Second Half Turns Sour For Orica

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-Minova remains a drag
-Structural issues emerging?
-Longer term view maintained
 

By Eva Brocklehurst

Most brokers aren't too happy with Orica ((ORI)). At least in the intermediate time frame. The mining chemicals and explosives business has issued a profit warning and expects net profit to be 10% lower in FY13. Driving the downgrade were higher integration costs for Minova, particularly weak European and North American markets, lower earnings from Indonesia and soft ammonium nitrate (AN) and sodium cyanide volumes.

Macquarie now expects a 3% lift in second half earnings, against previously expecting a 15% improvement. When FNArena last reviewed the stock in May it was off the back of a solid first half, which had been better than many brokers feared. What soured?

Mining services business Minova is the main problem. The rest of Orica's business has been unable to offset a further earnings decline on that front. Macquarie forecasts a 7% fall in the North American mining services earnings in FY13 and a 67% decline in European earnings. CIMB expects a further review of the book value of Minova will be forthcoming but anticipates optimisation costs should reverse from FY14. The magnitude of the earnings downgrade will make investors cautious but CIMB thinks many of the issues should be addressed in FY14, while the core business remains defensive. The broker is one of the more upbeat, believing the growth trajectory should resume in FY14 in the absence of Minova optimisation costs and non-recurrence of mine-site issues in Indonesia.

For CIMB the glass is still half full. OK, earnings forecasts have been downgraded in line with the guidance but eastern Australian explosives volumes are holding up well in the face of lower coal prices. Macquarie also cites positive Australian volumes and relatively stable margins and AN pricing. Nevertheless, whereas CIMB tends to see this business as resilient in the face of the weaker coal outlook, Macquarie suspects it will be downhill from here, with volumes flattening and margins increasingly challenged. There is risk of further deterioration in the Australian explosives/cyanide business should volumes ease and coal/gold production be cut amid weak commodity prices.

The main area of concern for JP Morgan is the implied fall in explosives profit per tonne in the second half of 2013. It means a slippage of earnings and even greater downside for FY14 forecasts, as a full year at a lower earnings base flows through to earnings. Volumes may be holding up but this is being more than offset by a deterioration in profit per tonne which management was unable to explain. JP Morgan was also surprised by the company's comment that volumes for explosives in Australia were weaker than had been expected in the second half. Both BHP Billiton ((BHP)) and Rio Tinto ((RIO)) has reported strong production numbers in the June quarter. Maybe, according to the broker, it should be acknowledged that the ramp up of Incitec Pivot's ((IPL)) Moranbah is resulting in a reduction in Orica's share of the market in Queensland.

Macquarie suggests the return to normal production at Kooragang Island is the most positive aspect for FY13, as it generates a full manufacturing margin. Bontang's ramp up in Indonesia is also expected to deliver a positive impact, albeit lower than expected previously.

Potential structural issues are emerging, nonetheless. Credit Suisse considers Orica's 60% share of the Indonesian market is under pressure. The Indonesia coal market has deteriorated and imports have increased. Orica is looking to increase its 60,000 tonne AN export licence out of Indonesia. This situation warrants close attention as it appears Orica is losing share of a shrinking Indonesian AN market. Bontang is now competing with cheap imports from China and Russia. The difference between 6% and 4% cumulative growth in the Indonesian coal market, augmented by increasing strip ratios, is the difference between oversupply and under supply of AN in the next five years, in Credit Suisse's opinion.

Credit Suisse also makes the observation that Australia's west coast and east coast markets should not be considered independently. The broker believes, while most conjecture surrounds the iron ore growth forecasts in the Pilbara, there is an equal or greater risk to AN demand from the east coast coal market. These concerns underpin the broker's resultant downgrade of the stock to Neutral from Outperform.

Despite lowering the recommendation to Neutral from Outperform Macquarie thinks the stock is cheap, but likely to stay that way until there is evidence Minova is no longer a drag. The stock is trading at a discount to JP Morgan's valuation and the broker does not expect the gap will close in the short term, given concerns around the sustainable level of earnings in the business, emerging market growth and the outlook for mining production volumes. Longer term is a different story and JP Morgan is prepared to be patient, retaining an Overweight rating.

Along with Credit Suisse, Macquarie and UBS also downgraded the stock's rating on the back of the latest guidance. Others chose to retain their ratings. Hence, on the FNArena database the Buy ratings are reduced to four from seven previously. Hold ratings now total four. No broker on the database has registered the stock as a Sell. The consensus target is $21.97, suggesting 23.7% upside to the last share price. In the wake of the profit warning the consensus target price fell from $26.55. Target prices now range from $19.00 to $28.50. The dividend yield on consensus FY13 and FY14 forecasts is 5.0% and 5.2% respectively. 

See also, Orica Clears The Way For Better Growth on May 7 2013

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