Is An Earnings Recovery Priced In To Orica?

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After a soft FY18 result Orica expects ammonium nitrate volumes will improve. However, uncertainties over the Burrup plant weigh on the outlook.

-Has the market priced in the earnings recovery?
-Growth still appears to be a challenge
-Burrup not expected to run at full capacity until 2020
 

By Eva Brocklehurst

Orica ((ORI)) appears at a crossroads, emerging from several years of underperformance with the levers in place to expand. Yet there are reasons to be cautious, as brokers note the Burrup plant is not performing at an optimal level and this is weighing on profitability.

In the company's favour, there is a tightening supply/demand balance in the Australia-Pacific region that is being reflected in improving contract outcomes. The company has guided for ammonium nitrate volumes to increase 3% in FY19. No specific financial guidance was provided but Orica expects growth in revenue and operating earnings will be supported by increased demand and manufacturing improvements.

Expectations for earnings growth over FY19 and FY20 are underpinned by volume growth, stabilised pricing and business improvement initiatives, such as a full year's contribution from GroundProbe, and a recovery in Minova.

Morgans believes the market has largely priced in the earnings recovery and, having to contend with internal challenges and a re-setting of prices, the company's positive leverage to a recovery in volumes has been reduced. Still, the broker believes FY18 should be as bad as it gets.

Deutsche Bank points out the FY18 result was boosted by profit on asset sales of $17m while cash flow was enhanced by lower tax. Earnings did accelerate in the second half, with an improved contribution from margin/mix and a reduction in costs. However, margins contracted to 11.4% from 12.6% during the year.

The company reported underlying net profit of $327.2m and operating earnings (EBIT) fell 2.7%, reflecting the impact of unplanned maintenance at Yarwun and Kooragang Island, as well as continued challenges in the cyanide market and cost headwinds.

Regionally the outcome was mixed: Asia-Pacific led the way, while North America was in line and Latin America missed expectations. While Latin America was poor, Credit Suisse notes this was because of factors beyond the company's control and accentuated by adverse currency movements.

Uncertainties Prevail

Credit Suisse upgrades to Outperform from Neutral, although not entirely convinced in the upside case. Still, the company seems to be getting on top of operating issues and the tightening of supply should carry profits higher over the medium term. The reasons to be fearful, the broker acknowledges, include recent history and Burrup.

Morgan Stanley goes the other way and downgrades to Equal-weight from Overweight. There were no major surprises for the broker and the result was better than feared. The environment appears favourable and Morgan Stanley believes a premium to history is warranted at this point in the cycle, but being convinced about the growth profile for 1-2 years hence is a challenge.

Citi observes there was a relief rally in the wake of the result, as operating issues appear largely resolved and cash conversion is recovering. Nevertheless FY19 guidance implies sharp downgrades to consensus expectations and the broker continues to believe the stock is overvalued, maintaining a Sell rating.

Burrup

Utilisation rates at Burrup are likely to be just 20% and the company now expects the plant will not be running at full capacity until 2020. Brokers are still unsure regarding the outcome as Burrup is not running consistently, plagued by technical problems, which will mean higher cost alternative ammonium nitrate supply will be needed for Western Australian iron ore contracts.

Macquarie finds Burrup problematic and believes this is a risk to the downside. Orica has identified more problems at the absorption tower, in addition to the heat exchangers. The broker notes it is costing Orica $200/t to service 240,000t of Burrup contracts whilst the plant is off-line and there is risk of further costs in the event of delays.

FNArena's database shows one Buy rating (Credit Suisse), five Hold and one Sell (Citi). The consensus target is $17.56, suggesting -1.4% downside to the last share price. Targets range from $16.00 (Citi) to $19.08 (Credit Suisse).

See also, Work To Do At Orica on May 9, 2018.

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