Orica: Interim result 2013

Since buying Minova, which makes ground support equipment for underground mines, Orica has reported financial results for its new division separately. No longer. At its interim result, the company announced Minova would fold into its giant mining services division. Shareholders who had been hoping for a sale will be disappointed. Instead of penance, Orica has opted for denial.

Management went so far as to cease mention of Minova altogether; it was presented as the ‘ground support business’. In a spookily Orwellian manner, the moniker ‘Minova’ has disappeared.

For the six months ending in March, Orica's revenue increased marginally, to $3.3bn, and net profit rose 5% to $267m. From earnings per share of 73.5 cents, up 8%, a 39 cent dividend was declared (38% franked, ex date 28 May). The newly enlarged mining services division, which now houses Minova as well as the world’s largest explosives business, generated earnings before interest and tax of $435m, 5% higher than last year.

That sounds uneventful but it’s an aggregate that hides both the strength of the explosives business and the weakness of Minova.

Dynamite returns

The supply response that has lowered commodity prices has increased explosives demand. As we explained in Exploding myths about Orica on 04 Apr 12 (Avoid – $26.99), blowing things up makes a small contribution to mining costs if done right but can be painfully expensive if done badly, a fact Orica has turned into pricing power.

In Australia, earnings before interest and tax (EBIT) margins in the explosives business have been dynamite, averaging over 26% for the past five years, a period which includes the global financial crisis. Despite lower capital expenditure from miners, EBIT margins in Australia actually rose slightly to reach 29% for the half. 

Orica’s powerful position is hard to explain. As the largest explosives producer there are scale benefits which reduce unit costs, and technology matters in increasing reliability, but inertia also plays a powerful part in success.

Detonation might account for 5% of mining costs, but a far higher proportion of risk. Many miners aren’t willing to risk changes for the sake of slim savings and Orica is the only local explosives maker that can get large jobs done reliably on the east and west coast. Last year its customer retention rate was 99%.

Overseas, however, margins are more fragile and competition more fierce. Five years ago, North and South American EBIT margins were 11% and 12% respectively. Now they have dived to under 8%. The currency has played a part but the conditions that cosset Orica locally make it hard to dominate internationally.

Ground support crumbling

Minova – sorry, ‘ground support’ – is performing abysmally, generating just $10m in EBIT for the half. For the full year, it might earn between $40m and $50m in underlying EBIT, compared to over $100m last year. With an asset value of over $1.2bn reported last year, another writedown is possible.

These results reflect changes to the international coal market. As we explained in Coal: a dark future ahead?, there are good reasons why coal volumes are falling and may not recover. Orica remains adamant that returns from Minova will improve but that depends on an optimistic view on coal that we don’t share.

Selling Minova would be an ideal outcome.  Assuming it earns $50m a year, a sale might bring up to $500m. Return on assets would rise, debt could fall and a burden stifling the business would be lifted.  Management have been unwilling to entertain such thoughts but, as their reporting shenanigans show, pressure is building.

With the high-quality explosives business diluted by an underperforming ground support business, an opportunity may exist. Assuming Orica can generate earnings per share of $1.70 this year it would trade on a PER of about 14. That’s fair value for a decent business, although a lot depends on the actions of management in stemming the decline of Minova.  

All things being equal, we would consider buying if prices fell below $18. In the meantime, with the share price down 13% since 09 May 12 (Avoid – $26.50), we’re upgrading a notch to HOLD.