Orica at peak performance

This chemical, paint and explosives company was spun off from its UK parent, ICI, at $11.90 per share in 1998. By 2001 the share price had fallen to a low of $4.04 and many analysts viewed it as a basket case.

So did we, having suggested in issue 79/Mar 01 (Sell - $5.00) that subscribers get out of it. At the time the problems were numerous.

The company had entered into three-year contracts for its explosives business without a conditional clause on the price of gas staying below a certain threshold.

US natural gas prices then sky-rocketed and the stock was punished for the potential loss of earnings.

It was the perfect example of what most saw as inept management, incapable of taking advantage of the company's market dominance.

Combined with high debt levels and uncertainty over who was eventually to head the company, we continually advised subscribers to steer clear, setting aside the valuable shareholding in Incitec. What, then, were we missing?

Buffett has said that 'a great investment opportunity occurs when a marvelous business encounters a one-time huge but solvable problem'.

Overdone

Now, this isn't a great business but it isn't in terminal decline either. The reaction to the company's huge problem was overdone.

The turning point was the arrival of new CEO Malcolm Broomhead who cut costs and disposed of non-core businesses. And in the past 12 months the price of natural gas has eased and the share price has almost doubled.

So, before expressing our latest view – and we understand if subscribers are reluctant to hear it – let's look at what the businesses are doing.

Orica operates four main divisions, with only limited synergy between them. The biggest, representing 42% of revenue, is the cyclical explosives and mining services division. It has yet to show great returns on capital (3.4% in 2001 and 8.8% for 2000) and, in our view, will struggle to do so.

A 77% stake in Incitec and Crop Care, a joint venture between Incitec and Orica, largely accounts for the agricultural chemicals business.

Incitec has been a successful business with good historical returns on capital and monopoly-like market shares.

The problem is that its major product, fertiliser, is dependent on global urea prices, which are weakening at the same time as the Australian dollar is rising. It isn't a great combination.

It's also important because Orica's shareholding in Incitec actually amounts to 30% of its own market capitalisation.

Orica also has a chemicals business that has just enjoyed a great six months, although even management talks of cyclicality and tough competition. That, perhaps, is telling us something.

Consumer products

The consumer products division, with brand names like Dulux, British Paints and Selley's, has done well, too. And strong building approvals should boost earnings in the short term.

But with Wesfarmers now owning BBC HardwareHouse and Bunnings Warehouse, margins will no doubt be under pressure at exactly the same time as the housing sector boom tails off, or is about to.

Finally, whilst cost-cutting and the deferral of capital expenditure can boost earnings in the short run – earnings in the six months to 31 March before significant items were 29 cents per share and likely to be better still for the year-end – such measures can hamper long-term growth.

Tough business

So Orica may have a good 12 months ahead of it, as we suggested it might in issue 103/May 02 (Steer Clear - $9.15). In this case some subscribers may wish to neglect our current advice and hang on.

Ultimately, though, this remains a tough business, probably enjoying the peak of its performance.

If you want this type of exposure we suggest you look to Futuris, which we admit to pushing quite heavily at present. It owns 20% of Incitec and its stock price has been slaughtered for a one-off bad insurance result. SELL and SWITCH to Futuris.