Incitec Pivot (ASX:IPL) shares have struggled over the last 18 months given a mixed performance across its key businesses. This is because of a stretched balance sheet and production challenges at the Company’s ammonia nitrate (AN) plant in the US and a string of profit downgrades.
After the Company announced its results for the six months to 31 March 2020 (1H20) and strengthened its balance sheet via an equity raising, when would it be a good time to invest?
About Incitec Pivot
Incitec Pivot is a globally-diversified industrial chemicals Company and primarily supplies three nitrogen-based products. They are: Explosives, Industrial Chemicals and Fertilisers. These products are supplied to a broad range of end markets. These include Quarry and Construction, Coal and Base 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 America (DNA) and Dyno Nobel Asia Pacific (DNAP)) and Incitec Pivot Fertilisers (IPF). Dyno Nobel holds the number two position in North America and Australia by volume. IPF holds the leading position in Australia by volume.
Key Fundamental Considerations
1. Conditions in Explosives Americas Division Likely to be Tougher Than Expected
The Dyno Nobel Americas business, which accounts for ~60% of Dyno Nobel’s global revenue and EBIT, delivered flat EBIT growth in 1H20. This performance was weaker than expected. This was a result of volume declines in two of the three key end markets for explosives. The key end markets include US Coal, Quarrying & Construction (Q&C) and Base & Precious Metals and the outlook for all three of these end markets over the course of 2H20 and into 1H21 is challenging.
2. Earnings Weakness in Dyno Asia Pacific To Continue
While Dyno Asia Pacific earnings fell 7% in 1H20 due to previously disclosed lost contracts in WA and repriced contracts at IPL’s 365ktpa Moranbah Ammonia Nitrate plant, the decline in earnings was not as bad as initially feared. This factor was due to: i) Strong sales improvements in value-added segments, namely emulsion (+62%) and electronic initiating systems (+14%), as well as ii) Increased production and efficiencies at the Moranbah plant, in line with the Company’s strategy to increased manufacturing reliability across its global ammonia manufacturing platform.
In terms of the earnings outlook, although demand in the Dyno Asia Pacific business for Australian metallurgical coal and iron ore appears to have held up in early 2H20, the net impact from contract renewals is expected to be higher than expected as a result of COVID-19 delays.
3. Exposure to Declining Fertiliser Prices
IPL’s decision to retain its Fertiliser business following a strategic review is symptomatic of the challenges presented by COVID-19. In particular, the underlying earnings volatility for the Fertilisers business was a likely headwind for an attractive sale price. This was given that the Fertilisers business remains towards the bottom of the cycle.
Further weakness in fertiliser prices, in particular Diammonium Phosphate (DAP) and ammonia as a result of excess global supply, underpins earnings pressure for Fertilisers through 2H20 and into FY21. While Fertiliser prices have recovered from their lows following improved seasonal conditions and some shutdown in supply, they are still historically low (and falling). They are also well under the 2-year and 10-year averages. Notably, both the DAP and urea price are near the marginal cost of production. IPL expects further downward pressure on ammonia prices. This is due to softer industrial demand which is being impacted by COVID-19 and low energy prices.
Fertiliser prices are not expected to recover to more normalised levels until FY22. In particular, DAP prices are expected to remain depressed as global DAP markets remain in oversupply.
4. Equity Raising Eases Balance Sheet Pressure
IPL’s decision to undertake a substantial equity raising (at $2.00 per share) was a pre-emptive measure to strengthen the balance sheet. This was in light of the current uncertain environment and support an investment grade credit rating (previously on negative outlook). Importantly, the equity raising alleviates balance sheet concerns. It reduced leverage and substantially boosts available liquidity. There are also no immediate debt expiries.
Given that IPL have suspended the interim dividend and cash conversion is seasonally stronger in 2H20, the gearing level as at 30 June 2020 is expected to be even lower. In turn, this creates flexibility to pursue small-scale bolt on acquisitions.
Although the balance sheet position has improved, we continue to take a cautious view on IPL at these levels for a number of reasons:
i. Uncertainty about the extent/timing of a recovery in Fertiliser prices. It is worth noting that IPL’s share price is correlated to ammonia prices and in turn, ammonia prices and oil prices are generally correlated.
ii. The impact on demand for key end markets in Australian & US explosives are the key concerns over the short-to-medium term.
iii. While the decision to retain the Fertilisers business appears a sensible one in the current climate, the inherent challenges that led to IPL undertaking a review remain. That is, the volatility in earnings and the constraints on IPL devoting capital to the Explosives segment, which has a more stable earnings profile compared to Fertilisers and where IPL’s investment in technology is mostly targeted. Accordingly, the market appears to be ascribing little value to the Fertilisers business, especially given that it is currently at a low point in the earnings cycle due to depressed (and falling) Fertiliser prices.
iv. The recent history of profit downgrades; where the Company issued about six negative trading updates in FY19.
Incitec Pivot has lagged the rest of the market during the last month. It has tried to recover on a few occasions, but the overall picture still looks weak. Unless it can push beyond the April high near $2.40, we will probably see IPL drift lower and retest the March low near $1.60. If it can successfully bounce off that level, then that would be a good buying opportunity.
Michael Gable is managing director of Fairmont Equities.
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