Australia | Mar 02 2021
This story features ORICA LIMITED. For more info SHARE ANALYSIS: ORI
Orica has always indicated the first half would be weak, but the extent of the latest downgrade has rattled the market
-Exposure to thermal coal remains of concern
-Main issue is when can earnings return to normal
-Business remains fundamentally intact
By Eva Brocklehurst
A spate of issues have plagued explosives producer Orica ((ORI)), resulting in brokers scrambling to ratchet down expectations and ascertain just what of their concerns may prove stubborn.
While Orica had always flagged a weak first half, the company's latest update proved materially worse than anticipated. No specific first half guidance has been provided and the chairman has indicated performance will be very dependent on the outcome of February and March trading.
Orica has indicated a negative impact on first half earnings (EBIT) of -$105-125m, which is equivalent to around 40% of Morgan Stanley's prior forecasts. The broker points out the past six years have provided range-bound earnings of $600-700m and its forecast for FY21 of $450m represents a decade low.
While the trading update was only for the first half, the broker believes there will be ongoing impacts. There is also the risk that the additional capacity at Yarwun may need to be idled.
Mining activity in NSW has succumbed to the lower production of thermal coal and Credit Suisse believes this aspect will be temporary, likely to moderate as trade flows re-balance. Mining activity in Latin America, Europe and Africa has also been affected by the impact of the pandemic.
The broker assesses Africa and Latin America could be longer-term recovery stories, extending into FY22. In the short term, additional costs for the arbitration surrounding Burrup are headwinds and the previously guided savings for the SAP program have been pushed back a year.
Ord Minnett notes the main internal issue is the the compnay's SAP (Systems Applications and Products in Data Processing) system changeover, affected to an extent by the pandemic, while the main positive to be taken from the update is the fact February volumes to east coast thermal coal customers have improved following a very weak January.
Morgans believes Orica is well-positioned and will benefit from its strategic growth initiatives, taking some comfort in the fact operating conditions have improved in the latest month.
Further write-downs can't be ruled out, the broker adds, given the poor earnings performance, pointing out the chairman has acknowledged the carrying value of assets will need to be reviewed.
Consequently, Morgans believes now is the appropriate time for a new managing director who can focus on execution and deliver on strategic growth priorities, noting Sanjeev Gandhi will take over as CEO/MD from Alberto Calderon.
Still, the uncertainty created for the short term means a downgrade to Hold from Add. Morgans acknowledges the fundamentals are not demanding for a global leader and, if operating conditions improve faster than previously expected and/or China removes its import ban on Australian coal, there is upside risk.
Orica has indicated some coal is getting through to China or is being diverted there by third parties. Exports are also occurring to other markets. With the share price at a 5-year lows Morgans does not dismiss the potential for corporate activity.
Goldman Sachs finds the non-mining impact of the downgrade – FX/SAP/Burrup – fairly straightforward. The impacts of the pandemic can also be rationalised across the global footprint, particularly in terms of my disruptions in Latin America, Indonesia and Africa.
What remains unclear is the Chinese trade tensions. While the severity of the downgrade surpassed expectations, Goldman Sachs believes it is justified by production cuts to thermal coal and compounded by Orica's regional fixed asset base and high thermal coal margins. This is something the broker will be closely monitoring.
The main issue, therefore, becomes the degree to which earnings can return to normal. While reducing estimates and expecting reduced benefits from the SAP program, the broker has maintained forecasts for a global mining volume recovery relatively intact.
Anticipating the latest downgrade will weigh on investor sentiment for a time, Goldman assesses the stock screens attractively in the context of a fundamental recovery and, not one of the seven stockbrokers monitored daily on the FNArena database, retains a Buy rating with a $16.20 target.
Macquarie downgrades to Neutral, citing a lack of earnings visibility, the transition at the top and tighter balance sheet metrics. Moreover, investors are likely to focus on the earnings outlook in FY22 and FY23, even though Orica needs to get through FY21 first.
The broker suggests the relations between Australia and China on the coal front represent an ongoing risk, along with further potential appreciation of the Australian dollar. UBS also downgrades to Neutral, expecting Orica will still provide leverage to a global recovery from the pandemic and the normalisation of mine activity.
Nevertheless, coal trade dislocation and increased ESG concerns surrounding the black stuff, amid the risk of a strategic re-set from the new CEO, are expected to weigh on short-term performance.
The point for Credit Suisse is whether external factors affecting the business are likely to ease in time, or whether there is something more fundamentally wrong.
The broker concludes there is a mix of both, and points out the progression of downgrades over the last several years reflects rising cost pressures and surplus industry capacity as well as delays with key assets such as Burrup.
On a positive note, market structure remains attractive and technology should drive further consolidation, while Orica has a clear leadership position.
Credit Suisse believes a sharp reduction in the share price provides the opportunity for long-term investors to gain exposure to the stock and upgrades to Outperform from Neutral. While a capital raising is not ruled out, the broker envisages sufficient upside to accommodate that eventuality.
Morgan Stanley believes the downgrade is another in a series of disappointments and also questions whether the issues are structural. While volumes and earnings are likely to recover the broker is wary about pricing.
Nevertheless, Morgan Stanley asserts the business is not structurally broken and Orica is a global leader in the industry, although parts of the value chain have become commoditised and the exposure to thermal coal remains of concern.
All up, the broker assesses there are too many unknowns and awaits further detail from Sanjeev Gandhi on the strategy in order to gain more confidence that the issues are temporary and prior earnings levels are achievable.
FNArena's database has two Buy ratings and five Hold. The consensus target is $15.30, suggesting 20.7% upside to the last share price. Targets range from $13.50 (UBS) to $18.65 (Citi, yet to comment on the update).
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