-Major complementary expansion
-Opportunities in fragmented market
-Higher up the value chain
-But more capital intensive
 

By Eva Brocklehurst

Orora ((ORA)) has ramped up its acquisition strategy, acquiring US specialist packaging business IntegraColor. Up until now the company had completed just three small acquisitions and this represents its first major branching out since the de-merger from Amcor ((AMC)).

IntegraColor operates a vertically integrated business, which designs and manufactures point-of-sale retail displays across North America. The business operates in an adjacent market to Orora's existing North American packaging and distribution business.

The acquisition is likely to be the start of a ramp-up in the company's expansion plans, with substantial balance sheet capacity in evidence, Morgan Stanley asserts. The company is now employing its growth capital in several ways. Glass production has been increased recently in Australia and now the acquisition of IntegraColor demonstrates an ability to draw on an under-geared balance sheet to accelerate growth.

Even after incorporating $85m in acquisitions and a buy-back of $125m across FY17-18 in forecasts, the broker believes net debt to earnings is comfortably below management's target. Morgan Stanley suspects its FY15-18 compound growth forecast of 15.7% could prove conservative.

Moreover, the North American packaging segment is highly fragmented, with the broker noting around 80% of the market is small private business, typically beneath the radar of private equity. Hence, Orora is expected to find plenty of opportunities at attractive multiples which are also accretive. Morgan Stanley estimates management has potential to invest an additional $115m in mergers & acquisitions above a FY17-18 base case of $85m.

IntegraColor is based in Dallas, Texas, and most brokers consider the purchase price of US$77m is reasonable. Macquarie agrees the acquisition highlights the growth levers available and the company’s North American exposure has also increased and is expected to reach 39% of earnings in FY18, up from 28% in FY15.

Furthermore, Macquarie observes a shift up the value chain in the business margin relative to the legacy Orora business. IntegraColor's pre-synergy margin of 11% compares with the group's North American earnings margin of 5.5-6.0%, and Orora's overall margin of 9.7%.

Ord Minnett estimates the acquisition will be 3-4% accretive in FY17-18, with an implied uplift to valuation of around 7.0c a share. Importantly, the transaction is seen providing support for earnings growth at Orora beyond the benefits of the new B9 Botany mill.

Combining all the recent developments such as the glass investment, B9 benefits and organic growth, Ord Minnett estimates group earnings should increase by a compound 10% over FY16-19. The broker adds that while Integra is considered an adjacent, albeit complementary, business, its operations do share similarities to the fibre-based specialty packaging business in Australia.

There may be some similar features but IntegraColor is still a new segment in Orora's supply chain, Credit Suisse contends. The broker notes, to the company's credit, it has downplayed cross selling opportunities and, while industry sales appear stable, they are influenced by the level of retail promotional activity in the US economy.

Credit Suisse also highlights the highly fragmented nature of the industry, with the top four capturing just 20% of the market. Given the difficulty in finding significant packaging distribution acquisitions at the right price the broker believes Orora has opened up a new revenue stream. Unlike the broader print/publishing segment some organic growth in point-of-sale and display packaging is noted. Orora believes the market is growing at around 1-2% annually.

Credit Suisse does point to some cyclicality in the business, particularly in terms of promotional activity from retailers, but IntegraColor's diversification into horticulture suggests it will experience less exposure to promotional activity compared with its peers.

The IntegraColor business is also more capital intensive, UBS cautions, given its base of 40 different printing presses that service multiple substrate requirements. Its focus is on strongly customised, short-run work. UBS increases FY17-18 estimates by 4-8% to incorporate the acquisition and the glass capacity expansion. This is partially offset by higher interest costs. Still gearing is considered comfortable with scope for further growth opportunities.

The stock is not overly cheap but Morgans believes it deserves a premium multiple given its defensive characteristics and strong market position, particularly in Australasia. The broker considers the acquisition multiple is reasonable and there remains plenty of room to pursue further growth opportunities. IntegraColor enhances the company’s geographical diversity and will increase its exposure to the food and pharma/health sectors.

FNArena's database shows six Buy ratings and two Hold for Orora. The consensus target is $2.60, suggesting 8.0% upside to the last share price. Targets range from $2.25 (Deutsche Bank) to $2.80 (Citi, UBS).
 

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-Affirms acquisitions key to strategy
-Approved for large NSW acquisition
-Signals intent to bolster organic growth
 

By Eva Brocklehurst

The performance of packaging producer Pact Group ((PGH)) was lifted in the first half by the contributions from acquisitions, partly offset by subdued underlying conditions. In FY16 the company will benefit from almost a full year of contributions from the Sulo business as well as the post September 2015 contribution from Jalco. Jalco is expected to lower the overall group margin, notwithstanding the delivery of synergies.

The company's efficiency program is continuing to focus on the elimination of excess capacity to align with customer demand and this expected to deliver annualised savings of $15m in FY17.

The company has completed 44 acquisitions since listing and this remains a key part of its growth strategy. Management indicated its acquisition opportunities remain strong in both Australia and internationally.

Macquarie is particularly pleased this is still the case in core markets as greater synergies can be realised. The broker believes the company's diverse and defensive end markets underpin a substantial market position, with several levers at its disposal to deliver earnings growth.

UBS is concerned about the growth outlook when excluding the impact of recent transactions. Sales ex acquisitions are expected to be down 4-5% in FY16, which highlights the pressure from a loss of contracts and the weak outlook in some segments such as dairy. Jalco and Sulo are expected to underpin growth rates in FY16-18, which UBS expects to be around 4.0%.

Given the lower growth profile relative to its peers, UBS does not believe the stock warrants its current valuation metrics. A higher debt load, lower liquidity and greater execution risk are envisaged. Moreover, a single shareholder owns around 40% of issued capital and the broker believes this warrants a liquidity-related discount. Hence, UBS downgrades to Sell from Neutral.

Morgans also considers the stock fairly valued, while being attracted to the company's dominant market positions in Australasia as well as the high margins and the faster-growing rigid plastics market. Going forward the broker assumes earnings growth of 6.0% in FY17 and 5.0% in FY18, but acknowledges this depends on further acquisitions over the next few years.

The results were ahead of the market's expectations despite the challenging environment and Deutsche Bank concludes this has a positive bearing on the outlook. The company affirmed full year guidance for higher revenue and underlying earnings, subject to economic conditions. The broker reduces FY16 estimates by 2.0% but upgrades FY17 by 3.0% to reflect the net impact of higher earnings in Australia as well as operating efficiencies.

Packaging demand has been soft in agricultural and industrial markets globally, which is partly offset by stronger demand for materials handling. One development brokers also note is that the Australian Competition and Consumer Commission has stated it would not oppose the proposed acquisition of Power Plastics, a non-beverage rigid plastics business in NSW.

Credit Suisse had expected the company’s substantial market share in rigid plastics would preclude it from most domestic acquisitions. Power Plastics is the third largest rigid plastics business in NSW. The company may have reiterated its intention to continue acquiring businesses but the broker suspects there will be more emphasis placed on organic growth going forward.

The new CEO has signalled a change in corporate structure is being considered and the company openly discussed the erosion of organic growth. The broker found this development refreshing as it improves confidence in the company's ability to address the issue. Credit Suisse acknowledges organic top line growth has been a challenge and, if the company can combine growth with acquisitions and cost savings, it should underpin the share price.

The new CEO has indicated further cost savings which may be quantified over the next six months and the broker includes a second cost reduction program in its modelling, upgrading FY17-19 estimates by more than 2.0%. Looking into the second half, Credit Suisse also observes resin prices have fallen by a similar order of magnitude to the rise in the first half and an earnings benefit is expected.

FNArena's database shows two Buy ratings, two Hold and one Sell. The consensus target is $4.98, suggesting 2.8% upside to the last share price. Targets range from $4.30 (UBS) to $5.30 (Deutsche Bank). The dividend yield on FY16 estimates is 4.3% and on FY17 estimates 4.8%.
 

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-Strong expansion outlook for Asia
-More domestic acquisitions in play
-US patent filing into Oz at all-time high
 

By Eva Brocklehurst

Patent attorney IPH Ltd ((IPH)) maintains a strong growth profile in Asia with the volume of patent filings with the company in the first half from that region up 19%.

The company is the number one IP (intellectual property) firm in Singapore and well placed to leverage that country’s role as the IP hub of Asia, brokers contend. In Australia, where the market is mature but fragmented, IPH is in a strong position to consolidate its share. IPH did not provide quantitative earnings guidance but highlighted a robust medium-term outlook.

The company has a track record of strong cash flow, underpinned by low working capital requirements. Bell Potter expects the company’s net cash position will continue to rise and provide significant ammunition to undertake acquisitions.

Nevertheless, the broker now believes the stock price has lifted enough to reflect the benefits of strong growth and downgrades to Hold from Buy. Bell Potter, not one of the eight stockbrokers monitored daily on the FNArena database, retains a $8.80 target.

Australasia is also growing but the broker observes a more mixed performance. In new business, Callinans, now merged with Fisher Adams Kelly, suffered a major client loss upon being acquired. Local business lost market share, based on patent filings, falling to 20.5% from 22%. Despite the fall in market share the company still achieved a rebound in patent filings in Australia, recording 3.0% growth in the first half.

The results were strong but at the low end of the company's guidance from the AGM, Macquarie observes. Two unexpected factors were blamed for the impact on the results versus guidance, a negative FX impact of $250,000 on US denominated receivables and a timing impact regarding slow collections in December (recovered in January).

The broker believes the Asian performance heralds the greatest long-term growth opportunity. Regional expansion opportunities over the next six months include Thailand and Hong Kong/China. Russia is also flagged as a region of importance strategically.

Domestically, Macquarie understands two firms are under due diligence. The broker is attracted to the business model but, with the stock trading at a 100% premium to the small cap industrials, a Neutral recommendation is maintained. Target is $8.62.

With around 85% of revenue in currencies outside of the Australian dollar, the business remains highly leveraged to a falling currency. IPH does not hedge this currency risk and therefore benefits materially from a weak Australian dollar. The broker observes, as the US economy strengthens, larger corporates are expected to increase their rates of international patent filings. IPH handles around 30% of all US patents entering Australia.

The quality of the result was weak, because of the lower tax rate, Deutsche Bank contends, but the business is still well positioned to meet market expectations. There is also upside earnings risk associated with further accretive acquisitions.

Morgans asserts the underlying quality of the result has been missed by the market. The result may have been at the low end of guidance and disappointing in that regard but but organic growth is strong, both in Australia and Asia. There are also a number of catalysts in the wind. The company has earmarked $108m in further acquisitions to support longer-term earnings.

While the market share in Australia has edged lower, some movement can be attributed to the one-off impact of the loss of the Callinans client. This client, Morgans notes, already used IPH and, as is common practice, wanted to maintain a diversity of patent attorneys.

The broker notes 2015 patent filings in Australia were very strong, up 10.2%. Putting this in context, patent filings usual run just ahead of GDP growth. With this observation, Morgans notes some of the 2015 strength can be attributed to the fact that 2014 was weak, affected by “Raising The Bar” legislation which dragged forward patents into 2013.

Significantly, the broker notes US patent filings into Australia are at all-time highs and the "America Invents Act" is likely to be the main reason for this. Morgans applies a premium to its discounted cash flow (DCF) valuation of 15%, given the company's clear intention to make further acquisitions. Once these are announced and future earnings are factored into estimates the premium will be removed. The broker has an Add rating and $9.60 target.

The consensus target on FNArena's database is $9.39, suggesting 14.8% upside to the last share price. This compares with $9.89 ahead of the results. There are two Buy ratings and one Hold.
 

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-Buy-back signals confidence
-Absence of Mac U contract in H2
-Flat earnings outlook in FY16
 

By Eva Brocklehurst

Despite the looming loss of the Macquarie University contract, Navitas ((NVT)) provided a modestly upbeat first half result, sweetened by the announcement of a buy-back of shares.  The buy-back is a positive surprise for brokers. Generally because a return of capital to shareholders is preferred to a potentially dilutive acquisition.

Navitas will buy back up to 7.5% of share on issue, which Morgan Stanley estimates to be 1-2% earnings accretive. The broker believes this announcement indicates a degree of confidence in the earnings outlook.

The company has stated that full year earnings should be broadly in line with FY15. Brokers expected this would be the case as while underlying growth is firm, the second half will be weaker because the Macquarie University contract concluded in the first half.

University program earnings grew just 1.0% in the first half, Credit Suisse observes, on lower margins, as the largest and highest-margin college began to wind down ahead of its transfer to Macquarie University. The broker estimates a negative $20-25m annualised earrings impact and does not expect the university programs will return to growth until FY18.

The buy-back appears to reduce the risk of acquisitions, following recent commentary that Navitas could be interested in acquiring vocational training assets, although Credit Suisse notes management was non committal regarding the scale and timing of the buy-back. The stock appears fully priced to Credit Suisse and a Neutral rating is maintained.

The company experienced solid earnings growth across its Australian operations and North America is performing well. UK revenue grew despite a tough regulatory environment. Despite this, Credit Suisse suspects margins could come under pressure.

The SAE division delivered the best results, in Credit Suisse's view, almost doubling revenue growth in the half. The company expects this earnings growth will likely moderate in the second half. The broker also notes this is the more capital-intensive, lower-quality business than the university programs and attracts a lower multiple.

Cash conversion was strong at 74%, Macquarie maintains, although lower than the prior period (88%) because of negative working capital movements. The broker expects this should recover in FY17.

The performance of SAE was the highlight for Deutsche Bank and the broker believes the earnings margin, increasing to 14.3% from 8.5% in the prior corresponding half, should provide comfort that the company has successfully cycled the one-off costs incurred.

The broker remains cautious about the impact of the loss of the Macquarie Uni contract, suspecting there is some risk to guidance if the other programs are unable to achieve sufficient growth from lower margin contracts.

Navitas recently renewed its contract with the University of South Australia for a further 10 years under similar terms and conditions. A joint venture model was considered but not pursued.

This illustrates to Deutsche Bank the likelihood that universities are uncomfortable about committing to a JV model, given the required investment. Hence, whilst such a model would deliver greater earnings certainty for Navitas, it is unclear whether it will be widely adopted.

Management also signalled that enrolment growth rates in the UK are being affected by low visa refusal requirements with any immediate positive change to education policy considered unlikely, in Deutsche Bank’s view.

There are five Hold ratings for Navitas on FNArena's database. The consensus target is $4.53, which signals 3.3% downside to the last share price.
 

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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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-WorleyParsons heavily hit
-Positives in civil infrastructure
-M&A activity heats up
 

By Eva Brocklehurst

The down-draft for commodity prices that kicked off 2016 is not just problematic for miners, but has signalled further hard going for those providing services to the sector. These companies build the mine infrastructure, oil platforms and provide the machinery and expertise that extracts, transports and analyses material.

Goldman Sachs expects pressure on mining and oil & gas capital expenditure will remain depressed this year. This signals a persistent headwind for contractors as the risk of project delays and deferrals increases.

The broker expects a further 16% fall in 2016 capital expenditure globally, following the 23% decline in 2015. The “lower for longer” outlook for oil prices is also expected the be a major obstacle for those servicing the oil industry.

WorleyParsons ((WOR)) is one such engineer & contractor (E&C) business which is facing a tough year of project delays and possible cancellations. Goldman Sachs has lowered forecasts for WorleyParsons by 6% and 17% for FY16 and FY17 respectively. The broker retains a Sell rating, cutting its target by 36% to $4.00, while noting 75% of the company's sales are exposed to the hydrocarbons industry.

Deutsche Bank has downgraded the stock to Sell from Hold and cleaved the target price to $3.09 from $9.55. The broker forecasts earnings to halve in FY16. There are also risks to the dividend, Deutsche Bank maintains, with the board expected to reduce the pay-out ratio below the typical 60-70%.

The broker also envisages downside risk to Downer EDI's ((DOW)) FY16 guidance, on the back of mining division weakness. The company is a diversified contractor but there is the potential loss of mining contracts amid uncertainty over rail project outcomes.

Some support for Downer is envisaged from power distribution work being outsourced and work on the NBN roll out. Still, Ord Minnett, also bearish on the E&C outlook, notes the company stands out as on of the few that are yet to downgrade is outlook. FY16 guidance at the AGM signalled conditions were challenging and the broker suspects the outlook has since deteriorated.

Previously Ords assumed contract wins in rail would act as catalysts for the stock but these appear to have been delayed. Meanwhile, Downer EDI has exposure to contract mining, which is at risk of being lost. Downer has the equivalent of $95m in revenue per annum from Gindalbie Metals ((GBG)), with the possibility, the broker maintains, that company could go into administration

Moreover, Downer could lose the Christmas Creek contract which expires in September this year and currently delivers an estimated 9.0% of earnings. Ord Minnett downgrades its rating to Lighten from Accumulate.

Cimic ((CIM)) is sustaining a reduction in resources construction and contract mining and, while there is a strong balance sheet which could allow for capital management or acquisitions, there is the potential for a further writing off of work-in-progress. Deutsche Bank is cautious about the margins embedded in Cimic's portfolio.

UGL ((UGL)) has a relatively more positive outlook as it has secured a strong exposure to infrastructure opportunities outside mining, with a $5bn order book. Still, it is working on the Ichthys power plant and, while construction has been progressing, there are risks of over-runs in costs an it remains only 50% complete.

Monadelphous ((MND)) is another E&C contractor which is facing a challenging outlook as mining and oil & gas companies limit capex. While the company is taking steps to diversify Deutsche Bank does not believe the growth in new markets will offset the decline in resource construction and forecasts multi-year earnings declines.

Goldman Sachs has lowered FY16 and FY17 earnings forecasts for Monadelphous by 10% and 16% respectively, retaining a Neutral rating and cutting the target by 18% to $6.77. This latest downgrade reflects the broker's weaker iron ore and metallurgical coal price forecasts.

Ord Minnett expects most of the E&C stocks will underperform at the upcoming results with the market cap of small contracts down 29.4% already in FY16, and most of the fall caused by downgrades to earnings estimates.

The two significant positives for contractors are takeover activity, which is at its highest for a decade, and the fact that contract wins announced in 2015 were up 19% on 2014. Still, even that good news is countered by the likely margin pressure on those contracts.

Not all contractors are equally subdued, brokers acknowledge, as there are differing end-market exposures and balance sheet resilience varies. Ord Minnett believes the market has shorted the sector and this should pay off for diversified contractors Service Stream ((SSM)), Millennium ((MIL)) and Mineral Resources ((MIN)). The broker has Buy recommendations on those stocks.

The broker has upgraded forecasts for Service Stream, as it has won an additional NBN contract, while forecasts for Mineral Resources are downgraded to account for a lower iron ore price and less engineering construction work. Ord Minnett's forecasts for RCR Tomlinson ((RCR)) are also downgraded as some work where the company is the preferred contractor is likely to be delayed.

In regard to more resilient divisions, Deutsche Bank has a positive outlook for the life sciences division of ALS ((ALQ)) but remains cautious about its oil & gas and minerals division. The broker expects Australian E&C companies could be acquisition targets as offshore companies seek to take advantage of depressed valuation and the benefit of a weak Australian dollar.

This is recently evidenced by the second bid for Broadspectrum ((BRS)) by Ferrovial recently. E&C stocks considered more likely to make acquisitions in 2016 are Cimic, Downer and ALS. Cimic and Downer both have share buy-backs in place and if suitable targets are not identified, Deutsche Bank believes another buy-back could be implemented.
 

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