Orica Outlook Improving But Challenges Continue

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Mining services business Orica will be flat out making sure its business improvements stay ahead of increasing costs and price re-sets, brokers believe.

-If cost reduction benefits are achieved a small improvement in earnings in FY17 may be forthcoming
-Orica may not be as leveraged to a volume recovery as current multiples imply
-Competitive dynamics heightened for delayed Burrup plant
 

By Eva Brocklehurst

Mining services business Orica ((ORI)) has a more positive outlook in terms of the cyclical volumes for explosives but its FY16 result indicates some structural problems remain. Brokers believe FY17 is shaping up as a year where the company will rely heavily on its business improvement measures to counteract price re-setting and increases to input costs.

The company did not provide specific earnings guidance and management has stated it remains conservative, despite some optimism on market conditions. Orica was careful not to call a bottom to the market but indicated there had been some stabilisation in prices.

The headwinds outlined by the company include a $60m negative impact on price re-setting as well as a $50-$70m negative impact for previously-negotiated input material contracts. Increased depreciation and amortisation expense, as commissioning of the Burrup project nears, is expected to be offset by business improvement initiatives.

Macquarie observes the Australian business has shown good sequential volume to date, although traditionally the second half is seasonally stronger. Collectively, the broker calculates $120m in price/input costs are expected to be offset by $30m in non-recurring costs plus business improvement initiatives. Macquarie observes, therefore, there is a bigger ask in terms of the cost reduction program this year, which increases the risk in execution and for which strong volumes may yet be required as an offset.

The stock is considered relatively fully valued and with a potential earnings recovery slated for FY18 rather than FY17. Macquarie prefers Incitec Pivot ((IPL)) in the sector. The broker acknowledges the previous problems with Minova have stabilised and there is more positive commentary regarding Indonesia, as well as coal market improvements and a $10m benefit for Bontang plant from lower ammonia prices.

Yet Macquarie cannot avoid the impression that cost reductions are required to do the heavy lifting. The share price has run up strongly on the back of higher coal prices and a more positive cyclical backdrop, but this appears factored in and a Neutral rating is retained. Be that as it may, the broker believes the stock should still trade at a premium to domestic contractors based on its less cyclical and relatively low-risk earnings.

Ord Minnett notes the impact of pricing re-sets in the explosives business has been severe in recent years, part of which relates to the flowing through of price terms from contracts signed previously. The broker notes there has been very little re-opening of existing contracts in the last 8-9 months and further price re-sets have not been ruled out. The broker factors in a further $20m in price re-sets in FY18.

The current market supports a further strengthening of volumes into FY17, Credit Suisse asserts, and if cost reduction benefits are achieved believes it likely that Orica will generate a small improvement in earnings in FY17. Improving export coal fundamentals are likely to support Australasia while the North American market is being driven by a less adverse outlook for domestic thermal coal. Growth in other regions appears to be a broadly-based improvement story.

Deutsche Bank believes the recent rally in commodity prices is positive, as this reduces the risk of further reductions in miner production volumes and mine closures. While the company is forecasting flat ammonium nitrate volumes the broker believes there is upside risk to its assumptions, given the improving outlook for explosives, while pricing appears to have bottomed.

The main surprise in the results for UBS was free cash flow, driven by lower net working capital and capex in FY16. The broker incorporates a lift in explosives volumes and additional cost reduction benefits into its forecasts to offset around the headwinds relating to lower explosives pricing and higher raw material inputs.

UBS acknowledges its forecasts incorporate a high degree of certainty around the company's ability to execute on another round of cost reductions and believes the stock is now fully valued, with a premium built in for a more positive cyclical outlook.

Given Orica only produces 50% of what it sells, UBS remains concerned that higher input costs and deteriorating end-prices for explosives mean earnings might not be as leveraged to a volume recovery as what current multiples are implying. The broker believes regional oversupply of ammonium nitrate will restrict Orica's ability to realise margin expansion.

The broker's Sell rating is based on the tougher outlook ahead for the main market of Australia. UBS is more cautious about domestic Australian explosives volumes and margins because of weak end-markets for coal and a regional oversupply through to 2020. The broker envisages a combination of weak demand, ammonium nitrate oversupply and a negative mix in the key Australasian and North American regions will weigh on growth prospects for the next several years.

Morgans is less concerned and found the result reasonable in the light of difficult market conditions. The broker believes the stock is fairly priced and that the self-help initiatives will largely offset the industry legacy issues. On the other hand, Morgan Stanley also highlights the need to have faith in offset targets and retains an Underweight rating. In the broker's calculations, the rally in the shares has placed the stock on the richest price-earnings ratio it has ever traded.

Meanwhile, the Burrup plant was delayed by unspecified commissioning issues, one year behind schedule, and is expected to begin operation early in 2017. It is expected to break even on EBITDA (earnings before interest, tax, depreciation and amortisation) in the year.

Despite the benefit of the later start, Morgan Stanley believes the outlook for the plant has materially deteriorated. Recent contract losses suggest the competitive dynamics may have dramatically intensified. Unless Orica can secure substantial new volumes the broker believes the risk is growing that it may need to impair Burrup.

Citi is quite confident that the turnaround has begun and the improvements ushered in are positive, although acknowledges these will take time to be realised. The company has a new customer-centric model based on geography rather than function and has enhanced its executive team. Minova is turning around and gearing has been reduced. The broker suspects the latter could play an important role in improving the medium-term growth profile.

Volume stability is a prerequisite for price stability, Citi asserts, and this should become more entrenched over the next 12 months. As there is insufficient upside to the broker's target price of $17.50, its recommendation is downgraded to Neutral from Buy.

FNArena's database contains one Buy (Deutsche Bank), five Hold and two Sell ratings. The consensus target is $16.15, suggesting 1.1% downside to the last share price. This compares with $15.11 ahead of the results. Targets range from $11.03 (Morgan Stanley) to $19.20 (Deutsche Bank).
 

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