015.
One of the bright spots among the various hard commodities is perhaps thermal coal. The outlook was unanimously positive, as experts believe that cheap energy will continue to power industrialisation in China and India. Insufficient domestic supply in China and the installation of more coal-fired power plants in India suggest strong support for thermal coal imports. Indonesia and Australia are currently the major coal exporters, but US and Mongolia could soon emerge as viable exporters given their ready port access and close proximity to China, respectively.
2. TRADE FINANCING – WHAT’S HAPPENING?
2.1 European banks retreated, Asian banks gained prominence
Locally-domiciled supply chain managers such as Olam was unfazed by the European banking crisis thanks to its access to Asian banks, highlighting the importance of funding diversification. European banks’ ability to provide trade financing liquidity was impaired as US$ inter-bank lending froze in Europe in 3Q11, on the back of escalating fears of a debt contagion in the thick of the European debt crisis.
In addition, the impending introduction of a more stringent Basel III resulted in European banks conducting a series of capital-raising exercises and reigning in riskier asset exposures in Asia. Consequentially, European banks had to scale back on their trade financing presence in Asia. This provided an opportunity for Asian banks to step into the trade financing shoes that the European banks left. Our ground checks with local banks confirm this, with robust ACU loan growth in the same time period.
2.2 Europeans are back but reliable Asian banks are here to stay
According to our ground checks with mining participants at the conference, recapitalised European banks are now regaining their presence in trade financing following a successful Long Term Refinancing Operation (LTRO). While this might put some headwinds on market share expansion for Asian banks, we think that stable and reliable Asian banks will continue to gain market share in trade financing. Gone are the days when industry players could rely on three or four European trade financing behemoths for working capital financing. Following the funding scare in 2011, miners and supply chain managers now understand the importance of funding diversification and are increasingly searching for alternative sources of funds.
2.3 Implementation of Basel III could raise financing costs
Industry participants were also concerned about the potential impact of the implementation of Basel III capital regulations. Many held the view that potentially higher risk capital charge in Basel III could raise the cost of trade financing. We believe that the impact on the industry will not be homogeneous and the competition gap between large players and small supply chain managers will widen. In our view, larger global players like Glencore and Cargill could see a less pronounced increase in trade financing charges on lower operational risk (geographical and product diversification; quality warehouse management) and sizeable peripheral fees from non-trade financing related services (cash management, forex transaction fees, etc). On the flip side, operating margins for smaller players like Mewah could be squeezed by a sharper hike in trade financing charges given their higher risk profile.
3. CONSOLIDATION – M&A HEATING UP
3.1 The pursuit of scale and supply reliability
Consolidation is heating up within the industry. We expect to see more M&A activities, motivated by two strategic thrusts. First, supply chain managers are scaling up via inorganic growth to remain competitive and enhance critical mass in an industry where scale offers strategic advantage. Second, supply chain managers are moving upstream to secure reliable long-term supply amid resource scarcity, manage risk (such as counterparty risks), and lower unit costs.
In recent months, Glencore has made a bid for Canada grain handler Viterra, while Noble has been reported to be one of the parties interested in US grain and energy trader Gavilon. This brings the focus back to balance sheet management. We believe that Noble’s plan to spin off its Agriculture division is partly motivated by capital recycling in order to free up resources for future acquisitions. Balance sheets of locally-listed supply chain managers are reasonably healthy. Excluding readily marketable inventories, adjusted net gearing of Noble and Olam stand at around 0.4x. Mewah’s stands at 0.1x, but this ratio will increase as it executes its post-IPO expansion plans.
4. RISKS RISKS – PRICE VOLATILITY, COUNTERPARTY RISK IN FOCUS
4.1 Global economies not out of the woods
The near-term outlook for supply chain managers remains clouded by ongoing macroeconomic uncertainty and slowing growth. Supply chain managers adopted a cautious tone during their 4QCY11 briefings, citing weak demand for economically-sensitive commodities. Until global economies regain a strong footing, headwinds will persist. We expect the performance of Noble’s Metals, Minerals & Ores segment and Olam’s Industrial Raw Materials segment to remain muted in the near term.
4.2 Renewed focus on price volatility, counterparty risk.
It appears that commodity price volatility is here to stay and one of the challenges facing supply chain managers is risk management. Some players said that commodity prices today are no longer a true reflection of physical demand and supply, but rather, have been distorted by speculation. Unprecedented price volatility has marred demand visibility and led to higher incidences of counterparty defaults. Non-delivery by cotton farmers is the most notorious example of such an instance.
Counterparty risk is the biggest risk in the supply chain manager’s business model. Unfortunately, supply chain managers’ hands are tied when it comes to managing counterparty risk. Insurance is expensive, bearing in mind that these businesses operate on thin profit margins. Even if contracts are backed by insurance, claims and legal proceedings can be lengthy and difficult to enforce.
4.3 What can be done?
There is no foolproof solution to eliminate counterparty risk. Supply chain managers can, at best, mitigate this risk by conducting due diligence on their counterparties, such as adopting KYC (know your customer) best practices and evaluating the credit history of their customers.
Diversification is also a commonly-used risk management measure. Large supply chain managers diversify their funding sources across geographical regions, financial products and financial institutions to mitigate risk of a liquidity crunch. Most large players also diversify their supplier and customer base to negate counterparty risk.
5. VALUATION AND RECOMMENDATION
5.1 Maintain Underweight
We maintain our Underweight rating on the Commodities sector, sensing that earnings of supply chain managers may remain muted in the near term. The last two quarters have been plagued by unprecedented commodity price volatility, weak demand (especially for hard commodities), counterparty defaults, and fears of credit tightening. While the worst of the downturn is over, we have yet to witness a convincing rebound in demand.
5.2 Stock Picks
Olam is our preferred pick among the supply chain managers. Amid lingering macroeconomic uncertainty, Olam’s earnings resilience stands out from its peers. The group continued to post earnings growth in recent quarters whereas its peers suffered earnings contraction or even swung into losses. Its earnings continue to be well-supported by its defensive portfolio which comprises 80% edibles. The stock remains an Outperform. Valuations are compelling with the stock trading 1.5 standard deviations below its 7-yr historical mean P/E.
Mewah is our conviction Underperform. The group’s battle with declining volumes and margins is not over. To make matters worse, it now has to grapple with intensifying competition from Indonesian refiners that enjoy export tax advantages.
We retain our Neutral stance on Noble. The worst is over and earnings are on the road to recovery. However, the stock’s rally since Jan appears to have run ahead of fundamentals. Demand for hard commodities remains weak. We need to see more concrete evidence of a meaningful recovery before turning bullish on the stock. Valuations appear fair – the stock is trading close to its 7-yr historical mean P/E.
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