Orica Warning Overdue

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

-Buy-back in jeopardy
-Asset sales to provide buffer
-Trading contract tenure for price

By Eva Brocklehurst

Orica ((ORI)) has bitten down hard on the bullet, announcing a substantial downgrade to profit expectations for FY15 and signalling a flat outlook for FY16. Several brokers maintain the announcement should have been made much earlier, given broad and well flagged suspicions the operating backdrop, particularly in mining, was deteriorating.

Orica has announced asset impairments of $1.35-65bn and downgraded FY15 earnings guidance to be 25-30% below the prior year, at $425-445m. Brokers also consider the downgrades reflect a reality check by the new CEO, Alberto Calderon.

Having already downgraded forecasts, Morgans downgrades again, with FY15 and FY16 reduced by 12.7% and 10.9% respectively. Of most concern is the deterioration in the second half, considered to be the company's seasonally stronger period. Morgans forecasts volume growth to return in FY17 in the Australian market, believing miners can only hold out by high grading for so long.

The one lingering positive from the challenges throughout FY15 has been the share buy-back but this now looks in jeopardy. The $400m buy-back is under review, pending discussions. To date $53.4m in shares have been bought back. Management stated its priority is to protect the credit rating and dividend. Morgans removes the buy-back from forecasts and retains a steady dividend. Given the buy-back is no longer in place to support the share price the broker is cautious.

Meanwhile, Orica is assessing the options for its Bontang ammonium nitrate facility in Indonesia. Morgans observes, once the new Burrup plant in the Pilbara ramps up in 2016, there is around 60,000 tonnes from Bontang, previously exported to Western Australia, which will have to find a new market.

Competition from China and a tough coal market in Indonesia means pressure is being placed on the facility at Bontang. At this stage, Morgans expects Burrup will generate sub optimal returns as the market will be oversupplied initially.

Management is re-establishing ground support as a separate business unit to provide more options in the future. Morgans notes the fact the company was unsuccessful in selling this business in the past. The company expects proceeds from the sale of the chemicals business, combined with the benefits of its transformation program, to provide a buffer for the current credit rating, although Morgans asserts the head room will be reduced by the lower earnings.

Macquarie estimates gearing will increase to 37%, in the middle of the company's 35-45% target range. The broker considers the downgrade is exacerbated by US price reductions, lower price for Australian volumes and pressure on services. As Australian and US earnings are heavily centred on coal this industry is the main culprit. Still, the forecast for a flat FY16 outcome was of particular surprise to Macquarie, given cost savings and lower FX were expected to deliver growth.

Volume downgrades are a major headwind and the extent of the downgrade suggests to Macquarie that profitability is under pressure, as transformation benefits are overshadowed by pricing pressures and an adverse shift in mix. The broker observes Orica has continued to trade tenure for price, with 90% of FY16 Australia/Pacific volumes now contracted. This is expected to outweigh the benefits of transformation in FY16.

Orica is only now facing up to just how weak conditions really are, Morgan Stanley maintains. The costs associated with this re-basing of earnings are larger than expected but it also confirms what the broker had largely feared. Morgan Stanley also suspects the market is deteriorating further and the prospect for Orica is challenging despite the revamped outlook.

Credit Suisse takes the view that the downgrade has now captured most of the downside risks and assumes the buy-back will be discontinued. Credit Suisse estimates bulk price contracts have been re-set marginally above import parity and this provides a reasonable base for pricing in the Australian market. The broker is not sure what operational flexibility exists at Bontang but cash break-even appears to represents a reasonable floor. 

On Credit Suisse's forecasts the balance sheet appears sustainable under the new earnings assumptions. However, demand growth is not expected to tighten the supply balance enough to produce pricing power before 2020.

The profit warning and impairments, albeit worse than expected, are more a case of re-basing of expectations by the new CEO, from which the company should be able to grow earnings and returns, in Deutsche Bank's opinion. The broker considers the forecast for flat earnings in FY16 is conservative and, while the call does not instill confidence, a Buy rating is maintained with the stock trading at a 29% discount to valuation.

Management would not expand on the quantum of transformation benefits in FY16 but Citi presumes an annualised effect should add to earnings in FY16, with no further deterioration in the underlying operating environment. While the downgrade to guidance was a disappointment, Citi is not so pessimistic about the outlook and believes the announcement reflects the usual re-basing that comes with new leadership.

The biggest risk to achieving a target of $22, the top of the range among brokers surveyed on FNArena's database, is slowing Chinese demand for electricity, steel and other commodities, in Citi's view. Mining services would be immediately affected by a sharp deterioration in the outlook for demand for commodities. Upside would come from a larger than expected rise in US and European GDP growth, or a substantially weaker Australian dollar, as well as more intense use of the company's products at a mine level.

UBS is far more negative and remains concerned about the flat outlook for FY16, cutting forecasts by 10-25%. The broker's forecast for FY16 net profit is below the bottom of the outlook range provided by Orica and implies a drop of 10% on FY15 guidance. UBS considers the probable halting of the buy-back, an uninspiring free cash yield and risks to the balance sheet mean there is not enough capital to support valuation should the outlook worsen.

On FNArena's database there are two Buy ratings, two Hold and three Sell. The consensus target is $17.34, suggesting 11.9% upside to the last share price. This compares with $20.04 ahead of the warning. Targets range from $14.00 (UBS) to $22.00 (Citi and Deutsche Bank). The dividend yield is 5.9% for both FY15 and FY16 estimates.
 

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