Earnings Gulf Widens For Orica

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-Are structural headwinds persisting?
-More downside potential to earnings
-Dividend cut suggests stock expensive
 

By Eva Brocklehurst

The challenges continue for explosives business Orica ((ORI)), which reported a soft first half and has retreated from its prior guidance of FY16 being an improvement on FY15. The company has also cut its dividend. Earnings in the first half were affected by price reductions in Australia and a decline in ammonium nitrate (AN) volumes in the coal markets of both Australia and North America.

The share price suffered substantially. Unnecessarily so, Credit Suisse contends. The result was 5% below the broker's forecasts and, while expecting FY16 earnings to be down 6%, the broker notes capital discipline has improved. Credit Suisse does not believe the stock warrants a Buy case, retaining a Neutral rating, but there is a sustainable level of profit around current levels. Hence, some value needs to be accorded the stock.

Furthermore, a duopoly situation in Australia – shared with Incitec Pivot ((IPL)) – is not conducive to long-term sub-economic outcomes in the broker's opinion. The US market has overshot on the downside, Credit Suisse suspects, and there is some recovery in volumes likely in FY17. Meanwhile, quarry and construction markets offer growth.

Citi sticks with a Buy rating, taking the view that this is the low point in the present cycle, or very close to it, and the company is better positioned than it has been in the past. Deutsche Bank is of similar disposition, suggesting capex reductions have meant the company has achieved its business improvement target.

Nonetheless, the decision to cease guiding for growth and reduce the dividend is a sign the company is facing structural headwinds, Morgan Stanley asserts. The broker believes the company needs AN volumes to grow as it cannot cut costs fast enough to offset the downturn. The broker continues to expect material downside for the stock and believes consensus estimates need to fall by more than 10%, with even larger reductions for FY17.

Earnings in the first half were 4.9% below Ord Minnett's forecasts and the downgrade to the outlook larger than expected. The broker reduces earnings estimates by an average of 15% over the next three years, noting no guidance was provided on the magnitude of the earnings impact in the second half from the reduced volumes, which suggest a decline of 8.5%, an omission which puzzles Credit Suisse as well.

There are other areas of uncertainty prevailing, with the Burrup (Pilbara) AN plant enduring losses as it ramps up to production by the end of the year and question marks over the displacing of Bontang (Indonesia) volumes as Burrup comes on line.

The interim dividend of 20.5c is well below Macquarie's forecast of 39c, and reflects a new policy with a 40-70% pay-out ratio. The broker was surprised by the reduction, suggesting the balance sheet appears less robust than foreseen. While the broker believes the metrics are alright, at 43% gearing, a move down to BBB-minus from BBB in terms of credit rating would mean a material lift in interest costs and less private placement liquidity.

The lower capex outlook for FY16, whilst a positive, is not expected to be enough to preserve the dividend. Macquarie reiterates a belief that the downgrade cycle is always longer and deeper than expected and, while Orica is doing what it can in terms of self help, it continues to be overwhelmed by negative price and volume trends.

On the positive side, the broker highlights an extended and expanded contract for AN supply to Fortescue Metals ((FMG)). Fortescue is the largest customer of the Burrup expansion. Orica has also won 100% of its contract renewals in Australia, Asia, Europe and Africa in the first half.

Morgans expected guidance to be downgraded for FY16 and the first half was better than feared, because of lower depreciation costs and $13m in asset sales. In light of the market conditions the broker believes the company is doing the best it can to take costs out of the business, increasing manufacturing efficiency and reducing debt. Free cash flow should improve as capex requirements will fall following the commissioning of Burrup. Morgans expects volume growth will return to the Australian market in FY17 but still urges caution.

While the company believes most of the re-pricing has taken effect, UBS suspects downside risks exist for AN pricing beyond the current year. Excess supply is a headwind, alongside weaker demand in the company’s largest markets of Australia and North America. The broker expects this to get worse as new manufacturing capacity is added in both regions.

Despite the re-basing of earnings expectations after the result, UBS retains a Sell rating. The cut to dividends makes the stock look expensive on the broker's calculations, with no earnings growth expected over the next three years.

FNArena's database shows two Buy ratings, three Hold and three Sell. The consensus target is $13.25, suggesting 4.1% downside to the last share price. This compares with $15.51 ahead of the results. Targets range from $11.32 (Morgan Stanley) to $14.60 (Ord Minnett).

See also, Orica Hesitates, But Earnings Downgrade Likely on February 1 2016.
 

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