Work To Do At Orica

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Orica sustained a poor performance in the first half, amid production problems at several of its plants. Brokers require progress on the issues into FY19 before becoming more positive.

-Needs to overcome manufacturing challenges before benefiting from improving commodity markets
-Reliability of Burrup remains an issue for FY19
-FY19 could be an inflection point, amid a tightening east coast market in Australia
 

By Eva Brocklehurst

Orica ((ORI)) may have guided to a weak result for the first half but it was worse than many brokers expected. The company sustained a poor manufacturing performance amid production problems at several plants.

The reduction in earnings, operating earnings (EBIT) fell 20% and underlying net profit -37%, reflected unplanned plant maintenance, challenges in the cyanide market, technical issues at Burrup and ongoing losses from Minova.

The company expects to take 2-3 years to sustainably improve manufacturing performance across its global ammonium nitrate network. The focus is on standardising production and more consistent maintenance.

This highlights the challenges Orica needs to overcome before it can benefit from improving commodity markets and the operating conditions its customers are enjoying, Morgans suggests. While volumes are rising, prices have fallen and pressure is not expected to completely dissipate until FY20.

The broker suspects this situation reduces the company's leverage to a recovery compared with past cycles and the results would have been materially weaker had Orica not deferred some of its contract re-negotiations until FY19.

Credit Suisse acknowledges there is not much objective evidence to support expectations of improved execution but, in the near term, additional sustaining capital and a slower rate of cost reductions should relieve some of the pressures on manufacturing.

The broker suggests manufacturing issues over the past several years have likely pushed the cost base and sustaining capital expenditure too low. The company has indicated that the manufacturing aspects of cost reductions will be less as it focuses on improving plant performance.

Ord Minnett also believes there are significant risks surrounding the growth prospects, along with uncertainty about the profit profile of Burrup and the future for Bontang once Burrup ramps up.

Burrup

The performance of Burrup remains uncertain until the heat exchanger equipment is replaced in FY19. Macquarie points out the ownership and operating structure of the joint venture is unwieldy, which does not help.

As recently as the November AGM, Burrup was expected to run at 30-40% utilisation in FY18 before ramping up towards 60-70% by FY19. The March update revealed the heat exchangers were faulty and would result in little output in FY18. Now management expects further delays and guides to low availability in FY19.

Morgan Stanley also assumes that reliability at Burrup remains in question throughout FY19. Regardless, ongoing robust volume growth, and absence of one-off issues indicate earnings should still improve significantly in FY19.

Citi suggests the domestic market will be pushed into oversupply once the Burrup plant is fully operational and the Yarwun operations re-start trains 2 and 3. The broker asserts the stock is trading well above historical levels and remains overbought.

Macquarie agrees the multiples are relatively full and the stock requires delivery of earnings expectations, or upgrades, to substantially re-rate. Reliability of plant remains key to the second half along with an assumption of improved pricing outcomes in Latin America and Europe Middle East Africa (EMEA).

The company delivered $35m in net savings from its business improvement program and a similar run rate is expected in the second half. Macquarie points out this is less than the previous guidance of $100m for FY18.

Pricing

The pricing environment in Australia is firming but Macquarie suggests this is occurring mainly in the eastern states, as there was surplus tonnage in Western Australia.

The company believes there should be opportunities to increase Australian ammonium nitrate prices over the next 1-2 years as contracts come up for renewal. Orica also expects lower negative ammonium nitrate price variance this year, the bulk of which relates to Latin America and EMEA, where competition continues.

CLSA is not distracted by the issues with the operations and remains of the view that the outlook is improving, as volumes are starting to rise domestically, while margins should improve in FY19 when production issues are worked through in Western Australia.

The broker believes real leverage for the business will come when prices start to rise on tighter supply/demand. CLSA, not one of the brokers monitored daily on the FNArena database, acknowledges the business has not performed well but believes the cycle has turned. The broker has an Outperform rating and $20.70 target.

Morgan Stanley is also more optimistic, although requires evidence of improvement in order to realise valuation upside. The broker's positive stance is predicated on the FY19 outlook, expecting this will be an inflection point, and forecasts 26% growth in earnings per share for the year.

Setting aside the previous production issues, Credit Suisse also expects earnings in the second half to be significantly stronger. A tightening market on the east coast of Australia should mean the company grows into the capacity at Yarwun, while Burrup appears to be fully loaded from FY20.

The broker suggests the outlook for North America and Europe is neutral while there is still some downside risk likely in Latin America.

FNArena's database shows one Buy (Morgan Stanley) rating, five Hold and one Sell (Citi). The consensus target is $18.29, signalling -3.4% downside to the last share price. Targets range from $16.50 (Citi) to $20.10 (Morgan Stanley).

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