Orica: Value Belies Weak Outlook

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

-No major recovery short term
-Substantial discount to market
-Catalyst may be in FY14 results
 

By Eva Brocklehurst

Chemicals and mining services business Orica ((ORI)) confirmed fears with a subdued first half and brokers are resigned to the fact that it will be hard going for a while. The stock is attractive in terms of valuation but many are just not ready to put a Buy recommendation in place.

Macquarie downgraded its recommendation to Neutral from Outperform, noting valuation was undemanding and the stock a quality name but earnings momentum is negative and there are risks regarding the second half. In contrast, Deutsche Bank's Buy rating remains predicated on the fact the stock is trading at a 24% discount to valuation. The broker acknowledges a significant recovery in earnings is not expected in the near term. The stock's discount to the market is justified, in Credit Suisse's view. The broker notes the stock has underperformed the broader market by 15% over the past quarter and end-markets are weak. Credit Suisse suspects the ground support business (Minova) may never generate adequate returns. Credit Suisse expects the stock to remain range bound until there's more clarity on the strategic review.

There's no Sell rating on the FNArena database. The stock has three Buy ratings and five Hold (or equivalent). The consensus target is $23.64, suggesting 13.2% upside to the last share price. The target compares with $24.51 ahead of the results. The dividend yield is 4.6% and 4.7% on FY14 and FY15 estimates respectively.

The company now expects FY14 profit to be "in line or exceed FY13", seemingly less confident of growth than in prior guidance. To Morgan Stanley this is a "soft downgrade". The broker thinks explosives pricing and volume pressure signal forecasts need to be re-based lower. Hence, an Underweight rating. Macquarie observes Orica still assumes a second half recovery in volumes, which should be driven by stronger US and European quarrying and construction. It's the weakness in Australia and Indonesia that's the concern. Orica expects flat volumes in eastern Australian coal, following on from declines in the first half. Macquarie notes this is a change to prior expectations, as explosives prices have been relatively stable for 12 months. The broker cites further risks of production closures the event of more weakness in thermal coal prices.

JP Morgan is also concerned the weakness in Australia and Indonesia, given the company's significant capital investment in these regions. The broker thinks guidance is optimistic, given potential for east coast Australian demand to fall if coal prices weaken further. Moreover there's a potential moderation in Pilbara growth ahead from the weak iron ore prices. JP Morgan also observes that, while Australia/Pacific and North American profit per tonne declined, group profit per tonne actually increased by 5% and finds it difficult to determine how this was achieved.

Goldman Sachs does point out that just under half of the earnings miss was attributable to the downward re-statement of prior years' earnings but, even so, chemicals and mining services are soft. As a result, the broker has reduced FY14-16 earnings estimates by 4.5-5.2%. The stock continues to offer long term value but it's the industry dynamics that worry Goldman. To the broker, key customer end-markets are likely to become worse before they get better. This is reflective of significant cost pressures on the customer base, rather than structural issues. The Neutral rating is retained.

CIMB considers the stock's investment credentials hold up and retains an Add rating. The broker takes heart in the fact there are further costs to be cut, management has announced broader reviews of the footprint, and the chemicals business could be separated. Management said it is exploring all options for the chemicals business. This broker also highlights the re-statement of prior earnings as a factor in the weaker first half result but, overall, acknowledges the volume softness. The catalysts for CIMB are good cash conversion, further reductions in gearing and potential capital management, perhaps as soon as the FY14 results.

BA-Merrill Lynch, too, takes a positive stance. Operationally, Australian earnings dived the most, down 10% in the half because of lower ammonium nitrate demand on the east coast, customer de-stocking and plant shutdowns as well as some one-off restructuring. Some of the fall can be attributed to mining customers deferring overburden removal in response to falling commodity prices and the broker thinks this is a temporary aspect to the results. Markets outside the Australian east coast are expected to recover in the second half. North American earnings were also down 9% in the half, because of cold weather, but this should improve from power plants re-stocking of coal and improved ammonia-gas spreads, according to Merrills.
 

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