Two Australian stocks with big bang fundamentals

Last year's mining recovery caught some investors under-exposed to resources, and the same might be said today about companies selling essential services to the miners.

Investors might be overlooking equipment makers and companies that manufacture the explosives used in mining, which is an Australian speciality.

Analysts at investment bank Goldman Sachs have reacted to the improved outlook for miners, especially in the US where coal is making a comeback, by recommending the big equipment maker Caterpillar as a buy.

Heavily sold during the mining downturn, and due to a tax dispute over the activities of a Swiss subsidiary, Caterpillar has been a solid performer over the past two weeks, adding $US5.60 a share (6 per cent) to trade at $US97.14, close to a 12-month high.

Goldman Sachs reckons the share price of the world's biggest manufacturer of mining and industrial equipment is heading for $US120 over the next 12 months.

Australia has a Caterpillar proxy in Seven Group, which owns the Westrac equipment business that sells and services Caterpillar equipment. The mining recovery has helped Seven's share price more than double over the past 12 months from $5.04 to $10.38.

Australia's explosive manufacturers – Orica, Incitec Pivot and CSBP – are seeing a similar, but slower, recovery.

The business units of the three ASX-listed companies that make explosives, namely the preferred mining material, ammonium nitrate, are part of groups with other operations. This makes it difficult for investors to get a clear picture of the financial performance of explosives on their own. For example, CSBP is the chemicals and explosives division of Wesfarmers.

But recent research by brokers and investment banks points to strong demand for explosives from the mining sector, especially in the coal and iron ore industries where tonnes shipped have been rising to catch a period of higher prices.

The explosives business represents an essential service because breaking orebodies and overburden is fundamental to the mining process no matter what the price of the material being sold. Without explosives there would be no mining.

Explosives, however, also require a higher level of security given their potential for destruction if they are misused. This is another reason why investors don't read much about the production and distribution of ammonium nitrate or explosive consumables such as electronic blasting systems and packaged explosives.

There is also another interesting aspect to the Australian explosive manufacturers; they are genuine world leaders in their field, and that can't be said about many Australian companies in any line of business.

Australia's big three of the big bang sector developed ammonium nitrate operations as an extension of their fertiliser and chemicals business units. Incitec Pivot and Orica are the most exposed companies to explosives with worldwide operations. CSBP was once the corporate heart of Wesfarmers but is now drowned by its retailing units such as Coles, Bunnings and Officeworks.

All three explosive makers have recently reported an increase in sales volume as the mining recovery gathers pace and the last effects of the downturn are absorbed.

Incitec Pivot, which generates roughly half its profit from fertiliser and half from explosives, incurred a 68 per cent decline in net profit to $128 million in its financial year to September 30.  Investment bank analysts have forecasted a rebound this year with Macquarie tipping an Incitec Pivot profit of $328 million, Morgans $358 million and Deutsche Bank $393 million.

Increased prices for fertiliser follow the better growing conditions and higher crop prices enjoyed by farmers, and Morgans also noted last week in a report on Incitec Pivot that the company's North American explosives operations should benefit from higher coal consumption in the US.

Morgans last reviewed Incitec Pivot in November, and since then the broker observed that: “Fertiliser prices (particularly ammonia) have risen, there has been a big summer cropping season and explosives demand has improved following stronger commodity markets”.

Despite those optimistic comments, Morgans believes Incitec Pivot's share price might have run as far as it can in the current cycle. The broker recommends the stock as a hold with a 12-month price target of $3.70, up marginally on recent trades at $3.66.

Macquarie analysts are more positive, forecasting a 12-month price for Incitec Pivot of $3.95. Deutsche Bank sees a future price of $4.25. Both Macquarie and Deutsche Bank have the stock as a buy.

One reason for the cautious tone in some recent analyses of Incitec Pivot is that it started its price recovery last September, shortly after touching a two-year low of $2.66.

It's a similar story to Orica, which dropped to a seven-year low of $12.04 last June. Most investment bank recommendations currently have this stock as a hold, with two significant outliers.

Morgan Stanley reckons Orica could drop to $11.03, largely because of Chinese coal production policies. Deutsche Bank leans the other way considering the improving outlook for explosives demand and sees Orica as a $20 stock over the next 12 months.

In a research report last week, Deutsche Bank noted delays to Orica's new explosive plant in the north west of WA and company guidance that volume and earnings would be flat in the current financial year. The investment bank then added a note of optimism:

“We believe there is upside risk to these assumptions given the improving outlook for explosives volumes and the delay in commissioning the new Burrup (WA) ammonium nitrate plant.”

CSBP, which operates the ammonium nitrate business of Wesfarmers, is such a small unit within its parent company that it isn't practicable to isolate it as a reason to buy, or sell, Wesfarmers shares.

The two best entry points for investors into the explosives industry, one of the few industries where Australia is considered a global leader, are Incitec Pivot and Orica.