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Are Headwinds Receding For Orica?

Australia | May 17 2017

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Mining services business Orica expects a gradual recovery in earnings while the question for brokers centres on the extent to which headwinds are receding.

-Business improvement initiatives expected to offset price re-sets and higher input costs
-Ammonium nitrate volumes increasing and mine plans and strip ratios normalising
-Yet, is the upside already manifest in the share price?

 

By Eva Brocklehurst

Mining services business Orica ((ORI)) expects a gradual recovery in earnings after reporting a first half result that suggests to brokers what can be controlled is being controlled. The outlook centres on the extent to which the mining environment has stabilised and the headwinds are receding.

As evidence for the positive, Macquarie cites the Australia Pacific & Indonesia (API) division, which sustained a 10% lift in explosives volumes off a low base, driven by higher mining strip ratios and new contracts. Volume growth in other regions was more subdued, contributing to a 4% lift overall. The broker also notes $53m in business improvement initiatives underpinned a 50 basis points lift in margins, despite a -5% drop in sales.

Weaker results came from North America, where operating earnings (EBITDA) were down -5% because of a higher Australian dollar. Latin American operating earnings fell -20%. Corporate costs were up materially. Management now includes an adverse FX impact of $50m in guidance, which is unchanged otherwise.

In noting the company's confidence that business improvement initiatives will offset price re-sets and higher input costs, Deutsche Bank expects higher volumes will also offset the headwind from FX. The market outlook is improving, the broker asserts, citing in evidence the 4% increase in ammonium nitrate volumes and the company's observation that mine plans and strip ratios are normalising.

The core API explosives business stood out for UBS as well. Still, while the volume outlook appears to have turned positive, the broker believes there is latent capacity across the footprint for explosives that is likely to limit significant margin upside for some time.

As there is a lack of material growth options, over and above near-term volume improvement, the broker believes the stock's valuation is expensive and retains a Sell rating.

Morgan Stanley is also among the bears and calculates that without the benefit of asset sales, first half operating earnings fell -4% and this highlights the extent of the structural headwinds the company faces. That pressure is largely manifest through lower ammonium nitrate prices.

Therefore, the medium term outlook remains challenged, in the broker's opinion, and demand is at risk from weaker bulk commodity prices, increased competitor dynamics among ammonium nitrate producers, as well as an oversupply.

Burrup

The new facility at Burrup is now expected to achieve beneficial production in the December quarter which, Morgans estimates, means an additional period for depreciation & amortisation and increased net interest costs that will hit the profit & loss statement, as the plant is no longer capitalised. Currently only about 50% of the plant is contracted.

The delay indicates expenses will be lower than expected in FY17 and, instead, be deferred to FY18. Ord Minnett, too, believes the growth outlook is challenged because of the expected pricing re-sets beyond FY17 and impending earnings drag from the part-loaded Burrup plant.

Macquarie calculates Burrup will sustain a -6% headwind to net profit as a result of the delay and acknowledges this constrains the extent of the earnings recovery in FY18. Coinciding with this, nonetheless, headwinds from costs and ammonium nitrate prices should abate and, all up, this drives the broker's forecast for 5% growth in earnings per share in FY18.

Inflection Point?

Morgans suspects the company is through the worst of the headwinds and operating condition should gradually improve. Nevertheless, the broker suspects the share price has run ahead of the near-term fundamentals and opts for a Hold rating.

Credit Suisse observes the heavy lifting in the first half was undertaken by cost reductions and, while increases in volume were evident, realised prices fell. The result was also boosted by asset sales, without which the result missed the broker's forecasts.

Credit Suisse suspects the stock, with maximum headwinds, is at an inflection point but would like to witness increasing margins, and cash and reported profit converging, before calling the change. The broker did not find the first half result particularly inspiring and retains a Neutral rating.

The main debate with respect to the inflection point centres on eastern Australian supply of ammonium nitrate, with the broker bearing in mind the Western Australian market is oversupplied once Burrup commences.

Credit Suisse finds the initiative to enter the liquid fertiliser market in Australia intriguing and one which supports full use of ammonia capacity at Kooragang Island and increasing ammonium nitrate capacity at Yarwun.

Management has stated, reflecting improved market conditions on the east coast, that it is likely to re-start production at Yarwun, which had been cut back previously because of oversupply. Regardless, Credit Suisse would like to witness the actual implementation and profitability of these initiatives before calling success.

Citi expects the normalisation of mine planning and strip ratios should help the company's ammonium nitrate business. The broker expects sequential improvement in mining services operating earnings margins along with an ongoing improvement in the mix towards higher-margin emulsions.

While improved earnings are factored into FY18-19 forecasts, the broker suspects much of the good news has already been discounted in the share price.

There are two Sell ratings, five Hold and one Buy (Deutsche Bank) on FNArena's database. The consensus target is $17.51, suggesting -4.3% in downside to the last share price. This compares with $16.64 ahead of the result. Targets range from $11.59 (Morgan Stanley) to $20.60 (Deutsche Bank).
 

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