A Mixed Bag, but Macro should beat Micro
Shares of diversified industrial chemicals company Incitec Pivot (ASX:IPL) have proven resilient in the face of a couple of contract losses in the first half of fiscal 2018. This as there has been an improvement in the macro backdrop for its core businesses, seemingly outweighing any company specific (micro) issues. Incitec is also coming off the back of a better financial performance in the financial year ending September 2017.
In FY17, Incitec (ASX:IPL) reported a more than doubling of statutory profit year-on-year and an 8% increase in underlying profit, with earnings surpassing the median analyst estimate. The Board signalled its confidence in the company’s prospects and improved financial health by announcing a share buyback of up to $300 million. In addition, Incitec maintained its pay-out ratio at 50%, resulting in a higher dividend for the full year.
And although the macro backdrop continues to have its challenges, fertiliser prices have picked up in 2018 and the long-term prospects for agricultural customers are positive in our view. The thematic of rising food demand and the need to boost agricultural yields due to the shrinking supply of arable land is supportive
for agricultural product producers. Incitec is investing in new distribution facilities at Port Adelaide to better service rural customers.
DAP (diammonium phosphate) prices have rebounded in early 2018:
Source: Index Mundi
At the same time, the explosives and industrial chemicals businesses should benefit from an improvement in the commodity markets and an increase in infrastructure spending and activity in the United States. The latter has been an area that has been underinvested in for many years and is a main policy thrust for President Donald Trump. New Incitec CEO Ms Jeanne Johns highlighted construction activity in the US as a bright spot, saying at the AGM, “As I recently relocated from the U.S., I saw first-hand that the construction activity was continuing at pace, and this bodes well for our Explosives and our Quarry & Construction business.”
Meanwhile, exploration activity in the commodity markets should continue ramping up, particularly in North America where shale companies are being lured back to more activity on higher oil prices.
A weaker Australian dollar against the greenback (US$) would also be tailwind. The following table shows the estimated sensitivity of Incitec Pivot’s FY17 numbers to a range of commodities and change in the Australian dollar versus the US dollar. As can be seen in the table, DAP prices heavily influence EBIT.
Source: Incitec Pivot (ASX:IPL)
Amid these relative positives, recent contract losses have been a negative and will impact future profits. The company will attempt to mitigate the impact with new business. Another factor weighing on Incitec Pivot and peers is energy pricing uncertainty in Australia.
As discussed in previous coverage of Incitec, this puts’ a cloud over the fate of the company’s Gibson Island plant in Queensland as the current gas contract expires 30 September 2018. If new terms are economically unviable, the plant may be shut down. A closure would sadly result in the loss of hundreds of jobs and hopefully it won’t come to that. In any event, Incitec has already taken a $167 million write-down on the facility and while it would cost about $50 million to close, it was previously estimated the land is likely worth $40 million to $55 million net for the company.
Relevant to the future of the Gibson plant, Incitec partnered with Central Petroleum Limited, one of the preferred bidders for the Queensland Government’s next gas exploration acreage for domestic supply. Incitec Pivot CEO Ms Jeanne Johns said in an update on the gas tender, “We were very pleased to partner with Central in support of its tender application for this tenement. While the economics for the supply of gas on both an interim and longer term basis remain challenging, the award of this acreage to Central Petroleum by the Queensland Government creates a pathway for IPL to work with Central to secure an affordable source of gas for our Gibson Island plant.”
Incitec (ASX:IPL) has a MOU (Memorandum of Understanding) with Central for a period of exclusivity to negotiate commercial arrangements for gas from the new acreage, with the intention some will be used to feed the Gibson Island plant. The company may also provide up to $20 million in funding to support the appraisal and drilling activities to try and prove reserves. Assuming reserves are proved, it is expected that development of this acreage will yield gas from 2022. While that leaves a gap in the timeline for Incitec, the company reportedly has scope for negotiation of at least some interim gas supplies.
Western Australia business updates
More negative for Incitec (ASX:IPL) is the loss of a couple of contracts in Western Australia in the first half of fiscal 2018. The first to be reported by the company was in December 2017, when Incitec was advised by BHP Iron Ore that when its current contract expires on 28 November 2019, Incitec will no longer be BHP Iron Ore’s contracted supplier of ammonium nitrate prill (used for blasting in Iron Ore mining). This is expected to have no financial impact in FY18 and FY19, and a one-off maximum impact on NPAT of roughly $10 million in FY20 and $25 million in FY21. The impact beyond FY21 is expected to be “minimal.”
That was followed not long after (January 2018) by the announcement that Roy Hill Iron Ore would not renew its contract with Incitec. The financial impact from that development is more immediate, as the contract expired on 9 February 2018. The one off impact on NPAT is estimated at $5 million in FY18, $16 million in FY19, $22m in FY20, $18m in FY21, and $20m in FY22, and minimal impact beyond FY22.
Incitec (ASX:IPL) is hoping new commercial arrangements can fill the void from these two contract losses.
Source: Incitec Pivot (ASX:IPL)
To provide some idea of the work that will need to be done to compensate for the contract losses, in Incitec’s FY17 group statutory came in at net profit after tax (NPAT) of $318.7 million.
That was 148.8% or $190.6 million higher than in FY16 when the company recognised $167.1 million in individually material items (IMIs) after tax.
FY17 Underlying NPAT of $318.7 million in FY17 was 8.0% or $23.5 million higher year-on-year.
Summary
Over the past decade, Incitec Pivot (ASX:IPL) has transformed itself from a southern Australian fertiliser company to a global diversified industrial chemicals company.
After countering macro headwinds with operational improvement initiatives (i.e. the Business Excellence (BEx) program), and some solid investments (i.e. Waggaman in the United States), the company is well positioned to benefit from a further recovery in commodity prices and a pick-up in construction activity in the United States.
Several headwinds battered statutory reported earnings in FY16, but earnings bounced back in FY17. Underlying profit also increased due to a record explosives segment performance, the contribution from Waggaman and Business Excellence initiatives.
The Waggaman Louisianna ammonia (WALA) plant delivered 74% of nameplate capacity in FY17 and above nameplate at 108% in September 2017. In FY18 the plant is expected to deliver nameplate capacity, boding well for a robust earnings contribution to the group. Incitec Pivot has been delivering on its business efficiency initiatives. A new CEO will bring a fresh perspective.
Incitec Pivot (ASX:IPL) shares are trading on approximately 16.7 times forecast FY18 earnings, falling to 15.5 times the following year. The projected dividend yield of 3.1% for the current fiscal year is expected to grow to 3.3% the next year.
We continue to rate Incitec Pivot (ASX:IPL) as a buy for Members with no exposure.
Disclosure: Incitec Pivot (ASX:IPL) is held in the Fat Prophets Small & Mid-Cap Model.
