Orica Hesitates, But Earnings Downgrade Likely

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-Further bulk price downgrades
-Cut-backs to production impact
-Volume probably slow to return
 

By Eva Brocklehurst

The environment remains challenging and mining services and chemicals company Orica ((ORI)) considers it too early to update further on the guidance provided last November, but brokers suspect the outlook is none too rosy.

The company previously stated it expects FY16 earnings to be an improvement on FY15 but customers continue to drive down costs and review their operations, with production being shut down and volume targets being lowered.

For Morgan Stanley it is not too early to be bearish, and the broker retains an Underweight rating. The broker continues to forecast a downgrade to earnings growth, as demand is deteriorating. Moreover, Morgan Stanley is sceptical regarding the company's belief that volumes will recover, and that the upward cycle will begin again as it always does.

Instead, the broker suspects demand for ammonium nitrate (AN) – used extensively in explosives in coal mines – is in a state of permanent structural decline. This is based on a view that increasing environmental regulation and, in the longer term, new technologies will displace both explosives and bulk commodity demand.

Credit Suisse's forecasts are heavily dependent on production in the thermal coal markets of Australia and the US, where considerable uncertainty remains. Thermal coal accounts for around half the company's volumes in these markets. In the short term the business is supported by take-or-pay contracts so the sustainability of the production scenario is not clear.

The broker envisages that,over the long term, demand for thermal coal is dependent on the expansion of coal-fired electricity generation in emerging markets. Credit Suisse has little confidence in forecast assumptions but does assume a partial recovery in coal production in FY17, based on higher winter electricity demand and a higher cost of gas leading to an increase in coal usage.

Credit Suisse expects little growth in earnings until FY18. While the company's dependence on thermal coal is a significant uncertainty, the broker considers the stock’s valuation is reasonably attractive on current forecasts and a Neutral rating is maintained.

The outlook is compounded by the fact that since September 2015, thermal coal prices have fallen around 16%, iron ore a further 20%, copper by 20% and oil by 49%, Macquarie observes.

The broker also notes that Orica's FY16 guidance for modest earnings growth assumed flat global AN volumes, with declines of 3-4% in Australia being offset by stronger global volumes. For Macquarie, the earnings risk is also on the downside and a flat FY16 outcome is expected, with the latest commentary from the AGM reinforcing that view.

Morgans does not expect Orica's earnings will improve until FY17, acknowledging the company is doing all it can to offset the difficulties. The broker notes Orica's November guidance was predicated on the forward curves for key commodities holding up and this has not been the case.

Morgans downgrades FY16 and FY17 earnings estimate by 6.0% and 9.1% respectively. Most of the reduction in earnings reflects the tough operating conditions in Orica's highest margin market, Australia.

North American forecasts are also downgraded, given US coal production is down around 30% year on year. Moreover, a particularly weak first half is expected at the May results, given the company is cycling much stronger comparables.

The broker does expect volume growth will return to the Australian market as there is only so long miners can focus on high grade and reduced overburden removal. Given the company's priority is to maintain its credit rating, Morgans considers the dividend policy is also unsustainable and assumes a 65% pay-out ratio going forward.

Deutsche Bank takes heart in the fact the company has introduced a new operating model and rationalised AN supply in Australia. It has strengthened its forward contract profile, separated Minova, and reduced its costs. Hence, Deutsche Bank sticks with its Buy rating.

Along with Citi, yet to comment on the latest update, this constitutes the two Buy ratings on FNArena's database. There are three Hold and three Sell. The consensus target is $16.17, suggesting 14.7% upside to the last share price. Targets range from $23.00 (Deutsche Bank) to $13.00 (UBS). The dividend yield on FY16 and FY17 forecasts is 6.3%.
 

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