Recovery For Orica Not Until FY19

This story features ORICA LIMITED. For more info SHARE ANALYSIS: ORI

Explosives supplier Orica provided a subdued outlook and is not expected to show the benefits of a rebound in activity until FY19.

-Oz outlook positive, with increased removal of overburden and mine expansions
-Business improvement benefits expected to offset negative impacts in FY18
-Ongoing headwinds from lower ammonium nitrate prices and higher gas costs
 

By Eva Brocklehurst

The benefits of a rebound in mining activity are yet to be felt by Orica ((ORI)) and the company's share price suffered after disappointing FY17 results. The company did not provide formal guidance but said the normalisation of long-term mining plans is continuing.

Revenue was weak versus growth in volume. Sales volume in Asia Pacific increased 10% while North America fell marginally. In Latin America the business recovered from the impact of higher sourcing costs, resulting in earnings growth of 5% in the second half. The company expects operating earnings (EBIT) in FY18 to be broadly flat.

Albeit subdued, the outlook is still positive, particularly in Australia, because of the increased removal of overburden and brownfield mine expansions, but Macquarie suggests it will take time for this to flow through, and the earnings recovery will be in FY19 rather than FY18. Meanwhile, the company continues to face headwinds from ongoing reductions to ammonium nitrate pricing and the incremental effects of higher gas costs.

Given the stock was fully valued leading into the result, Morgans considers the market's negative reaction to be expected. The broker retains a view that the stock is more of a late-cycle play because of its leverage to volumes. Volumes are rising but prices continue to fall and are expected to remain under pressure in FY18 before recovering in FY19. Morgans calculates that this reduces leverage to a recovery versus past cycles.

Citi sums up the results as "running hard to stand still" and downgrades to Sell from Neutral. The broker suspects a recovery in profit is some way off and reduces forecasts by -13.5% for FY18 and -6% for FY19.

While the may be some upside risks to the FY18 outlook, Credit Suisse agrees that the disappointing revenue outlook in the results, because of price and mix, warrants some caution. At an aggregate level, price re-setting and cost increases were offset by some benefit from the company's transformation initiatives.

Orica is a natural beneficiary of the growth in market demand in Australia but there are few near-term catalysts for outperformance. Hence, Credit Suisse considers the outlook quite neutral.

Morgan Stanley suggests this may not be the last time the trajectory of the cycle disappoints. The broker suspects FY18 will represent a trough in earnings and headwinds will then moderate. Still, given the disappointment with both the FY17 result and the FY18 outlook, the broker suspects the market will discount FY19 until the earnings up-cycle begins to take shape.

Acknowledging evidence of robust cost reduction, Morgan Stanley still considers the operating environment is challenged, given the negative impact associated with explosives pricing and volumes.

Burrup

The company's outlook also signals the benefit of increased capacity utilisation is now pushed out to FY19 and Macquare expects the loss-making Burrup (WA) facility will weigh on the short-term profitability. Burrup ammonium nitrate plant has received all environmental approvals and is expected to commence production in FY18. The company is expecting a full loading over a period of four years.

The company forecasts the headwinds to pricing and increased R&D investment to be offset by continued improvement in the business, but Ord Minnett points to the continued uncertainty around the near-term profit profile of Burrup and the future for Bontang (Indonesia). Business improvement benefits amounting to $100m or more have been guided, to offset the negatives in FY18. Ammonium nitrate volumes are expected to be flat.

Macquarie suspects the company has taken a conservative approach to expenses rather than capitalise these costs and this hurts near-term profits. The broker assesses some of the expenditure could be categorised as "stay-in-business" to preserve savings, while the rest is designed to accelerate the use of value-added products and services. The long-awaited expensing of Burrup will also create an earnings drag in FY18.

Price variance in FY18 is larger than Macquarie previously expected as the company continues to experience the lagged effect of legacy renewals locally and, according to feedback, increased competition in Europe and Latin America.

The broker forecasts a contraction in FY18 earnings per share of -2.5% before growth returns in FY19. The company is investing an additional $40m in technology and R&D in FY18 to facilitate more automation, including advanced blast simulation models and wireless blasting technology.

FNArena's database shows five Hold ratings and three Sell. The consensus target is $18.08, signalling -4.8% downside to the last share price. Targets range from $16.50 (Morgan Stanley) to $18.85 (Deutsche Bank).

This stock is not covered in-house by Ord Minnett. Instead, the broker whitelabels research by JP Morgan.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms