Incitec Pivot: an explosive break up?

Fertilisers and explosives share a common chemistry. So when Orica announced way back in 2002 that it would separate its explosives business from its fertiliser business, there were some who mourned for the loss of much adored ‘synergies’. They were not long disappointed.

Orica’s orphan – Incitec Pivot – was quick to use synergies to justify buying an explosives business, Dyno Nobel, to add to its fertiliser business. Like Cat Stevens warned, the child came to resemble the parent.

Like Orica a decade ago, Incitec is itself now talking of demerging into separate explosives and fertiliser businesses. As we argued in Incitec Pivot: a smelly business? on 14 Mar 12 (Avoid – $3.27), Incitec is a poor quality business. One would only buy it if it was very cheap or fertiliser prices were set to rise. Now there’s a third possibility; that a breakup will unlock value.

As Table 1 illustrates, fertiliser accounts for about 30% of company revenue but just 15% of profits. Dyno Nobel, the world’s second largest explosives maker, is a far more stable, higher margin business that now dominates Incitec’s profitability. Like Orica before it, the company now wants to hive off fertiliser and concentrate on explosives.

Fertilisers are a commodity and producers can control neither the price of inputs nor outputs. They are at the mercy of gas prices (see Shoptalk) and final fertiliser prices.

The fertiliser bull case is well rehearsed and seductive. More people with more money will consume more food; to grow more food, fertiliser will be needed. Demand is thus expected to soar. Yet higher demand does not necessarily mean higher profits. Typically, an increase in fertiliser demand is accompanied by an increase in supply.

In fact, this is happening right now. In the American states of Louisiana and Texas a petrochemical boom is underway. Cheap, abundant gas and willing state governments are encouraging unprecedented increases in the supply of petrochemicals. In those two states alone, 110 new projects worth about US$77bn have so far been announced, with many more in waiting.

Ammonia, the key ingredient in both fertiliser and explosives, is among the chemicals booming. Until two years ago, no new ammonia plant had opened in the US for more than 20 years. Now, 14 new plants are under various stages of approval. There are only 25 working plants in the entire United States and, if new plants are approved, ammonia output will more than double. The US is a relatively small producer, accounting for just 6% of global ammonia output but the vast bulk of new capacity.

It’s a commodity

In the long run, no industry can expand output and raise prices at the same time. The higher capacity of which ammonia producers boast is sure to lower prices. The fertiliser business will bear the brunt of the pain as fierce competition lower prices. Fertiliser EBITDA margins over recent years have fluctuated wildly (see Table 2). The sensible fear now is that margins will become predictable, and low.

Incitec’s fertiliser business has averaged earnings before interest, tax, depreciation and amortisation (EBITDA) of about $380m per year over the past four years. That number could fall substantially as lower prices bite.

Let’s assume fertiliser EBITDA margins fall from 10% to 6% and revenue grow to $1.2bn; EBITDA would then fall to about $70m. From the trading business, Southern Cross, we’ll assume margins fall slightly from 27% to 24% and revenue rises to $750m. In this case, EBITDA comes to about $180m, bringing divisional EBITDA to about $250m. A multiple of five to seven times would value the fertiliser business at between $1.3bn-$1.8bn (see Table 3).

Explosive value?

What of explosives? Although they both share nitrogen chemistry, explosives are far from a commodity business. As explained in Exploding myths about Orica on 04 Apr 12 (Avoid – $26.99), detonation is a small part of mining costs but a mighty part of the risk. This is not where miners look to save pennies.

Explosives are, however, dependent on mining volumes. The bulk of Incitec’s explosives sales come from iron ore and coal miners. We have grave doubts that volumes in these industries will be sustained. Lower volumes, if they eventuate, will mean lower earnings.

The explosives business generated EBITDA averaging $450m per year over the past four years. About 75% of sales are contracted so, although we are concerned about mining volumes, let’s assume the business can generate average EBITDA of about $400m per year.

Adding debt to today’s market capitalisation provides an enterprise value of $5.7bn, suggesting the market values explosives on an EV/EBITDA multiple of between six and seven (see Table 3). By comparison, Orica, which generates the overwhelming bulk of its earnings from explosives, trades on an EV/EBITDA multiple of just over 8 and is arguably the better business.

With high exposure to US coal and no certainty that a break up will happen, there is not enough value on offer today; the business trades at fair value. That makes it hard to recommend buying. At cheaper prices, we might consider another look but, with the share price down 21% (including 7% this morning because of a plant problem) since 14 May 12 (Avoid – $3.16), we’re sticking with AVOID.