Great Expectations For Orica’s Second Half

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-Headwinds easing, but by how much?
-Volumes down but earnings per tonne improve
-Key gas supply agreement
 

By Eva Brocklehurst

Orica ((ORI)) has flicked the earnings switch to the second half, announcing a weak first half outcome is likely given weather-related effects in North America and subdued market demand. The company presented the latest scenario at an investor conference and reaffirmed FY14 guidance. Brokers are concerned about the weighting of expectations to the second half, accepting that while the headwinds are dissipating, the extent of a rebound remains to be seen.

Morgan Stanley calculates, assuming a 3% decline for profit in the first half but achieving FY14 expectations, this means a record 39:61 split between first and second half earnings. Hence, the broker is sceptical. Chemicals made up 8% of earnings in FY13 and the company admits the division is under pressure. There's speculation a trade sale may occur but Morgan Stanley does not think such a transaction would have a material impact on either the capital position or valuation. The broker does not resile from an Underweight rating, believing Orica is most exposed to structural change in the regional explosives market and this is likely to pressure returns.

Macquarie is not overly worried. A weaker first half is not a great surprise given the harsh US winter. Comparatives will become easier in the second half as $24m of the $30m in ground support restructuring costs were incurred in the second half of FY13. The broker acknowledges delivery on expectations is now vital and the profit warning last July lingers long in the market memory. The important features of a second half rebound will be movement in the Australian dollar, the degree of improvement in US coal production and Australian ammonium nitrate demand.

Growth forecasts over FY14 could still be achieved if volumes have simply been affected by seasonality and adverse weather, Citi maintains. The benefits of operating synergies, reduced debt and catching up on lost winter volumes are potentially there but whether the most optimistic of expectations can be achieved is another question, in the broker's view.

While explosives volumes are down year on year the contribution per tonne is higher. Moreover, the company expects volumes to improve the second half. Deutsche Bank takes a positive line from this observation. The broker expects earnings to increase by 15% in FY14, with the depreciation of the Australian dollar and the restructuring of Minova adding 14% alone. Orica has also entered into an agreement with Strike Energy ((STX)) for the supply of an additional l0PJ per annum for 10 years from 2020. The total requirement for Kooragang Island and Yarwun is 17.5PJ, which would be fully covered by the Strike and Esso/BHP Billiton ((BHP)) agreements from 2017 to 2029.

The broker also observes the outlook for the North American market is improving, given appreciation in the gas price, which will improve the competitiveness of coal, while non-residential building was up 2% in the four months to January. Deutsche Bank thinks Orica has scope to improve margins by focusing on operations, manufacturing and capex reductions. Still, there's plenty of downside risks. The broker names uncertain mining sector demand, increasing raw material costs and the ability to pass these on to customers in a timely manner, increased freight and energy costs, increased ammonium nitrate supply in the Asia Pacific and, critically for Orica, the Australian dollar. The broker reminds us that Orica's earnings are highly leveraged to the Australian dollar with every US1c move affecting pre-tax earnings by $7m. The company has hedged 63% of its US dollar exposure at US95c.

What pleased Credit Suisse was that earnings per tonne has improved. The broker thinks manufacturing flexibility should help normalise brief periods of regional oversupply, while the proactive gas strategy could enable Orica to be in the fortunate position where it has excess gas. Credit Suisse still struggles to see ground support breaking even in FY14 and maintains a Neutral rating. CIMB accepts that the FY14 forecasts require a material improvement in second half profitability but, further out, the company could surprise on cost cutting and this would improve leverage to an eventual recovery in underlying markets. This broker contends recent weakness provides an attractive buying opportunity for a quality business and retains an Add rating.

BA-Merrill Lynch believes, despite the downgrade to expectations for the first half, the stock still looks undervalued against longer-term averages and its peer group.There are a number of positive developments, including securing east coast gas and North American ammonium nitrate supply, which keeps Merrills on a Buy recommendation.

Orica scores four Buy ratings and three Hold on the FNArena database. The consensus price target is $25.15, suggesting 17.1% upside to the last share price. The targets range from $23.00 to $29.40. The dividend yield on FY14 forecasts is 4.5% and on FY15 it's 4.8%.
 

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