Orica Sparks Upgrade Scramble

This story features ORICA LIMITED. For more info SHARE ANALYSIS: ORI

-Resilient explosives business
-Strong cash flow
-New gas contract sourced
-Capital management potential
 

By Eva Brocklehurst

What a difference a quarter makes. Diversified chemicals company, Orica ((ORI)), delivered a FY13 result that was better than broker forecasts and better than the guidance issued in July. Then, brokers responded to the guidance downgrade with key concerns about the company's outlook. These concerns have not been eliminated entirely but, heaving a collective sigh of relief, at least three have now chosen to upgrade recommendations.

Macquarie has upgraded Orica to Outperform as the result was better across the board, albeit from a downgraded base. The broker thinks the stock is still cheap on 12.3 times FY14 estimated price/earnings, which is at a 15% discount to market compared with the long term average of 8%. Growth looks set to resume in FY14 and while the outlook continues to be tough, the broker believes it's now better than feared.

 JP Morgan counters Macquarie's view and thinks the stock is marginally expensive, despite the earnings upgrades. The broker believes a large proportion of the reaction in the share price following the results was because expectations had been materially reduced. The mining services business provided the greatest surprise, driven by a rebound in volumes in Europe/Middle East and Africa in the second half and stronger margins in Latin America. The results may be stronger than expected but for JP Morgan the underlying numbers indicate conditions are still difficult for Orica. 

Deutsche Bank notes the resilience of the explosives business and the benefits of an improved product mix, as well as productivity improvements. Brokers acknowledge the strong net operating cash flow of $1.06 billion, up 95% and well ahead of Deutsche Bank's forecast of $855m. Mining Services' earnings were ahead of forecasts as well. The company is guiding to underlying earnings improvement in FY14, subject to market conditions. Deutsche Bank expects earnings to increase by 14% in FY14, with the depreciation of the Australian dollar and restructuring benefits from Minova to add 13% by themselves.

Minova managed to reach EBIT break even in the second half and, looking into FY14, BA-Merrill Lynch considers the benefits of the restructure provide for $54m in earnings improvement, before any volume and price assumptions. The broker observes Orica reported its best cash flow performance since 2003 and this resulted in debt levels being constant despite the increase in capex, which was primarily for the Burrup ammonium nitrate (AN) investment. The gearing levels of 36% are now at the low end of the company's target range of 35-45%, presenting an opportunity for capital management, in Merrills' view. Based on FY14 forecasts and company guidance the broker expects gearing to be just shy of 35% at the end of FY14 and interest cover at a comfortable 7.6 times. Should the company be comfortable with only a 250 basis points increase in gearing, Merrills highlights the prospect for an additional 48c per share of capital management in addition to a 98c ordinary dividend.

ORI reported FY13 net profit of $602m, 3% above prior guidance of $585m. The final dividend of 55c, fully franked, was up 1c on the prior year. UBS is raising earnings forecasts by 5-6% for FY14-15 to reflect better explosives-driven earnings and lower net interest costs. The broker has lifted the recommendation to Neutral from Sell.

Orica also announced it will use Esso/BHP Billiton to source up to 14PJ of gas for its ammonia manufacturing operations at Kooragang Island in NSW. This has removed a structural hurdle, according to UBS, and the broker thinks Orica has capacity to produce 380,000 tonnes per annum of ammonia. The broker previously maintained that the upcoming renewal of gas contracts with existing suppliers AGL and Santos could potentially cost Orica $55m, using an assumption of over $10/gigajoule for east coast gas from FY17. This new deal appears to have been struck at significantly more attractive levels, adding an incremental cost of just $12m, or around 85c/GJ. Moreover, UBS calculates this deal adds around $1.20 per share to valuation. The other way to look at this deal is via Citi's observations. The new gas sales agreement de-risks future earnings but as the negative cost impacts have been limited to $12m per annum, Citi suspects the current gas contract was struck at a higher underlying price than previously thought.

The other structural hurdle, according to UBS, is the supply deal with CF Industries in North America. Orica has the capacity to sell 1.5mtpa of AN-based explosives in North America but only manufactures around 500,000t, relying on third party suppliers for the remainder. Orica has a 10-year agreement – signed in 2006 – with CF Industries for the supply of up to 500,000tpa of explosives grade. Commercial terms of this contract are unknown but UBS suspects terms are linked to gas feedstock at CF's Yazoo City plant and referenced to an indexed gas price over the contract term. Renewal of the supply arrangement could cost Orica up to $60m but UBS has factored just $15m into calculations, expecting a more positive outcome.

Deutsche Bank notes the company anticipates a more normal year in 2014, with a slightly softer first half and strengthening in the second half. The broker observes an improvement in North American and European quarry and construction volumes in the September quarter and the North American coal market appears to have bottomed. The Australian AN surplus is diminishing and the outlook for sodium cyanide appears sound, given the company's contractual position. Indonesia remains the most problematic region, in Deutsche Bank view, with one customer still not operational and there is a major contract up for renewal in FY14.

Morgan Stanley is not so sure. While upgrading the rating to Equal Weight on the back of the results and admitting the bear case now appears less likely, the broker sees risks still on the horizon. Nevertheless, until these risks materialise, the market is expected to take an optimistic view. The risks envisaged are with Chinese AN, which continues to be exported at a record level. Prices are down 26% from the May 2012 peak and oversupply exists in Australia. The company confirmed that Western Australia may be long 150,000-200,000 tonnes in 2017. The outlook for sodium cyanide is also weak, after several years of price rises amid any ongoing weakness in thermal coal. Other than that, the company has shown resilience in the context of profit and earnings expectations, according to Morgan Stanley. Australian earnings (62% of EBIT) grew 2% and strong cash flow was the main positive, as Orica flexed payment terms. If this is sustained, and with capex expected to roll off over the next two year, management signalled the potential for capital management in FY15.

Orica has four Buy ratings on the FNArena database, with four Hold and no Sell ratings. The consensus price target of $23.58 suggests 2.1% upside to the last share price and compares with $22.07 ahead of the results. The dividend yield on the FY14 consensus earnings estimates is 4.1% and 4.4% on FY15.

See also, Second Half Turns Sour For Orica on July 22 2013

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