BUY HOLD SELL – Orica (ASX: ORI)
Orica (ORI) is a business tied to the resources boom and make no mistake, we are in the midst of one. The decarbonisation and electrification of the world coincidently requires a lot of stuff to be dug out of the ground. Orica’s main operations facilitate part of that process by providing explosives to the mining industry. Orica claims the title of the world’s largest provider of explosives. Half-year results in mid-May showed an underlying profit, revenue and dividend all ahead of expectations. A positive overtone also flowed from the outlook statement with management noting that a stronger performance is expected to continue into the second half of the financial year. The small caveat was that performance was subject to market conditions, meaning commodity prices need to hold up and higher gas costs are not helping. They are the biggest cost in producing ammonium nitrate (AN), a key ingredient in explosives. Sanjeev Gandhi the new CEO back in May said “Steady commodity growth, particularly in gold, copper, quarry and construction in H2 will continue to drive demand for our products and services.” Gandhi also reaffirmed performance expectations despite the exit from its operations in Russia which cost the company $80m, plus restructuring costs. Orica has a well-diversified business in terms of geography, almost half of its revenue comes from Australia and Indonesia, around one quarter from North America and the balance from Latin America, Europe, Africa and Asia. In terms of commodities, copper and gold are its biggest revenue drivers, followed by coal then iron ore. The obvious conclusion you could draw from that breakdown is that if the gold and copper prices fall over, so too will the demand for its services. The good news for ORI is that the gold price and copper price are both holding up (commodities like inflation) although technically they have peaked and fear of a recession will not help commodity prices. Orica's Australian explosives market share is estimated at 55%-60%, with the remainder largely held by peer Incitec Pivot (IPL). 55% of Orica’s revenue is derived from what it calls Bulk Emulsion and AN/ANFO which are fancy ways of saying explosives. One benefit of being in the explosives industry at the moment is that the intensity of explosives and chemicals used in mining is increasing. This is because ore grades are falling and strip ratios (the amount of waste that must be removed to release a quantity of ore) are rising. The main point is that miners need more "bang" for their buck.
The Ammonium Nitrate (AN) market has found itself in a perfect storm as demand for explosives spikes as rising commodity prices combines with a fertilizer supply shock flowing from the Ukraine war. The AN price has eased from the highs at the start of the year and steadied at a key support of ~600 Euro/mt. An interesting point brought up in the half-year results was that Orica doesn’t really get much of a margin benefit from higher prices given it produces AN but also goes to the market to purchase supplies to make explosives. Main observations
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- ROE of 10.5% is OK - Anything over 15% is typically considered as excellent. Incitec Pivot (IPL) sits on 19%.
- EPS growth is expected to outpace revenue growth for the foreseeable future but there is a hiccup expected next year due to slowing global economic growth.
- A PE of 22.7x is a little pricy but it is expected to fall as earnings improve. IPL sits on a PE 6.5x.
- ORI has a gross yield of 2.1% which is below the market average.
- The clear winner on a fundamental basis is IPL.
- Sustainable overhead cost reductions, net of inflation.
- Continued focus on future-facing commodities which is what a large portion of the Australia Pacific and Latin America mining pipeline is focused on.
- Improved product mix as customers shift to premium products.
- Quarry and construction markets in the US are seeing growth, supported by the US infrastructure bill.
- Progress on last year’s transformation strategy sets a pathway towards profitable growth and value creation.
- Signed deals in Australia to explore the feasibility of green hydrogen and green ammonia production hubs.
- Slowing global growth is the major concern. In the half-year presentation ORI noted volume growth was tied to economic growth. The implication is that when economic growth slows, which it is expected to in the next year, so too will demand for its services.
- ORI is a cyclical stock and we are at the top of the economic cycle.
- Past chemical spills have damaged the company’s reputation. Future spills and contamination would damage the share price and reputation further.
- The biggest cost of producing ammonium nitrate is the cost of gas which is very expensive. Higher gas prices have a direct impact on the cost of goods sold.
- Currency risks also bubble away as it operates in so many geographies.