Can Orica Withstand Explosive Price Pressure?

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-Earnings weak but costs decline too
-AN pricing pressure continues
-Able to influence explosives market
-Gaining share in North America
 

By Eva Brocklehurst

Orica ((ORI)) sustained a weak first half, swamped by pricing challenges in mining products, with the one major positive being the ongoing buy-back of its stock. The company’s earnings from continuing operations have declined by around 15% and guidance points to worsening conditions in the second half.

It is not as bad as some fear, Morgans maintains. Guidance implies a deterioration in Australian market conditions and there is likely to be material downgrades to consensus estimates. While operating conditions are difficult and earnings uncertainty prevails the broker retains a Hold rating. Nevertheless, the strength of the balance sheet is one positive the broker highlights, with gearing below the company’s policy range. Furthermore, despite the lower earnings the interim dividend was maintained, a sign of confidence in the future.

Given the full impact of revised guidance on explosives, Morgans downgrades FY15 earnings forecasts by 6.4%. The company is considered to be in safe hands and has proactively reduced its cost base, although the operating environment may offset much of the benefit, the broker suspects. The share price is likely to be supported by the share buy-back and an attractive dividend yield.

There is one broker that is not half-hearted about the outlook. The result may have been soft but it highlights the resilience and diversification of the business, in Deutsche Bank’s view. Early benefits of a transformation are coming through with cash flow conversion of 84% and a reduction in capex guidance. The broker has reduced underlying forecasts by 3-5%, to reflect lower mining services earnings in Latin America, Asia and Australia, partly offset by higher earnings estimates for North America. Deutsche Bank is now treating chemicals as a discontinued item, given the sale of that division earlier this year which leaves the company as a pure mining services business.

The broker observes the interim CEO provided a candid appraisal of the challenges and how the company was meeting the pressures of the mining industry. Deutsche Bank believes this candour will be welcomed, given extremely low expectations of the company’s prospects. Orica will review its ammonium nitrate (AN) manufacturing footprint and is exploring options for Yarwun and Bontang. The company remains committed to the Burrup plant, scheduled to start up in FY16.

Morgan Stanley is not convinced, expecting the earnings downgrade cycle to continue. Earnings forecasts are lowered by 5-9% and the broker believes a more bearish view of the outlook will emerge as the market absorbs the information in the update. Pricing pressures remain greatest in Australia where AN prices are seen falling around 20%. Falls in emulsion prices are likely to be even greater, in Morgan Stanley’s opinion, given the larger premium historically seen in this product, and competition is strongest in this part of the market. Underweight retained.

If the company does lower capacity, impairments may be required in the second half as the carrying value is assessed. Although ground support is now integrated within mining services, market conditions suggest impairments may also be required against these assets. The one strong area Morgan Stanley contemplates is the balance sheet, which holds sufficient capacity to absorb additional costs.

Credit Suisse believes the share price is undemanding and reflects a structural adjustment to earnings. Although earnings are likely to weaken further the capital expenditure profile is declining, hence cash generation improves across the forecast horizon. This should make it possible to increase the dividend pay-out ratio even on a declining earnings base, in the broker’s opinion.

Trading conditions may be challenging but Citi found the company upbeat about its positioning and medium-term outlook. The broker considers the business model is more robust than many assume and the company has the ability to respond to the pressures common in cyclical downturns. Moreover, the multiples do not appear demanding even after a material reduction to forecasts and this should garner increasing attention as the management succession is formalised and visibility improves.

Orica, as market leader, has the ability to favourably influence the domestic market balance which Citi notes has been the cause of much concern given the 30% increase in AN capacity since 2013. Orica can flex production at Yarwun, which materially reduces any likely oversupply. It could also place excess production in export markets, the broker suspects. Moreover, as one of the largest global traders in explosives, Orica’ss merchant margins also benefit from lower industry prices. Citi’s forecast now show a much sharper decline in FY15 and into FY16 but, with net benefits forthcoming in FY16, forecasts are substantially de-risked.

Australian earnings are shrinking because of weak end markets and competition, in Macquarie’s observation, whilst Orica is gaining share offshore. This is negative for the margin mix, with 7.0% margin in North America versus 27.0% in Australia. The broker believes the transformation benefits only partly offset price declines in Australia in the first half while the company faces a soft second half. Despite the challenges the broker expects the share buy-back will remain supportive.

Orica has now contracted 73% and 63% of its Australia Pacific volumes in FY16 and FY17 respectively and confirmed that price reductions are no worse than import parity, having walked away from business to ensure this is the case. Macquarie estimates, on average, that Orica has experienced around a $100/t reduction in contracted pricing as the premium over imports comes out of the market. While securing longer term offtake is a positive the broker is mindful this has occurred when the market is in a trough.

UBS also found the trends worsening and reduces Australian explosives earnings forecasts. Importantly, management appears more willing to tackle over-capacity via reduced output if poor demand persists, hence the broker’s modelling suggests a largely neutral impact from lower explosives prices. Orica’s improved transparency should allow the market to re-base forecasts more appropriately to incorporate the pricing risk. Still, metrics are stretched, in the broker’s view, given the weaker medium-term outlook and Incitec Pivot ((IPL)) is preferred in this sector. UBS retains a Sell rating.

There is just one Buy rating on FNArena’s database – Deutsche Bank, with four Hold and three Sell otherwise. The consensus target is $20.38, suggesting 2.6% downside to the last share price. This compares with $20.17 ahead of the results. The dividend yield on FY15 and FY16 forecasts is 4.5% and 4.8% respectively. 
 

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