We recently researched Incitec Pivot (ASX:IPL) in The Dynamic Investor to assess whether weakness in the shares back to yearly lows presented an opportunity. Uncertainty about both the timing of a planned demerger and a potential asset sale have weighed on investor sentiment. But is the underlying business performing well enough to potentially offset these concerns and, at current levels, is the risk/reward better balanced?
Overview of Incitec Pivot
Incitec Pivot is a globally diversified industrial chemicals company. It primarily supplies three nitrogen-based products: Explosives, Industrial Chemicals and Fertilisers. These products are supplied to a broad range of end markets. These include Quarry and Construction (Q&C), Coal and Base & Precious Metals (for Explosives), industrial and specialty chemicals (for Industrial Chemicals), and agriculture (for Fertilisers).
The Company’s businesses comprise two international brands: Dyno Nobel (which include Dyno Nobel North Americas (DNA) and Dyno Nobel Asia Pacific (DNAP)) and Incitec Pivot Fertilisers (IPF). The Dyno Nobel Americas and Dyno Nobel Asia Pacific business comprise four ammonium nitrate manufacturing facilities and five long-term ammonium nitrate storage facilities, 13 initiating systems manufacturing sites, and 23 emulsion manufacturing facilities.
The IPF business encompasses two core businesses: Manufacturing and Distribution. The Manufacturing business predominantly represents the core Phosphate Hill asset, which manufacture Monoammonium phosphate (MAP) and Di-ammonium Phosphate (DAP). The Distribution business operates the largest East Coast fertiliser distribution business.
Key Fundamental Drivers
Explosives Business Lagging Main Competitor – But is There Scope for Improvement?
In FY22, the DNA and DNAP Explosives businesses appeared to suffer in comparison with its main competitor Orica (ASX: ORI). Costs provided a meaningful impost for both companies, however ORI appeared to have better success in offsetting this. Having said that, Dyno America’s explosives EBIT margin of 11.5% (FY22) remains above the 8.4% reported by ORI for its North American division, whilst Dyno Asia Pacific (13.5%) is the same as ORI’s Aust Pacific division.
EBIT for DNA declined by 13% as cost inflation pressures outpaced customer price pass-throughs. However, 2H22 EBIT declined by 30%, as inflationary cost pressures, higher energy costs and supply chain interruptions offset the customer price pass-throughs to an even greater degree.
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These cost issues are expected to be “largely recovered in FY23” with more focused cost recovery, This should underpin a decent rebound in DNA earnings for year ahead. DNA is also expected to benefit from further growth in Quarry & Construction (Q&C) volumes, which is expected to be driven by a continued recovery in residential and infrastructure investment. Further, IPL also won new customers and expects continued growth from its technology offering, especially following the acquisition of Titanobel in April 2022.
Demerger Plans Contingent on Potential Asset Sale
In May 2022, IPL announced its intention to de-merge its fertilisers and explosives businesses to create two separately-listed companies on the ASX. At the Company’s FY22 results release in November 2022, IPL announced its intention to delay the demerger by 6-12 months to facilitate a strategic review of the Waggaman asset (an 800Ktpa gas ammonia facility in Louisiana US). The decision to delay the demerger was due to the Company receiving several unsolicited bids for the Waggaman asset.
Another reason as to why IPL is assessing a potential sale is that global nitrogen markets have shown higher prices over 2021/22 as a result of supply tightness and elevated natural gas prices, particularly in Eastern Europe. This has led to elevated earnings for US-based ammonia producers, including Waggaman. As at November 2022, gas prices were expected to stay higher for longer, with European gas futures at the time pointing to a continuation of supportive prices into 2024. However, this position has changed more recently, with European and US natural gas prices falling sharply in recent months. European gas prices have more than halved since end of September to US$18/mmbtu on a warmer-than-expected winter and better LNG supply.
In terms of the potential net proceeds from a potential sale, IPL has noted that the tax base for the Waggaman asset is very low and that the current estimated replacement cost is over US$1.5b. The upside to the estimated sale proceeds is likely to come from: i) Cost advantaged position on the global cost curve, ii) Potential for blue ammonia production (Waggaman has one of the lowest emission profiles) and iii) Increasing replacement cost dynamics in the US that support the valuation.
Further Capital Management Potential in the Event of an Asset Sale
Gearing as at 30 September 2022 is well below the Company’s target range of 1.0x – 1.5x. This has allowed the Company to announce a $400m share buyback as well as still having optionality for further capital management. It is worth noting that the share buyback has not yet commenced, in light of the ongoing review/sale process for the Waggaman asset.
A sale of the Waggaman asset would facilitate even further capital management. Given that IPL has limited franking availability, it is likely that further capital management will entail additional share buybacks, which may be accompanied by a return of capital to shareholders.
While Incitec Pivot shares are currently trading on a 1-year forward P/E multiple (~9x) that is well below the average multiple over the last two years of ~12.5x, we outline several factors limiting a meaningful recovery:
i. Historically, IPL’s share price performance has had a strong correlation with ammonia prices. To this end, the significant drop in European gas prices is likely to place further pressure on the contract price for Tampa ammonia.
ii. Fertiliser prices have begun to ease, with urea and DAP prices as at December 2022 down by around 44% and 34% from their peaks, to around US$520/t and US$625/t, respectively. As such, fertiliser prices are expected to provide even lesser of a tailwind in FY23.
iii. An update on the strategic review of the Waggaman asset is expected at, or prior to, the interim results release in May. While it is possible that the Company may have made meaningful progress on one of the several non-binding unsolicited approaches from external parties. Accordingly, it would be unwise to assume that a sale of Waggaman is imminent – given that European and US natural gas prices have fallen sharply in recent months. This is a significant shift from expectations at the time the strategic review was announced for gas prices to stay higher for longer.
In turn, this would further delay additional capital management initiatives (a key share price catalyst) that would follow receipt of proceeds from the sale of Waggaman.
IPL remains in a large trading range. At the moment it is near the lower end of that range and it looks like heading back to about $3.20 in the short-term. A break under $3.20 would be a negative sign as that could lead it towards lower levels.
Michael Gable is managing director of Fairmont Equities.
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