Burrup Remains The Key Concern For Orica

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Explosives company Orica produced a robust first half result, as market conditions improved and several issues with manufacturing were largely resolved. Burrup continues to concern brokers.

-GroundProbe performs well and Minova improves on a loss-making position
-Explosives markets continue to improve, reflected in import parity pricing
-Once Burrup is reliable Orica expects to displace around 200,000t of Chinese imports
 

By Eva Brocklehurst

Orica ((ORI)) has removed any doubt regarding its performance in FY19, revealing strong revenue and earnings growth in the first half. Market conditions, manufacturing and industry trends are all seen improving.

On the other hand, capital expenditure is expected to increase and there is still risk around the re-commissioning of the Burrup plant. While the growth rate appears impressive in the first half, Morgans points out the company was cycling a soft comparable period, where every operating business unit went backwards and all major manufacturing plants had issues.

Earnings (EBIT) of $301m were up 20% in the first half, supported by higher volumes and value-added products and services as well as favourable FX. Citi suspects FY19 guidance, which is retained, is overly conservative as it implies a flat second half.

Profit was affected by temporary factors in the half year, as margins were reduced 100 basis points to 17.6%. This was largely because of lower contract pricing. The company calculates, excluding the Yarwun cyanide turnaround and disruptions at Bontang, earnings margins would have been around 20%.

The GroundProbe acquisition is performing well, Macquarie observes, and there is finally an improvement in Minova from a loss-making position. However, limited ammonium nitrate contract renewals this year signal to the broker that the benefit of a firming spot price is a FY21 story.

Orica expects the Latin American business will profit from new service and cyanide contracts, and strong copper and gold fundamentals should help mine planning in the region. Strong ammonium nitrate volume growth was reported in key areas such as Kazakhstan, Russia and Africa. Turkish volumes were lower because of economic weakness.

Developments

Credit Suisse notes the take-up of electronic and wireless blasting solutions appears to be accelerating. This, potentially, validates the company's technology. Orica has secured several commercial services contracts with its WebGen technology.

The broker is also pleased with the prospective upside from product rationalisation, with 21,000 obsolete units removed, amid more confidence from management in the price environment. FY20 appears likely to be a flat year for prices in Australia, Credit Suisse assesses.

Based on tightening supply and demand that should mean some expansion in FY21. A new gas contract is required for Kooragang Island from early 2021. The company appears confident the cost increases will be passed through in contracted volumes.

Explosives markets continue to improve and this is reflected in import parity ammonium nitrate prices of $680/t, up from $550-600/t last year. Once Burrup runs reliably, Orica expects to displace around 200,000t of Chinese imports.

Burrup

The main concern for brokers is the Burrup plant, as its ramp-up to full capacity keeps being delayed. Morgans expects Burrup will weigh on profit and market conviction regarding the company's earnings stream over coming years.

The plant is now expected to be at 50% in FY20 (Macquarie assumes 40%) and at full capacity by the end of that year. The rectification of the faulty equipment is likely to be completed at the end of 2019, resulting in a hand-over to operations from early 2020. In assessing the downside risk, Morgan Stanley estimates a further six-month delay would represent -3% downside to its FY20 earnings forecast.

The company has estimated Burrup's negative impact on cash flow and FY19 is around -$40-45m. Operating earnings (EBITDA) from Burrup are forecast at $45m in FY21, so Citi estimates a $90m swing in cash flow. Additional capital expenditure of $40m is expected at Burrup.

Burrup will have the main earnings impact in FY20/21, Credit Suisse asserts, with modelling suggesting a $25m contribution to earnings on a 270,000t loading. The broker, along with Ord Minnett, believes some downside risk exists, therefore, in terms of Yarwun profitability.

An expected shortfall in meeting contract obligations in the second half of 2020 is likely to put pressure on Yarwun to increase utilisation. Ord Minnett calculates an additional 30-40,000t minimum would be required and incur at least $200/t in shipment costs in the west.

The east coast market remains in balance and Orica is likely to source tonnage from Yarwun or a third party, with freight and costs a key consideration, in the broker's opinion. Orica assesses the east coast explosives market is in balance and the west coast will be balanced in the next 2-3 years.

Citi believes Orica has entered an upgrade cycle and moves to Neutral from Sell, while Ord Minnett maintains a Lighten rating, believing the premium in the stock is unwarranted. Credit Suisse downgrades to Neutral from Outperform, believing while there is a little more momentum in the stock, there are still operating hurdles to clear.

FNArena's database shows one Sell (Ord Minnett) and seven Hold ratings. The consensus target is $18.76, signalling -4.1% downside to the last share price. This compares with $17.69 ahead of the results. Targets range from $16.50 (Ord Minnett) to $20.00 (Morgan Stanley, Citi).

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