-Positive aspects for 1H14 disappear
-Global reach may come to the rescue
-But are all risks factored in?
 

By Eva Brocklehurst

WorleyParsons ((WOR)), a global procurement and construction manager to the resources sector, is testing the market's resolve. At the company's Annual General Meeting, management announced that, while earnings growth would fall short in the first half of FY14 against the prior corresponding first half, guidance for increased earnings over the year was staying put.

The company has raised questions about just how it will manage to achieve earnings growth in FY14 yet deliver lower first half growth. Does the company plan to pull a rabbit out of the hat? Or is it quietly confident that the contracts in hand will stack the required numbers in the second half? Either way, Morgan Stanley has a list of questions to ask at the upcoming investor briefing. The broker was surprised by the AGM announcement that the first half earnings will be weaker, driven by the "flow pattern of awards", as growth had been anticipated based on foreign exchange support and the incremental impact of acquisitions.

Presumably, a stronger flow of contracts will deliver the increased earnings in the second half. What concerns Morgan Stanley is that it could be a repeat of FY13 where timing issues led to downgrades in the first half and a miss in the full year. The broker also wants to know if market share is being affected. Many of the company's international peers are reporting solid growth so why is WorleyParsons not following this pattern? The broker also wants to know what's in the pipeline in terms of acquisitions, given the balance sheet is robust and the company has flagged acquisitions as a strategic imperative.

Credit Suisse was also querying why the investment community should have faith in a better second half, considering the company failed to deliver on the promise in FY13. The broker does acknowledge that increased share of revenue from North America accentuates seasonality, and the momentum in contract wins remains impressive. Credit Suisse does not believe the AGM update alters the compelling medium-term growth story, underpinned by a solid outlook for the company's hydrocarbons base. The lives of these assets are shortening and technically more challenging and this gives WorleyParsons an edge. In addition, industry capex compound annual growth of 15% over the past decade, and over 10% over the past 40 years, shows no signs of abating so, for Credit Suisse, the key is how quickly WorleyParsons' global reach can chase the movement in capital expenditure.

Like Morgan Stanley, Deutsche Bank was also surprised by guidance that first half profit will be lower, expecting the company should benefit from FX tailwinds and lower corporate costs. Despite this, the broker does not think it will miss FY14 guidance because management took restructuring and costs above the line in FY13. Deutsche Bank calculates that WorleyParsons could achieve second half net profit of only $176m (implying a 12% organic decline) and still achieve 1% growth in reported net profit for the year.

Management had not previously remarked on the impact of a weak flow of contract awards from early in FY13 impacting on the first half half of FY14 and this should have been known, in JP Morgan's opinion, back at the FY13 results presentation. Hence, the broker believes the guidance implies further weakness in the underlying market. This is consistent with peer commentary in key market such a Western Australia and western Canada.

The broker had previously expected modest first half earnings growth, as the decline in the Australian dollar, the first full period of contributions from acquisitions and the benefits from cost cutting offset the gain accrued on the sale of power contracts into the joint venture with Transfield Services ((TSE)). The broker thinks the stock is well positioned over the longer term to benefit from work in the hydrocarbons market, but near-term headwinds could play havoc and these risks are not being fully factored in. JP Morgan has the lone Underweight rating on the FNArena database,rating stocks in the sector on a relative basis.

WorleyParsons may be relying on the second half to make up ground but comparatives should get easier through the year, according to Macquarie, given the extent of the recent restructuring. On revised numbers ($147m in H1 and $348m FY), the broker forecasts a 42:58 split, admittedly more accentuated than 44% and 48% for the first half over the last two years. Macquarie observes that sharp pull-backs in WorleyParsons' share price tend to provide buying opportunities but this needs to be complemented by a delivery on earnings expectations. On a positive note, the contract momentum is considered to be the best it's been for two years and the stock is trading in line with global peers on FY14 earnings estimates as well as a 7% premium to the market.

Amid the speculation on earnings splits, UBS has decided to stay put and retain a Neutral rating. UBS had expected the first half would be weaker, down 6% because of the challenging Australian conditions, but believes the large geographical footprint and diverse sectors in which the company operates mean it can deliver on FY14 guidance. Hydrocarbons capex remains the key growth area and UBS assumes 8% year-on-year earnings growth from that segment in FY14. Nevertheless, as a whole the company will be affected by the slower outlook for other end markets in mining, power and infrastructure so the descriptive word remains "subdued".

On the FNArena database the ratings encompass two Buy, four Hold and one Sell. The consensus target price is $22.57, suggesting 2.7% upside to the last share price. The consensus target fell from $23.25 ahead of the AGM and ranges from $19.16 (JP Morgan) to $26.10 (Credit Suisse). The dividend yield on FY14 forecast earnings is 4.4% and on FY15 it is 4.8%.
 

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-Debt deal onerous
-Interest rate high
-Difficult time ahead
 

By Eva Brocklehurst?

Brokers were keen to get a handle on details of Boart Longyear's ((BLY)) new debt deal, as the drilling services company faced a multitude of concerns about covenant breaches and defaults. There was relief as the debt offering was finally put to bed but little comfort to be found in the outlook.

There's no changes to ratings. The FNArena database has four Hold and four Sell ratings with a consensus target price of 49c, suggesting 6.5% upside to the last share price.

The company priced US$300m of debt at an interest rate of 10%, at the top of, or slightly above, broker forecasts. Proceeds will pay down the US$450m bank facility. This then reduces to US$140m and has less onerous covenants attached. It removes the risk of a rights issue but the net debt is still elevated and the interest cover is tight. For Citi, this means an equity raising cannot be ruled out further afield. Macquarie notes additional security was required to get the debt offering underway. Suspicions that investors pushed back on the earlier proposal of a US$40m unsecured portion appear well founded. The amended debt offer is such that the full US$300m is secured by a first-priority lien on most of the assets, and a second-priority lien lies over accounts receivable, inventories, cash and related proceeds.

Citi forecasts net debt of US$541m in FY13 and US$490m in FY14 and also notes demand is still deteriorating as rig utilisation fell in August and is now around 50%, in line with the lows of the GFC. Moreover, utilisation has further to fall with BHP Billiton ((BHP)) and Rio Tinto ((RIO)) pointing to lower exploration spending in FY14. Citi expects volumes will be down 30% this year and 7% next year with pricing of services down 15% this year and 5% next year. Not a good look for revenue estimates.

Macquarie sees a balance sheet that remains stretched. The debt deal will remove the leverage covenant test so a breach has been averted but net debt and gearing are expected to remain severely high for at least another 12-18 months. Macquarie forecasts US$515m in net debt and a 4.4 times net debt to earnings at 31 December 2013, falling to US$427m and 4.0 times net debt to earnings by the end of FY14. This compares to domestic mining services peers which average net debt to earnings of 0.6 times.

The company will also sustain a substantial increase in net interest expense over the next few years at a time when earnings are likely to be subdued. Taking into account this increase in net interest, Macquarie calculates first half FY14 interest cover of 1.61 times against the new minimum of 1.55 times - not much head room. This debt refinancing leaves few alternatives to an equity raising if revised banking covenants were to be breached in the future, according to Credit Suisse. The reduction in head room leaves the company with US$140m of available liquidity under the amended facility. For sensitivity, the broker estimates a 32% FY14 EBITDA downgrade in the vicinity of US$40m to US$85m would trigger an interest covenant breach.

In fact, brokers agree that the debt problem will not go away until demand for drilling services recovers. From Credit Suisse's feedback that's not happening any time soon. Conditions have, if anything, deteriorated over the past three months and utilisation rates are expected to decline heading into the northern hemisphere winter. Financial stress and such conditions makes Credit Suisse nervous about the outlook.

UBS finds the new terms restrictive. It may provide a short-term solution to the balance sheet problems but the lenders have first priority over the assets and restrict the company's ability to incur further debt or spend. Moreover, the timing of the cyclical rebound in mining is difficult to predict. Credit Suisse is also concerned that capex is likely to be kept at an absolute minimum. Challenging is the key word brokers are using for the next year or so.

See also, Boart Longyear Not Out Of The Woods on September 16 2013
 

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-Brokers see equity issue still possible
-Concern as lenders gain upper hand
-How burdensome is the cost of debt?
 

By Eva Brocklehurst

Drilling services and product supplier, Boart Longyear ((BLY)) has restructured its debt. This reduces the near-term risk of a breach of covenants, but brokers contend the company is not out of the woods yet.

Boart Longyear will restructure by issuing US$300 million in US senior notes. Of these, US$260m are secured and US$40m unsecured. The notes will mature in 2018. Proceeds will pay down the $450m bank facility, which will reduce to US$150m with less onerous covenants. The new funding leaves the company with US$600m in senior notes and the US$150m revolving credit facility.

The lenders under the amended revolving credit facility will have first priority security interest in accounts receivable, inventories, cash and related assets. These lenders will have second priority interest in all other tangible and intangible assets. Additionally, under the amended revolving facility, the lenders will be able to restrict additional debt raising, spending, acquisitions and payment of dividends.

Citi's contention is that, with the company facing a multi-year downward cycle, net debt will remain elevated. This means an equity raising, or rights issue, cannot be ruled out further down the track. In the absence of asset sales, i.e. the products business, and an equity raising, net debt is likely to remain elevated until demand recovers. This is some time away, given the weak operating cashflow outlook and the drag on inventory because of declining exploration volumes. The broker forecasts net debt of $541m in 2013 and $490m in 2014 against $564m for the first half of 2013.

The company may be able to manage debt better with the revised covenants around liquidity (minimum $30m) and asset coverage but, in Credit Suisse's view, this will come at the price of increased control by lenders. The broker worries key lenders will have increased control over daily operations. The lenders are expected to keep the company on a very tight budget. Capex is expected to be reduced to a minimum until there is evidence of a cyclical recovery in exploration spending and that's not expected in the near term. The broker is also of the opinion that the reduction in the debt ceiling of $300m also leaves the company with few alternatives to an equity raising, if revised banking covenants were to be breached in the future.

What's the cost? That's Macquarie's question. At a minimum the broker estimates 9.0% on the new US notes. Citi has estimated 9.5%. This compares to the existing US unsecured notes at 7% and the current revolver at 250 basis points over LIBOR. Of note too, amendments to the revolver, which is in place until July 2016, are accompanied by restrictions on the company's ability to spend on capex and pay dividends. For Macquarie, net debt looks uncomfortably high for at least another 12-18 months. Timed with the debt restructure was news of competitors Major Drilling and Layne Christensen results. They're not pretty either. Revenues fell 54% and 41% respectively. This compares with Boart Longyear's 35% fall in revenue in the first half and Macquarie's forecasts for revenue to fall 37% over 2013.

All up, brokers think there's more deterioration in the outlook on the cards. Rig utilisation continued to fall in August and Citi notes it is currently in line with GFC lows. Moreover, there is further to go. BHP Billiton ((BHP)) and Rio Tinto ((RIO)) have pointed to lower exploration spending in FY14. Citi models Boart Longyear's drilling services volumes as down 30% in 2013 and 7% in 2014, with pricing falling 15% in 2013 and 5% in 2014. Deutsche Bank thinks the company's valuation is attractive on a longer-term view but remains very cautious, given the uncertainty around activity levels. 

The FNArena database reveals four Hold ratings and four Sell. Citi was a little more positive as a result of the debt deal, raising the recommendation to Neutral from Sell. The consensus price target is 50c, suggesting 2.1% upside to the last share price and inching up from 48c ahead of the debt raising. The range of price targets is from 36c (CIMB) to 72c (Deutsche Bank).

See also, Going Gets Tougher For Boart Longyear on August 27 2013
 

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-FY14 forecasts looking more realistic
-Small industrials outperform in August
-Strong revenue growth underscores Buy-rated stocks
-Margin risk underscores Sell-rated stocks
 

By Eva Brocklehurst

Are FY14 expectations looking more realistic for the small industrial and emerging company sector? Citi thinks so. So does Morgan Stanley, with some caveats, as FY13 results were marginally positive compared to expectations. Morgan Stanley thinks revenue growth will still be a challenge and there remains a bias towards bigger stocks.

There have been some downgrades after the FY13 reporting season but Citi thinks the worst has now passed. Profit growth for the small industrials sector was 4.6% in FY13, well below the 10% expected at the start of the year. There are signs the global economy is synchronising gears and there is the further stimulus from lower interest rates on the local front. Citi is forecasting bottom-up sales growth for the sector of 9.5% for FY14 while earnings per share growth forecasts are stronger, at 14.9%. Morgan Stanley finds the small industrials outperformed large industrial peers in August, as evidenced by Navitas ((NVT)), Domino's Pizza ((DMP)) and Cardno ((CDD)).

Citi's preferred stocks based on this outlook include G8 Education ((GEM)), which is delivering strong revenue growth and has significant balance sheet capacity to drive earnings opportunities. Another education stock which has strong earnings leverage is Navitas. Morgan Stanley has an Overweight recommendation. A return of foreign student volumes to Australia should, given recent price trends, procure margin expansion and growth in return on capital invested. SAI Global ((SAI)) is another for whom Citi thinks the worst has passed. The stock hit guidance for the first time in 18 months and there is plenty of room for Compliance division margins to improve. Morgan Stanley has also reiterated an Overweight call for this company, considering the earnings as defensive with long-term structural drivers. 

Mining service names outperformed in August and for Morgan Stanley the question is now: how high can they bounce? Some expectations may be pared back through the AGM season in October and November. In this segment the broker prefers Mineral Resources ((MIN)), Tox Free Solutions ((TOX)), Mermaid Marine ((MRM)) and Ausdrill ((ASL)). Morgan Stanley thinks Ausdrill is one of the most undervalued stocks in the Australian emerging company sector. The FY14 price/earnings ratio is still just 5.9%, despite the 87% rise in the stock price from the July low. Revenue, rather than margin, remains the key risk.

Cardno is another emerging company which the broker thinks will show continued growth, forecasting 10% profit growth in FY14. Mermaid Marine continues its strong record and, significantly, has announced a $100m vessel contract, which underpins earnings and moves the stock up the contractor supply chain. Contrary to most resource-linked names, Morgan Stanley expects Mineral Resources to grow FY14 earnings by 30%. Price realisation remains a risk but the volume drivers for this growth are considered largely in place.

Citi also likes Forge Group ((FGE)), which has had a big win with a Roy Hill contract and has growth potential with its power business roll-out in Asia and Africa as well a the US asset management business. On Morgan Stanley's list of those favoured by a significant contract win is Tox Free, where a $170m contract with Chevron provides a significant increment to the company's sustainable earnings base.

Others rated Buy by Citi include Amcom Telecommunications (AMM)), with ongoing growth, and NextDC ((NXT)), with strong sales from existing businesses and pre-sales for the Sydney data centre. Morgan Stanley also has greater conviction on software service company, CSG's ((CSV)) turnaround, with sustained annuity earnings growth seen over a 4-5 year horizon, supported by a 9c pay-out. An Overweight call on UXC ((UXC)) is also retained, as the company continues to take share in a tough market. The acquisition of Domino's Japan has underscored Domino's Pizza's compelling growth profile, according to Morgan Stanley, tarnished only by cost issues in Europe.

On the Sell-rated side in the sector for Citi is Wotif.com ((WTF)), where heightened competition remains a risk to margins. Morgan Stanley is also worried about Wotif.com, seeing structural challenges from increased competition and the response to that competition underlining an Underweight call. Jetset Travelworld ((JET)) has negative momentum across all its divisions and Morgan Stanley thinks the company is at risk of losing share in FY14 and FY15. Citi has a Sell on GUD Holdings ((GUD)), where margins are compressing and the medium-term outlook for industrial products is modest. Emeco ((EHL)) is another where Morgan Stanley expects losses for at least the next 12 months.

Fantastic ((FAN)) has guided to a weak second half and the focus is on strategies to capture opportunity in both top-line growth and ultimate margin expansion. Morgan Stanley notes trading conditions are still tough and retains an Underweight recommendation. A second year of double digit earnings decline is also considered likely for SMS Management & Technology ((SMX)). Despite cutting forecasts aggressively Morgan Stanley finds the downside risk still lingers and there is a risk to the stock's premium rating in the near term.
 

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-Big contract raises confidence
-Revenue forecasts well covered
-Cash position improved
 

By Eva Brocklehurst

Construction, electrical and engineering contractor, Forge Group ((FGE)), has won a critical contract which puts the company on a very strong footing. Forge has been craftily diluting its exposure to the Western Australian mining services sector over the past 18 months but still, this contract is a big one and elevates the company's order book to $2.1 billion. Of this, brokers estimate $1.1bn is in hand for FY14.

The latest contract is worth $1.47 billion and is to be performed in joint venture with Spanish contractor, Duro Felguera. The contract is with Samsung C&T and the ultimate client is the Roy Hill iron ore joint venture. Forge's share of the spoils is $830m, easily its largest job. Macquarie expects $300m of revenue will fall in FY14. The full works under the contract terms will not be ramped up until Roy Hill has confirmed debt financing. Nevertheless, the fact the contract was publicised, along with announcements from other contractors in relation to the project, suggests to CIMB this major project is on the starting block.

Diversity has been the blessing for Forge. Macquarie suspects the fact the company covers power, oil and gas, iron ore, coal and metals sectors and has a global footprint, particularly in the US, means revenue can be maintained in the current resources downturn. For FY14, the broker is forecasting revenues of $1.2bn, including Taggart. The order book excludes the $221m Coalspur contract, where Forge is the preferred contractor. Including this contract, Macquarie estimates Forge would have 100% of FY14 revenue forecasts in hand.

This is an enviable position in CIMB's view and shows Forge is ready to play with the big guys. The broker is not yet prepared to crunch the forecasts higher but is increasingly confident. More than 90% of projected revenue is covered in both FY14 and FY15 and CIMB can't think of another contractor with this much revenue certainty. Margins are a dark area in this contract, given the heightened competition in the tender process, but the broker notes Forge had early involvement in this project via the joint venture with Clough ((CLO)) and should know the dynamics. Provided the market remains comfortable about the margin on the contract and Forge's ability to execute, the broker sees little obstacle to a re-rating.

The stock continues to trade at more than a 30% discount to the contracting peer group but CIMB notes the peer group has a relatively lighter order book average. CIMB applies a 20% discount to comparative peer multiples, given the stock's size and liquidity. Any material win, such as in Thailand where the company has entered the power sector but is yet to announce any contract award, would be materially incremental to the broker's earnings forecasts. Moreover, assuming the Taggart business is able to roll over it coal maintenance contract book and create further contract wins for the company in North America, it can only add to revenue coverage.

Citi also thinks the price/earnings re-rating is likely. Despite the recent rebound, the stock is still cheap. Citi removes the discount to peers that was previously applied. Forge has historically traded at a discount to contracting peers. Initially because it was a small starter in a boom market - it's only been around six years - and then because the market was waiting for Forge to trip up, given such rapid growth. With the Roy Hill contract and recent wins with top miners such as Rio Tinto ((RIO)), BHP Billiton ((BHP)) and Fortescue Metals ((FMG)), plus an increased proportion of asset management earnings from the Taggart acquisition, Forge is now deserving of a multiple in line with peers, in Citi's opinion.

Moreover, the improved cash position might lead to... dividends and/or more acquisitions? At 30 June Forge reported cash on hand of $104m, enough capital to mobilise and provide bonding for the Roy Hill contract. Whilst this cash number was lower than forecasts because of weak second half cash flow, the majority of the increase in working capital was a function of increased inventories which Citi thinks will be run down in FY14, releasing additional cash onto the balance sheet. Macquarie also notes a large build up of work in progress which should reverse in the first half of FY14. With a net cash position and 25% pay-out ratio, Macquarie sees more dividends on the horizon, and acquisitions.

Citi's on a Buy rating. So are the other two rating the stock on the FNArena database. Price targets range from $6.25 to $6.74. The consensus target is $6.53, signalling 14.2% upside to the last share price. This compares with a consensus target of $6.15 ahead of the contract news.

Citi sees Forge having growth levers that many others don't. These include the power business roll-out in Asia and Africa, the US asset management business and suite of complementary contracting services.Whilst Forge has had a strong price run over the past two days, the stock was considered oversold on its FY13 result last week, so much of the increase is simply seen as a rebound from an over-reaction.
 

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-Danger of covenant breach
-Risk of equity dilution
-Recovery some way off
 

By Eva Brocklehurst

Just when you thought an outlook couldn't get more disappointing, one did. Drilling services and product supplier Boart Longyear's ((BLY)) interim results disappointed brokers again on a number of fronts including margins, cash flow and guidance. A breach of debt covenants looks likely unless some quick fixes are put in place.

There was minimal net debt reduction from the May peak. That disappointed Macquarie. Three months ago the broker had been inclined to see the build-up in debt as seasonal and did not think a breach of finance covenants was on the cards. Now, these fears could being realised. 2013 earnings are expected to be at the low end of a US$116-159m range. The bottom end of this range is nearing the nadir experienced during the GFC, when earnings fell to US$111m.

The numbers tell the story. Without any debt restructure or refinancing in the coming months, the company will be in breach of its leverage covenant as at 31 December 2013. Macquarie suspects metrics are likely to worsen in 2014, given a further deterioration in earnings is implied by the weak second half run rate. Management is confident of a successful debt restructure, with a combination of refinancing the existing US$450m revolver with high-yield US debt and asset-backed loans, coupled with increased covenant flexibility. While this should remove the risk of a covenant breach, there are no guarantees it will be achieved. Net debt looks like staying uncomfortably high for another 12-18 months. On the positive side, if successful, a debt restructure in coming months would likely see the stock rebound. Macquarie has given the company the benefit of the doubt, to the extent the recommendation is downgraded to Neutral from Outperform.

There's no recovery on Credit Suisse's horizon. Hence a downgrade to Underperform from Neutral. The broker understands interest costs could be around 9.5% on the refinanced debt and agrees this is the best course of action to re-capitalise, rather than a highly dilutive equity raising. US high yield refinancing is now included in Credit Suisse's forecasts. It's just that a cyclical recovery is the key to a rebound in the stock's price and there's no evidence, yet, that a bottom in the mining industry cycle has been reached.

It's a simple description for CIMB: Deja vu. The broker notes Boart Longyear's precarious financial position looks similar to that of 2009 and it was not meant to happen again. CIMB believes shareholders face equity dilution as the capital position is repaired for a second time. There may be no escaping the cyclical nature of the company's operations, but, CIMB asserts, this is why low debt levels should be used. Net debt of US$563.8m as at 30 June 2013, coupled with weakening operating conditions, leaves the company with limited options to manage its capital position. If an equity raising can be avoided interest rates will increase significantly. As a result, debt holders will be exchanging debt for equity on highly punitive terms.

Adding further pressure, CIMB believes the mining down cycle will run at least another couple of years, consistent with previous commodity cycles. This is in contrast to the GFC, which was credit related and recovered very quickly. CIMB also downgrades to Underperform from Neutral, with a view recovery is a long way off. UBS had suspected worse was to come when FNArena last looked at the stock in May. The broker expects a refinancing of existing banking facilities to a covenant-light structure in the short term, assuming a cost of finance of 10% from 2014. Should the company be unsuccessful, current covenants could become a significant risk for investors. Whilst conditions are depressed and there is significant earnings leverage, UBS thinks the timing of a cyclical rebound remains difficult to predict. The Sell recommendation stays in place.

The company is targeting US$90m in additional cost savings and, while a positive, brokers like Macquarie think management has been slow to act and there will not be a full benefit from this until 2014. Moreover, CIMB suspects, given the very high operating leverage, if prices fall by more than 5%, earnings downgrades will follow. Citi also stays negative and rates the stock as Sell/High Risk. The deterioration in demand due to the fall in commodity prices and a focus by mining companies on cutting operating costs and improving cash flow and margins is expected to materially affect utilisation and margins in the short-medium term.

Macquarie crunches some numbers on an equity raising. A US$200m equity raising at 34c a share, a 30% discount to the current price, would dilute 2014 earnings per share forecasts by 66%. Net debt under this scenario would fall to US$315m in 2013 and gross debt to US$362m. Gross leverage falls to 3.07 times in 2013 and 4.15 times in the first half of 2014, both below the recently revised gross leverage covenant of 4.75 times. Interest cover of 3.81 times and 4.47 times, respectively, remains above the 3.0 times minimum. Based on forecasts and under this scenario, Macquarie expects the company will generate a small after-tax loss in 2014 and return to profit in 2015. Under this hypothetical equity raising scenario, the stock would be trading on a price/earnings ratio of 42 times 2015, and 12 times 2016 estimates.

On the FNArena database there's no Buy rating. It's a sea of five Sell and three Hold. The consensus target price is 48c, suggesting 3.5% upside to the last share price. This compares with a target of 70.3c ahead of the results.
 

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-Worst may have passed
-Weaker AUD a strong aid
-Return to better growth seen
 

By Eva Brocklehurst

The latest results from SAI Global ((SAI)) were welcomed with relief by brokers. The information services and standards auditor has finally reached a point where, having ploughed along the bottom of expectations for some time, there's a large repository of hope now that the worst has passed.

Deutsche Bank, upgrading to Buy from Hold, notes the investment case is de-risked because the risk/reward balance has altered, given improving growth and margin outlook for information and assurance services while compliance division client issues have stabilised. There is also a more robust compliance platform being implemented. On valuation, the stock offers 20% upside potential to the broker's revised price target and it is trading on 14 times forecast FY14 earnings, a discount to the market which is trading at 15 times.

The stock has five Buy, two Hold and one Sell rating on the FNArena database. There was a swag of upgrades in the wake of the result. All four moved from the Hold to Buy categories, suggesting the balance of factors in favour of the stock has indeed shifted.The consensus target price of $4.34 suggests 1.0% upside to the last share price. The consensus target has moved up from $3.97 ahead of the result.

So, what did it for brokers? The results revealed revenue growth of 6%. Information services was the highlight, with 10% earnings growth, but assurance was still soft, down 3%, while compliance was up 1%. It's the outlook that really delivered. Drivers are seen as continued strong growth in subscription revenue for information services, new business wins in both information and property services, a full year contribution from ANZ and Commonwealth Bank contracts, a return to trend growth of 5-7% in assurance services and last, but not least, the favourable Australian currency movement.

Credit Suisse thinks the fall in the Australian dollar came at the right time. Operationally, the results were a bit weaker than the broker expected and might not have clinched an upgrade (Outperform from Neutral) if it were not for a sizeable second half reduction in corporate services costs. In addition, there are still issues and residual uncertainty around the compliance division and a lacklustre FY13 performance in assurance. Despite this, the broker is wary of staying negative for too long on a company that still has fundamentally attractive attributes. The likely benefit from a weaker Australian dollar in FY14 makes up for forecast risk in other areas and Credit Suisse envisages a return to reasonable earnings growth over the next few years.

Another broker to upgrade the stock, Citi, thinks the worst has passed. FY13 should represent the bottom of the downgrade cycle. There was no downgrade to guidance for the first time in 18 months and, whilst compliance will continue to weigh on margins in FY14, the business looks to be stabilising and margins should start to improve. With 40% of group earnings not in Australian dollars the stock is seen as a major beneficiary of the weaker currency.

CIMB also thinks the stock has reached an inflection point. After a sustained period of operating underperformance, this broker has also decided it's spent enough time at the bottom. Earnings risks are now seen moving to the upside.

Why did UBS decide to stick with the Neutral rating? While the second half of the year revealed positive momentum within the information services division, more specifically the property business, and arguably a stabilisation within compliance and assurance, the broker thinks this is more than reflected in the stock's current valuation.
 

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-Company needs to improve confidence
-Depressed DAP prices hinder outlook
-Questions over plant capacities
 

By Eva Brocklehurst

Incitec Pivot ((IPL)) has tested brokers' resolve with more production problems at Phosphate Hill. While ratcheting down earnings forecasts for FY13, they are mostly prepared to forgive, again.

This is the third outage in as many years at the Phosphate Hill plant and has been attributed this time to the failure of the iso-thermal shift reactor, which scrubs carbon out of the gas feed. The plant will not be back on line for a week and will operate at 50% capacity for the following two weeks. The prior outages pertained to the sulphuric acid plant. The company also experienced production interruptions recently with the newly commissioned ammonia plant at Moranbah and has had to address the damage. Production and earnings guidance for Moranbah was subsequently reduced to 200,000 tonnes and $56m for FY13 from 250,000 tonnes and $90m respectively.

The latest Phosphate Hill production problems are expected to reduce the second half's manufactured diammonium phosphate (DAP) by 110,000 tonnes and deliver a $23.5m reduction to the FY13 profit. CIMB believes this impact from the incident is modest and should not be capitalised, but the track record is a concern. This may be a one-off but it raises questions for brokers about the capacity to execute on expectations.

Credit Suisse maintains the short term priorities must be about improving manufacturing capabilities, along with issue at Moranbah which have delayed the ramp up. If the company is successful it should improve earnings predictability and the market's confidence in the company's capacity to execute. CIMB also questions the real capacity of Phosphate Hill, but acknowledges the company is reviewing the manufacturing processes.

Ratings might then improve. As it stands, on the FNArena database there are two Buy ratings and six Hold. This compares with competitor Orica ((ORI)), which has four of each. The consensus target price on the database is $3.16, suggesting 17.2% upside to the last share price. The target has slipped from $3.28 before the announcement. The dividend yield is 4.4% for FY13 consensus forecasts and 4.8% for FY14.

The $23.5 million impact to the bottom line is based on a DAP price of US$470/t and AUD/USD rate of US92c. For Credit Suisse, this implies that fully absorbed costs at Phosphate Hill have increased by 13%. This should normalise when the plant ramps up but, given the frequency of outages, the broker wonders whether nameplate capacity and longer-term assumptions shouldn't be revisited. Operational issues are weighing on the share price near term but the broker has identified many catalysts that can drive the stock towards the $3.25 valuation. This could be via improving utilisation at Phosphate Hill and Moranbah, favourable fertiliser prices, the falling Australian dollar and rising US gas prices - to name a few.

Deutsche Bank has reduced FY13 and FY14 earnings forecasts by 3-10% to take account of the outage as well as slightly lower global fertiliser price assumptions. Global fertiliser prices are in decline, with DAP at US$458/t and urea at US$323/t currently. The DAP price has been affected by soft demand from India and increasing supply from China and Saudi Arabia. Urea's price has been affected by weak demand and increasing supply from China and the Middle East. Macquarie thinks fertiliser prices may have found a bottom but they remain weak and are expected to continue being a drag on earnings. CIMB has reduced FY14 DAP price forecasts to US$475/t, taking into account the 5% decline in the benchmark Tampa price that has been seen for the year to date.

Production reliability is an ongoing issue for the last 12-18 months and Macquarie has reduced FY13 and FY14 earnings forecasts by 9% and 3% respectively. This relates to lower earnings for Dyno Asia Pacific as well, in the light of tougher gold and nickel markets and a more challenged margin environment. Macquarie is encouraged by some progress being seen at Moranbah but feels this has to be seen to be maintained to improve confidence. 

UBS also thinks a successful ramp up at Moranbah is critical to an overall re-rating of the stock and has incorporated more conservative production and cost related assumptions for the DAP business. The broker finds the stock's valuation attractive, but catalysts such as a recovery in fertiliser prices and the explosives markets are not expected until late next year. CIMB maintains a Neutral stance but is concerned about the impact of the upcoming gas supply contract rollover on profitability, coupled with the subdued DAP price outlook. Incitec Pivot and Orica are trading at relatively similar FY14 multiples but at this stage the broker prefers Orica. 
 

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-Minova remains a drag
-Structural issues emerging?
-Longer term view maintained
 

By Eva Brocklehurst

Most brokers aren't too happy with Orica ((ORI)). At least in the intermediate time frame. The mining chemicals and explosives business has issued a profit warning and expects net profit to be 10% lower in FY13. Driving the downgrade were higher integration costs for Minova, particularly weak European and North American markets, lower earnings from Indonesia and soft ammonium nitrate (AN) and sodium cyanide volumes.

Macquarie now expects a 3% lift in second half earnings, against previously expecting a 15% improvement. When FNArena last reviewed the stock in May it was off the back of a solid first half, which had been better than many brokers feared. What soured?

Mining services business Minova is the main problem. The rest of Orica's business has been unable to offset a further earnings decline on that front. Macquarie forecasts a 7% fall in the North American mining services earnings in FY13 and a 67% decline in European earnings. CIMB expects a further review of the book value of Minova will be forthcoming but anticipates optimisation costs should reverse from FY14. The magnitude of the earnings downgrade will make investors cautious but CIMB thinks many of the issues should be addressed in FY14, while the core business remains defensive. The broker is one of the more upbeat, believing the growth trajectory should resume in FY14 in the absence of Minova optimisation costs and non-recurrence of mine-site issues in Indonesia.

For CIMB the glass is still half full. OK, earnings forecasts have been downgraded in line with the guidance but eastern Australian explosives volumes are holding up well in the face of lower coal prices. Macquarie also cites positive Australian volumes and relatively stable margins and AN pricing. Nevertheless, whereas CIMB tends to see this business as resilient in the face of the weaker coal outlook, Macquarie suspects it will be downhill from here, with volumes flattening and margins increasingly challenged. There is risk of further deterioration in the Australian explosives/cyanide business should volumes ease and coal/gold production be cut amid weak commodity prices.

The main area of concern for JP Morgan is the implied fall in explosives profit per tonne in the second half of 2013. It means a slippage of earnings and even greater downside for FY14 forecasts, as a full year at a lower earnings base flows through to earnings. Volumes may be holding up but this is being more than offset by a deterioration in profit per tonne which management was unable to explain. JP Morgan was also surprised by the company's comment that volumes for explosives in Australia were weaker than had been expected in the second half. Both BHP Billiton ((BHP)) and Rio Tinto ((RIO)) has reported strong production numbers in the June quarter. Maybe, according to the broker, it should be acknowledged that the ramp up of Incitec Pivot's ((IPL)) Moranbah is resulting in a reduction in Orica's share of the market in Queensland.

Macquarie suggests the return to normal production at Kooragang Island is the most positive aspect for FY13, as it generates a full manufacturing margin. Bontang's ramp up in Indonesia is also expected to deliver a positive impact, albeit lower than expected previously.

Potential structural issues are emerging, nonetheless. Credit Suisse considers Orica's 60% share of the Indonesian market is under pressure. The Indonesia coal market has deteriorated and imports have increased. Orica is looking to increase its 60,000 tonne AN export licence out of Indonesia. This situation warrants close attention as it appears Orica is losing share of a shrinking Indonesian AN market. Bontang is now competing with cheap imports from China and Russia. The difference between 6% and 4% cumulative growth in the Indonesian coal market, augmented by increasing strip ratios, is the difference between oversupply and under supply of AN in the next five years, in Credit Suisse's opinion.

Credit Suisse also makes the observation that Australia's west coast and east coast markets should not be considered independently. The broker believes, while most conjecture surrounds the iron ore growth forecasts in the Pilbara, there is an equal or greater risk to AN demand from the east coast coal market. These concerns underpin the broker's resultant downgrade of the stock to Neutral from Outperform.

Despite lowering the recommendation to Neutral from Outperform Macquarie thinks the stock is cheap, but likely to stay that way until there is evidence Minova is no longer a drag. The stock is trading at a discount to JP Morgan's valuation and the broker does not expect the gap will close in the short term, given concerns around the sustainable level of earnings in the business, emerging market growth and the outlook for mining production volumes. Longer term is a different story and JP Morgan is prepared to be patient, retaining an Overweight rating.

Along with Credit Suisse, Macquarie and UBS also downgraded the stock's rating on the back of the latest guidance. Others chose to retain their ratings. Hence, on the FNArena database the Buy ratings are reduced to four from seven previously. Hold ratings now total four. No broker on the database has registered the stock as a Sell. The consensus target is $21.97, suggesting 23.7% upside to the last share price. In the wake of the profit warning the consensus target price fell from $26.55. Target prices now range from $19.00 to $28.50. The dividend yield on consensus FY13 and FY14 forecasts is 5.0% and 5.2% respectively. 

See also, Orica Clears The Way For Better Growth on May 7 2013

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