Waiting for the dust to settle with Orica

The supplier of explosives to mining companies is beset by tough conditions … but the long-term outlook is more favourable.

With origins over 140 years ago during the Victorian gold rush, Orica is one of Australia’s oldest companies. Today it is the world’s largest supplier of commercial explosives to the mining and infrastructure markets, with 28% global market share.

The company operates across two business segments: mining services and chemicals. Mining services is the largest, generating over 92% of revenues in the first half of 2013-14, while chemicals provided 8%. The earnings from the divisions are diversified geographically; however, around 60% of earnings are from Australia and the Pacific.

Key strengths are its duopoly Australian explosives business position together with Incitec Pivot (IPL), which enables Orica to generate relatively high margins, and a global explosives distribution network.

Orica’s primary activity is the manufacture and supply of ammonium nitrate (AN) and emulsion products to the mining services industry. These are commodity products and pricing is subject to market supply and demand. Activity in the explosives industry is tied to mining production volumes and strip ratios – the ratio of the volume of ‘overburden’ (waste materials) required to be removed to the volume of ore mined.

Orica operates in a challenging market. Depressed coal prices and weaker demand from the mining downturn are constraining revenues and weakening margins, so the company has had to make job cuts and undertake a strategic review for its chemicals business and operations. The company announced it had completed the review of its chemicals business on August 6, 2014, and that it will separate the business either by demerger or sale. This will effectively turn Orica into a pure-play mining services operation. Details for operational improvements are due at the end of 2013-14 (Orica’s year end is September 30).

For the first half this year, revenue grew 1% to $3.4 billion and net income fell 8% to $242 million. Operating earnings fell 7% on the previous corresponding period to $402 million. Mining services’ operating earnings fell 2% to $419 million and chemicals’ operating earnings fell 32% to $39 million.

The profit decline was attributed to lower mining services volumes and a reduced profit contribution from chemicals caused by temporary customer site shut downs, lower caustic prices and rationalisations and write-offs in Latin America.

Figure 1. Orica historical financial performance

Graph for Waiting for the dust to settle with Orica
Source: StocksInValue

Over the last five years Orica has demonstrated varying performance. Net profit after tax (NPAT) has been flat, coming in at $509 million back in 2009-10 (when excluding proceeds of $851 million from discontinued operations) and $578 million on a trailing twelve months basis in 2014. Normalised return on equity (NROE) has averaged 16.2%, though it has fluctuated widely. This reflects the maturity of Orica’s business and the cyclicality of the mining services industry.

Over the same period total equity has increased by $610 million and net debt lifted by $1.29 billion, resulting in net debt to equity jumping from 35% to 60%

Although gearing is high at 60%, first-half operating cash flow was strong at $313 million this year versus net income of $242 million. Orica has a reasonable record of cash flow realisation, with operating cash flows greater than earnings each year from 2009-10 onwards.

Company guidance is for group earnings before individually significant items to meet or exceed 2012-13 NPAT of $593 million. The expected uplift in explosives volumes in the second half will be the most influential factor in the full-year results following a 2% volume decline compared to last year.

However, volatile market conditions add uncertainty to this outlook, with cost-cutting by coal miners and an expected oversupply of explosives in Western Australia being the main risks.

Cost-cutting by coal miners

Orica’s explosives business is largely geared to coal production volumes and strip ratios. Its largest segment, Australia Pacific, generated 47% of segment revenues through coal-related business in the first half of 2013-14.

Figure 2. Australia Pacific revenue by commodity

Graph for Waiting for the dust to settle with Orica
Source: Orica

It is a challenging time for coal miners, with prices at multi-year lows in an oversupplied market.

Figure 3. Australian thermal coal price

Graph for Waiting for the dust to settle with Orica
Source: World Bank

At low coal prices miners increase their focus on cost reduction and increasing productivity by deferring overburden and reducing strip ratios, which translates to softer demand for explosives.

It is uneconomic for many miners to remain in operation at current prices and, due to the flatness of the coal production cost curve, a large volume of thermal coal production is at risk if the thermal price drops further over an extended period.

These conditions are likely to persist for some time as the coal market adjusts to oversupply. Lower demand growth from Australian East Coast coal miners is likely to result in oversupply of explosives over the short-term accompanied by continued AN pricing pressure.

Oversupply in Western Australia

We expect iron ore output in Western Australia to increase by 10% per annum by 2020, driving explosives volume growth in the region, which is expected to support Orica’s Australia/Pacific volumes given weaker conditions in other areas.

Management noted, however, that the Western Australian AN market will be oversupplied by around 150 kilotons from 2017, once the Burrup joint venture facility (45% owned by Orica) is commissioned. This is significant because it represents approximately 15% of expected Western Australian demand for AN in 2017.

The oversupply is expected to continue through to 2020, softening Western Australian AN prices over the period. The Burrup facility is around 60-70% contracted and there is uncertainty over whether the facility will be fully contracted ahead of commissioning. Surplus AN volumes are likely to be managed via exports or production of fertiliser grade UAN, both of which would constrain margins.

Management focus

Orica is pursuing a long-term strategy to move toward value-added services leveraging technical capabilities which may see it earn higher returns on capital and generate free capital.

In response to difficult conditions, Orica is attempting to entice miners onto blasting contracts under terms where Orica takes on all the risk of executing the blast, and where payment is contingent on the success of the blast.

Orica’s chief executive, Ian Smith, recently said: “miners still view explosives as a commodity. If you own the blast, you make more margin. The issue is trying to change the mindset of miners by allowing you to come in, charge a higher price and promise to improve productivity.”

Although these arrangements increase Orica’s risk exposure, the push by the company to de-commoditise its business may unlock future value.

While Orica benefits from its explosives business position and global explosives distribution, there is some uncertainty about whether explosive volumes will lift in the full year – and earnings growth depends on it.

Nevertheless, the long term outlook is positive, underpinned by long-term global demand for resources. Our view of sustainable return on equity (NROE) of 18% below reflects a long-term, through-the-cycle view of Orica’s profitability. We adopt a required return of 13%, reflecting uncertainty to company earnings and moderately high gearing supported by sound cash flows.

Using our adopted metrics we derive an equity multiple of 1.6 times, 2013-14 valuation of $13.28 and 2014-15 valuation of $19.50. Valuation growth at 5% and 8% in each year respectively reflects our view Orica can reinvest a reasonable proportion of earnings at our sustainable ROE.

Figure 4. Orica future value and value metrics

Graph for Waiting for the dust to settle with Orica
Source: StocksInValue

By Jonathan Wilson, Associate Analyst StocksInValue

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