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Morningstar | Orica Meets Fiscal 2018 Expectations in What we Anticipate Is the Earnings Nadir. No Change to FVE.

We make no change to our AUD 16.50 fair value estimate for no-moat Orica, predicated on material margin expansion due to mix shift and cost efficiencies. EBITDA expansion in the second half of fiscal 2018 highlights this potential and we expect there is more to come. Underlying fiscal 2018 NPAT fell 16% to AUD 324 million, in line with our forecast. This excludes AUD 372 million in exceptional items after tax, comprising AUD 204 million Minova impairment, AUD 80 million Botany environmental provision, and AUD 48 million U.S. tax write-down, among others. The AUD 51.5 cent unfranked payout was only slightly below our AUD 52.5 cent target on a modestly lower payout ratio of 60%.

We make no change to long-term assumptions, nor to our AUD 418 million underlying fiscal 2019 earnings forecast. Orica anticipates continued ammonium nitrate, or AN, volume growth from Australia Pacific, with Bontang plant expansion due to stronger demand, and despite expected delays from the Burrup plant to first half 2020. We agree with the timing and with growth expectations. North American and EMEA volumes are anticipated to grow into fiscal 2019 with further penetration of technology-based productivity solutions driving higher margins. The Minova turnaround is also starting to deliver benefits with overhead reductions to flow into fiscal 2019.

Orica shares are down 15% from AUD 21 highs of a year ago, but at AUD 17.70 still trade marginally above our assessed fair value. The current price offers a none too enticing 3.3% unfranked fiscal 2019 yield, but with an attractive outlook of 8.4% five-year EBITDA CAGR, reflecting our expectations for improving margins on AN sales. Our fair value estimate equates to a fiscal 2023 EV/EBITDA of 6.7, a price/earnings of 11.9 and a dividend yield of 4.2%, all discounted at WACC. In nominal terms, the fiscal 2023 PE and yield improve to 7.6 and 6.6%, respectively.

We credit Orica growing revenue at just 2% per year to AUD 5.9 billion by fiscal 2023, only 10% ahead of fiscal 2018 levels. We assume a midcycle AN price of AUD 1,425 per tonne (2023 dollars), little changed from fiscal 2018, reflecting oil prices trending lower to Morningstar’s USD 60 per barrel long-term forecast and Henry Hub gas prices to USD 3.00 per mmBtu. But we anticipate strong EBITDA margin improvement to 22% from fiscal 2018’s 16.4%, anticipating scale benefits, cost-outs with restructuring and mix shift. As a proportion of total AN volumes, in just five years higher margin emulsion has increased as a percentage of total AN tonnage to 62% in second half fiscal 2018 from 54% in first half fiscal 2013. Longer term we think there will be further operational improvement and forecast EBITDA growth to AUD 1.3 billion by fiscal 2023, 50% above what we expect was fiscal 2018’s AUD 885 million nadir. Orica has made changes to the manufacturing team and is anticipating better performance, as do we.
Second-half EBITDA improved by one-third on the first half to AUD 506 million enjoying the first material half-yearly increase in AN pricing in more than two years. Second half underlying EBITDA margin improved to 17.7% from 14.9%. Volumes improved, particularly in the Australia Pacific region which accounts for the largest 44% of group tonnage, ahead of North America at 28%. But there was also mix/margin improvement including benefits from new contracts and improving higher margin emulsion share, particularly from North America. Total fiscal 2018 AN product volumes increased by 5% to 3.82 million tonnes.
Net operating cash flow increased by 32% to AUD 613 million. Despite this, net debt increased by 14% to AUD 1.65 billion reflecting acquisition of GroundProbe, increased Burrup shareholding and unfavourable foreign exchange translation. At 35.7%, gearing remains at the low end of Orica’s 35%-45% target range, and we anticipate net debt/EBITDA to fall from an already nononerous 1.9 to 1.0 by as soon as fiscal 2020 all else being equal. This could leave room for capital management though the lack of franking credits discounts the potential for off-market buybacks.