Is The End Of The Downside In Sight For Orica?

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

-Commodity prices need to hold up
-Supply rationalisation still likely
-Brokers welcome more transparency

By Eva Brocklehurst

Orica ((ORI)) is making the best of the current environment, daring to make a more positive assessment of FY16, based on commodity prices holding up. The company's FY15 result revealed net profit was down 26%, at the low end of the guidance range.

This new found optimism has not convinced Morgan Stanley. The broker is not sure that FY15 represents a trough in earnings for Orica. Bulk commodity exposures, particularly coal in Australia, Indonesia and North America, are expected to endure further rationalisation of supply in the short to medium term. This will place more pressure on the company's ammonium nitrate/emulsion volumes and, importantly, on plant utilisation.

Morgan Stanley notes there is no contractual protection against this downside and, in light of the fixed costs at AN plants, any reduction in volume could affect profitability. In the short term, the company has the challenge of loading the Burrup (Western Australia) and Bontang (Indonesia) plants adequately. The broker also notes that, in FY17, if demand continues to weaken plants will be under pressure given the current high utilisation levels.

This is particularly the case in Western Australia where the company's Burrup plant competes with Kwinana, and in North America where demand is moving to a flat part of the cost curve, to gas rather than ammonia-backed supply. In such a structurally declining demand environment the broker finds it hard to put a floor under valuation.

UBS is inclined to a view that while raising FY16 earnings estimates by 6.0% to account for a better run rate on cost cutting, the outlook for explosives, particularly in Australia, is subdued. The broker highlights the sharp contraction in underlying margins in FY15, because of a shift in mix and weaker prices.

UBS forecasts imply flat 3-year average earnings growth – just 1.0% – off a FY16-19 base. Moreover, this outlook relies on the sustainable delivery of cost reductions. Hence, risks are to the downside and, at the current share price, the broker believes the valuation is full.

Deutsche Bank found the FY15 results positive, in that net operating cash flow was stronger than expected and net debt lower than expected. The broker takes heart in the improved outlook and believes the company's indications for FY16 suggest earnings of $770m, with some conservatism built in as Deutsche Bank suspects FX benefits will be more supportive.

The broker observes the company's contracting position is improving, with 88% contracted in Australia in FY16 and 76% in North America. This provides confidence in relation to its volume and pricing guidance. The company is also more positive on the Indonesian market, given a reduction in Chinese AN imports following the recent incidents in Tianjin and the lower ammonia price.

In August the company announced it was accelerating its transformation program, targeting FY15 gross benefits of $170m, hence one-off costs were likely to be higher than previously forecast. At the FY15 result the company announced it had achieved $175m in gross benefit, with a cost of $81m relating to restructuring and redundancies.

Orica indicated it expected the transformation benefits to be sustainable at around 80% over the long run. In FY16 a further $50-60m in net transformation benefits is forecast, but JP Morgan suspects further pricing impacts and inflation pressures will temper this.

JP Morgan is cautious, given the considerable uncertainty regarding the ramp-up at Burrup and the future of Bontang. As well, Macquarie, while liking the more new transparent approach from management, believes the pressing issue is whether earnings have found their nadir.

The broker's wisdom gained from experience in the mining services/contractors sector is that downturns are usually longer and deeper than widely expected. Orica may be a high quality business but the macro environment remains very challenging across thermal coal, gold and copper, in Macquarie's opinion.

If anything, the report builds confidence, Citi contends. The broker accepts FY16 will have its challenges but believes there is enough evidence that FY15 could be the bottom of the current cycle. Citi likes management's new, more transparent style of disclosure… and then there is the dividend yield.

Morgans also lauds new management for changing the operating model and expects the commentary will be well received. Still, the broker concedes the outlook is not without risk. Morgans also highlights the benefit of a falling Australian dollar, although reduces profit forecasts because of higher interest and tax estimates.

Profit growth is expected to resume in FY17 as volume growth returns to the Australian market, with the broker observing miners can only prioritise high grades for so long. The share price may be supported by an attractive dividend yield but, nonetheless,Morgans is cautious and retains a Hold rating.

FNArena's database is evenly spread, with two Buy ratings, three Hold and three Sell. The consensus target is $16.82, signalling 2.9% upside to the last share price. Targets range from $13.47 (Morgan Stanley) to $23.50 (Deutsche Bank). The dividend yield on FY16 and FY17 forecasts is 5.8% and 5.9% respectively.
 

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