Investor focus for Orica has shifted dramatically in the last few weeks. The economic implications from the coronavirus (COVID-19) outbreak have challenged previous expectations for: i) Higher ammonium nitrate (AN) volume growth in FY20, ii) Margin recovery to continue, iii) The recent acquisition of Exsa to improve the performance of the Latin America segment and iv) ORI to use its balance sheet to pursue further acquisitions and/or growth initiatives.
In this note, we examine the earnings growth and the balance sheet implications from potentially weaker global growth/commodity prices and mine shutdowns.
Orica (ASX:ORI) is the world’s largest supplier of commercial explosives and related services. The Company manufactures and supplies commercial explosives, initiation systems and blast services to the mining, quarrying, and construction industries. ORI is one of the world’s leading suppliers of sodium cyanide and has a sizeable position in the ground support sector for both construction and underground mining.
Earnings are highly leveraged to volumes for AN, which is determined by the level of demand for mining activity, as well as AN pricing. Key operating segments include: Australia Pacific and Asia (APA), North America, Europe, Middle East & Africa (EMEA) and Latin America. The APA segment is the main contributor to group earnings and AN volumes. In Australia, ORI is estimated to have a market share of 55-60% In explosives, with the majority of the remaining share held by Incitec Pivot.
Risks to Volume Growth Emerging
At the FY19 results release in November, the Company provided guidance for AN volumes in FY20 to increase by 5%. This growth was expected to be driven by strong demand from the APA (including the ramp-up of volumes from the Burrup plant), North America and EMEA segments.
More recently, Peru, Argentina, and South Africa have imposed quarantines/lockdowns, resulting in suspension of mine operations. Further, there have been stoppages in Canada. While disruptions are not widespread at this stage, the situation is developing and presents uncertainty in light of the fact that the number of new COVID-19 cases continues to expand. As such, AN volume growth is expected to be affected. However, it is worth noting that that there is some protection from take-or-pay contracts. In particular, a meaningful portion of ORI’s sales are contracted on a take-or-pay basis, while other volumes can be deferred in line with production.
Implications for Earnings Growth
More broadly, a slowdown in global growth and potential deterioration in commodity prices may result in the deferral of mine expansion projects. This presents a risk to ORI’s medium- to longer-term growth. In addition to temporary mine closures/deferrals, there are other factors relating to COVID-19 and seasonality that may impact earnings near term. In particular:
i. Recent heavy rainfall on the East Coast of Australia has caused slowdown in production at some mines, which may result in the loss of some tonnes in 1H20.
ii. There may be delays to the rollout of business improvement/ERP projects. These have been important from the viewpoint that margin recovery was expected to continue into FY20/21. This is due to ORI’s compelling technology offering, contract wins, cost efficiencies, and manufacturing efficiencies. These factors, especially technology, acted as an offset to ongoing pricing pressure across all segments.
iii. Logistics costs may increase, as many companies have flagged rising transport costs as a result of switching to airfreight out of China. ORI operates two initiating systems plants in China.
iv. Further delays to the start-up of the Burrup plant in WA is likely, given current workplace restrictions. In mid-February, ORI advised that the start-up of the Burrup plant, which had been expected to provide a positive EBIT contribution from 2H20 onwards, has been delayed from the beginning to the end of April 2020.
Is the Balance Sheet Holding up?
Net debt has declined over the last four years from $2.0b to $1.6b as at 30 September 2019, which represents a gearing level of 35%. Gearing in 1H20 was expected to increase, given the higher levels of working capital associated with Burrup as well as a ramp-up in SAP expenditure.
Overall, gearing is expected to be at the upper end of ORI’s target range of 30-40%, but remains well below covenants (57%). Further, refinancing risk is minimal. The next major refinancing is a A$500m US private placement due in FY21. ORI has access to $3b in committed bank facilities, of which $1.5b is undrawn.
While the balance sheet remains reasonably solid in the context of potential COVID-19 impacts, the potential impact on earnings growth may curtail ORI’s pursuit of further acquisitions and/or growth initiatives. Pre COVID-19, the latter was expected to support the earnings growth profile over the medium- to long-term.
ORI is currently trading on a 1-year forward P/E multiple of ~14x. While this places the shares in value territory, given that the current multiple is well below the 2-year average of 18.5x, we contend that the weaker outlook for global growth and commodity prices (which impacts AN volumes) is likely to result is further downward revisions to earnings and/or a downgrade to Company guidance. Therefore ORI may well get cheaper at some stage.
ORI is bouncing off the lows, like many other stocks on the market. In terms of risk/reward, we can see resistance nearby at around $19.30, but support is back at the recent lows of $13.25. Ideally we want to see the support level close by and the resistance level much higher up. Therefore, any dip in the ORI share price which sees it holding above $13.25 would provide a better entry point from a risk/reward point of view.
Michael Gable is managing director of Fairmont Equities.
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