Someone's got it wrong on Orica... But who?

In the analyst community, views on the industrial explosives manufacturer are diverging widely.

Summary: Orica, the world’s biggest manufacturer of industrial explosives, is making more explosives to generate broadly the same level of revenue while margins are squeezed as customers demand better prices. Analysts’ views are spread widely between buy, hold and sell.

Key take-out: As long as miners use explosives, Orica’s services will be required – but at what price, is the question keeping the acting CEO awake at night.

Key beneficiaries: General investors. Category: Blue-chips.

If the views of investment bank analysts are a guide Orica is a well-balanced company with a perfect spread of recommendations that move up and down in harmony with buy, hold, and sell notes published over a few days, a bit like a pianist practising scales.

Another way of describing the way the market sees the world’s biggest manufacturer of industrial explosives is that analysts are confused, which is hardly surprising given that most of its customers are miners and there has been severe management turmoil at the top.

The key to the confusion, apart from the spectacular exit in March of former managing director, Ian Smith, lies in two words; manufacturer and mining.

Orica is a manufacturer, but its customers are in mining, an industry where margins are being squeezed and all suppliers are being forced to take a haircut on the services they provide.

Exposure to mining explains why Orica’s share price has been on a roller-coaster ride over the past eight years, peaking at $34 in April, 2007, and bottoming at $13 in February, 2009. It’s currently trading at around $19.15, a price which values the business at $7 billion, making it one of Australia’s top 50 listed companies.

Since those highs and lows in the period immediately before and immediately after the 2008 global financial crisis Orica has been in repair mode, though it has never been able to get back into top gear.

This review of Orica will not provide investment advice. That’s for licensed analysts to do. But it will take you through the arguments for and against a company which should have “can do better” written boldly across its report card.

In simple terms, Orica makes products such as ammonium nitrate (AN), a preferred explosive in bulk mines such as coal and iron ore, and chemicals such as sodium cyanide which is used to extract gold from crushed ore. It also provides a range of other mining-related services.

Because its customers are miners it is easy to mistake Orica as a company riding the whirlwind of commodity prices.

A more correct view is that its exposure to mining is at the production part of the industry where tonnages are rising in the aftermath of the construction boom and that means more (not less) explosives are required.

So, here’s a company making more to generate broadly the same level of revenue while profit margins are squeezed as customers demand a better deal on price because they’re being hammered in commodity markets.

Orica’s performance in the six months to June 30 is a guide to the challenge. Total production of ammonium nitrate rose by 3 per cent, revenue was steady at $2.8 billion, and earnings were down 9 per cent to $330 million before interest and tax.

Importantly from the perspective of yield hunters Orica’s dividend was steady at 40c a share and an on-market share buy-back was launched with a budget of $400 million over the next 12 months.

Analysts now estimate Orica’s FY15 dividend yield at 4.82 per cent, compared to an FY15 estimate of 4.68 per cent for the ASX200.

Whether the December 31 full year result will show that Orica is working hard to make more explosives and cyanide for steady revenue and a modestly lower profit is uncertain because the company said in its June half report that “explosives prices have been substantially reset” – code for the haircut demanded by big customers such as BHP Billiton and Rio Tinto.

Citi, the investment bank to compile the most recent analysis of Orica, likes the stock, upgrading its view from neutral to buy in a report published last Friday with the 12-month target price lifted from $19.90 to $22.

UBS, which reviewed Orica six days earlier, does not like the stock, retaining a sell rating and tipping a 12-month target price of $17.50.

Morgans, one week before the UBS report, hedged its bets with a hold tip on Orica and a target price of $19.15, which was the stock’s closing price yesterday.

That trend of analysts spreading their views between buy, hold and sell, can be traced back to the previous set of research reports which were published earlier this month.

Deutsche Bank was a buy on July 8 with the most optimistic price target of $26.75. Morgan Stanley and Macquarie were in the sell camp with price targets of $14.07 and $19.30 respectively, while Credit Suisse, which last reviewed Orica in mid-May, was a hold and a price forecast of $21.50.

What that assortment of views demonstrates is that if you’re confused about the outlook for Orica you’re in good company because so is the investment banking community.

The company itself appears to be in what might be called repair mode after the abrupt departure of Smith who quit following a physical altercation with a female member of his staff and an admission that he his style had been too aggressive.

Fortunately for Orica it had a ready-made, though perhaps short-term, chief executive in waiting already on its board. Alberto Calderon, one-time head of BHP Billiton’s aluminium, nickel and corporate development operations, joined Orica after being overlooked for the top job at BHP Billiton.

Calderon has been a calming influence on Orica’s management team while the board was further boosted this week with the appointment of former Australian Government Treasury chief Martin Parkinson.

While repair work has been underway at the board and chief executive level Orica has been quietly getting on with the job of securing its position as a supplier of choice to the world’s biggest mining companies.

What some analysts like about Orica is that it is more than an Australian company with worldwide operations and an ability to adjust its costs and pricing to ensure it retains a dominant share of the global explosives and mining chemicals market.

What some analysts do not like is that exposure to mining which is an industry in a cyclical trough that is forcing miners to squeeze the prices of all suppliers.

Fortunately for Orica it is not exposed to the construction phase of mining where engineers and builders have been devastated by the collapse of work which has turned a pipeline of new orders into a graveyard.

Citi’s view, which acknowledges the risk to earnings from squeezed margins on rising levels of explosives production, is that Orica has probably seen the worst of the downturn.

“Orica’s business model remains relatively robust in our view,” Citi said. “It is more than just an Australian business and has the ability to respond to cyclical challenges as its scale and well balanced sales mix helps mitigate regional pressures.

“It is the global leader in a market where incumbent suppliers continue to enjoy formidable advantages given the regulatory barriers to entry (explosives are a sensitive business), has a broad geographic and product base and its capital light manufacturing model.”

Citi reckons Orica is heading for a dip in annual revenue from $6.79 billion last year to $6.5 billion, for pre-tax earnings to slip from $929.7 million to $744.5 million and for the annual dividend per share to slip from 96c to 95c, and be held at that 95c level for the next two years.

Boiled down, so long as miners use explosives to break orebodies, and cyanide to extract gold, and ground support tools to stop the roof of an underground mine collapsing then Orica’s services will be required.

But, at what price is the question which will be keeping acting chief executive Calderon awake at night, and be the challenge for his successor – unless he opts to stay.