AGAINST a backdrop of weak commodity prices and a challenging business environment, Sime Darby Bhd saw its earnings weaken for its financial year ended June 30, 2015 (FY2015), and how it will address its RM18 billion debt remains unclear.

The conglomerate is committed to strengthening its balance sheet — which saw net gearing balloon to 58% from 38% after the acquisition of New Britain Palm Oil Ltd (NBPOL) in March — but has no concrete plans yet on how it will do it.

“We have not come up with a plan yet, it is still a work in progress. But definitely, we are working on strengthening our balance sheet,” Tan Sri Mohd Bakke Salleh, Sime Darby’s president and group chief executive, said at a press briefing after the release of its quarterly financial results last Wednesday.

“The intention is to come up with a gearing ratio that is a bit more palatable for ourselves and our stakeholders. If we can bring it to anywhere between 30% and 35%, that would be a lot more desirable,” Bakke remarked.

But he also noted that given the cheaper cost of debt compared to equity, it makes sense to borrow at this point in time.

Bakke added that Sime Darby (fundamental: 0.80; valuation: 1.40) would also consider merger and acquisition opportunities to expand its footprint.

“Everything we are encountering today is not all doom and gloom. Even in bad times, there will be opportunities to pick up assets or enter into strategic collaborations with other players in the market. We have been receiving many offers from such players to partner or buy over their assets,” he said.

Asked later by digitaledge Weekly  if it would consider gearing up further to fund potential M&A, Sime Darby declined to respond.

A company spokesperson instead said Sime Darby hopes to achieve its target of 30% to 35% gearing in the short to medium term. Analysts estimate that this could be done in six to nine months.

There has been market talk recently that the group is considering a RM6 billion rights issue to pare down its debts, but Sime Darby has not confirmed or denied this.

Analysts tracking the stock, however, believe that a cash call may not be Sime Darby’s best option as it would enlarge its share base and dilute earnings.

“It would depend on how the rights issue is priced for investors. Unless Sime Darby can immediately buy something that is earnings accretive, would shareholders want to fork out the extra cash?” asks CIMB Research’s regional analyst Ivy Ng.

“It does not seem critical for it to buy more assets at this point. But if the offers coming to it look increasingly interesting, then the rights issue might be an option to consider if it offsets the dilution effect,” she says.

In that vein, others point out that Sime Darby will have to hold off any major acquisitions until it has reduced its debt level.

“It is highly likely that until it deleverages sufficiently, it might not do another acquisition, or do a combination of debt and equity to maintain gearing at current levels, or even bring down debt,” Fitch Ratings’ director of corporate ratings Nandini Vijayaraghavan tells digitaledge Weekly.

“Sime Darby historically is always looking for M&A, but it is careful and most [of the] acquisitions it has made have been value accretive,” she adds.

In March, Fitch Ratings downgraded Sime Darby’s outlook to “negative” after imputing debts from the NBPOL buy.

Sime Darby’s FFO (funds from operations)-adjusted net leverage has risen to 2.5 times, well above the 1.75 times level at which Fitch would consider negative rating action.

Interestingly, one analyst notes that Sime Darby’s current gearing level is not untowardly high. “The negative rating by Fitch is the bigger concern because that will impact Sime Darby’s cost of borrowing,” he says.

Bakke had said at the briefing, “We need to respond to what credit rating agencies are looking for.”

According to Alliance Research, Sime Darby’s borrowing cost is currently 3.4% per annum.

That said, Sime Darby may not have to actively borrow more or make a cash call if business operations improve and cash flow rises.

As at June30, Sime Darby had cash of RM3.65 billion, giving it a net debt of RM14.4 billion. But earnings have taken a hit for FY2015 with net profit falling 31.3% year on year to RM2.3 million on flat revenue of RM43.7 million.

Profit before interest and tax from its biggest income earner, the plantation division, fell 39% y-o-y to RM1.15 billion as average crude palm oil (CPO) prices dropped 11% to RM2,193 per tonne. Its fresh fruit bunch (FFB) production for the year also fell 5% to nine million tonnes.

Quarterly net profit slipped 17% to RM988.67 million for the fourth financial quarter ended June 30 (4QFY2015), from RM1.19 billion in the previous corresponding period. Revenue was marginally higher at RM12.86 billion against RM12.56 billion previously.

The board has declared a lower dividend of 19 sen per share for 4QFY2015, bringing the total annual dividend to 25 sen per share for FY2015, compared with 30 sen in the previous corresponding quarter and 36 sen for FY2014.

The difficult operating environment has prompted many analysts to cut their target price: Alliance Research to RM7.40, CIMB Research to RM8.08, AffinHwang Capital Research to RM7.59 and AmResearch to RM8.

“If CPO prices start to perk up or cash flow from its businesses starts to improve, then leverage is likely to moderate and they might not need to take on any major fundraising, but it is still too early to tell at this juncture,” says Fitch’s Nandini.

In an Aug 27 note, she writes, “Robust CPO and other vegetable oils output will continue to pressurise the CPO price in the short to medium term. An El NiNo is expected to occur in 2H15, while the resultant adverse impact on FFB yield and output will not be immediate.

“CPO prices are still at a level sufficient for the large players to cover their costs and generate adequate operating cash flow. The credit profiles of even the large CPO operators would deteriorate should prices stagnate at the current levels or decline further.”

Spot CPO prices fell as low as about RM1,860 per tonne in the middle of last week, over 9% lower than in the week before, according to data by the Malaysian Palm Oil Council. Spot CPO closed at RM1,994 last Friday while the benchmark three-month futures ended the week at RM1,802.

Sime Darby is bearish on the CPO price, forecasting the commodity to trade between RM1,900 and RM2,000 per tonne up to end-September. “Beyond that, it’s difficult to predict because of the uncertain outlook,” said Bakke.

The group’s silver lining would be the added earnings from NBPOL, which has already begun contributing to the group. For FY2015, it has raked in RM102.6 million in profit before interest and tax.

NBPOL’s palm trees are about 10 years and have brought Sime Darby’s average tree profile down to 14 years. One analyst says that given its fairly young age profile, Sime Darby is in a fairly good position to weather low CPO prices.

In the meantime, apart from more borrowings or a rights issue, Sime Darby is also considering unlocking value by divesting some non-core assets — a strategy it has had in place for some time now.

Analysts concur that monetising assets such as land parcels and its 30% stake in Tesco is the best option for now.

In FY2015, Sime Darby said that Tesco was the main contributor in its “Others” division, making a loss before interest and tax of RM35.8 million compared with a RM52.7 million profit the year before. This was due to a one-off impairment on property, plant and equipment and stocks, in which Sime Darby’s share was RM89.2 million.

Most recently, Sime Darby sold off its 50% interest in Sime Darby Sunsuria Development Sdn Bhd for RM173.4 million and a 9.9% stake in Eastern & Oriental Bhd for a total of RM319 million.

But the difficulty in the current weak market would be finding a buyer, and Sime Darby has been burnt before.

The group, which distributes BMW, Hyundai and Ford cars, has put on hold indefinitely the planned listing of its motor division that was initially slated for 2HFY2015.

The initial public offering had been estimated to raise some RM2 billion but is now deferred “until the market is conducive for the exercise.”

In FY2015, the motor division’s profit before interest and tax fell 25% y-o-y to RM473.6 million on lower earnings in all regions except for Australia, New Zealand and Vietnam.

Sime Darby said that the division’s sales in Malaysia were affected by tighter lending rules, the Goods and Services Tax, and the depreciating ringgit.

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This article first appeared in digitaledge Weekly, on August 31 - September 6, 2015.