Things are Picking Up
Shares of Incitec Pivot (ASX:IPL) have staged a solid recovery from 52-week lows in recent months. The backdrop for end markets is improving in our view, with inflationary pressures likely to continue flowing through to commodity prices. In addition, following the reporting of interim results, Incitec Pivot reported a contract win in West Australia that will mitigate the earlier loss of two other contracts. The company also inked a deal for gas supply to the Gibson Island plant. Although this will see costs go up, the change was in line with management’s earlier guidance.
Gibson Island Update
In June, Incitec Pivot and Central Petroleum Limited announced that, consistent with an earlier announcement, they had signed agreements for an interim gas supply to the Incitec Pivot Gibson Island facility in Queensland from the commencement of commercial operations on the Northern Gas Pipeline (currently anticipated to be from December 2018) until 31 December 2019. The new gas agreements will increase manufacturing costs by about $50 million in FY19, in line with previous guidance.
Incitec (ASX:IPL) is continuing to look at options for sourcing gas to the plant for the calendar years 2020 and 2021. Incitec Managing Director & CEO Jeanne Johns said that “while the finalisation of the interim gas agreements is a significant step, it is just one of several in our ongoing efforts to secure future operations at Gibson Island.”
As discussed in our prior coverage of Incitec, the company is also working with Central Petroleum to develop gas acreage in Queensland. The joint venture has a commitment to spend up to $20 million on drilling and appraisal works expected to be completed in calendar 2019. If sufficient reserves are proven, it is likely the acreage will begin producing gas from 2022 and supply some of Gibson Island’s needs.
Spectre of Inflation
We believe President Trump’s ‘America First’ agenda, along with other factors such as tighter job markets around the globe are raising the spectre of inflation, which will see upward pressure on various base and precious metals prices. Indeed, we have already seen this in recent weeks and months. This should result in increased demand from explosives customers in upcoming quarters.
In addition, fertilizer prices have been trading at or near cyclical lows and there are signs of stronger prices on the horizon. The likes of DAP (diammonium phosphate) prices have already been on an upward path in 2018, in a tighter supply and demand environment.
Source: Incitec Pivot (ASX:IPL) September 2018 Investor Day presentation
As can be seen in the table below, Incitec’s fertilizer business earnings are sensitive to commodity price changes, along with foreign exchange rates. A weaker Australian dollar is positive for the translation of US$ earnings when the greenback rises.
Source: Incitec Pivot (ASX:IPL)
Looking ahead and cash flows are expected to increase across the group due to improved business returns. This combined with reduced capital expenditure needs due to several completed major projects such as Waggaman, along with the near completion of previously announced capital return initiatives should see free cash flows to the group increase going forward and these will be allocated to debt reduction and/or new growth projects.
Source: Incitec Pivot (ASX:IPL) September 2018 Investor Day presentation
At the end of August, the company had repurchased approximately $200 million worth of shares and is targeting completion of the $300 million share buy-back as “soon as practicable.” The dividend policy is expected to remain stable at a 30% to 60% pay-out ratio. We have no concerns around the balance sheet, with the net debt to EBITDA ratio at 2.2 times at the end of March 2018.
1H18 recap
Recapping the first half result briefly and group revenue increased 9.6% year-on-year to $1,683.2 million. All businesses contributed to the increase, with Dyno Nobel Americas (DNA) revenue leading the way with a 14.7% increase in Australian dollar terms to $677.8 million. The Fertilisers business was the second largest contributor and revenue ticked up 5.2% to $557.1 million, while Dyno Nobel Asia Pacific chipped in $479.1 million, up 7.7%. The negative contribution to group revenue from the Elimination and Corporate line increased 4.1% to $30.8 million in 1H18.
There was strong demand in the US and Australian explosives markets, but the fertiliser business was impacted by dry weather across eastern Australia.
Group EBIT (earnings before interest and tax) excluding IMIs (individually material items) decreased $2.5 million, or 1.0% year-on-year to $240.3 million.
Commodity prices, plant efficiencies at the Moranbah and Waggaman operations were positive factors, while foreign exchange movements and some maintenance were negative factors. The following table outlines the impact these key factors had on EBIT excluding IMIs.
Source: Incitec Pivot (ASX:IPL)
Net profit after tax (NPAT) excluding IMIs of $147.1 million represented a 3.3% decline from a year earlier. Statutory NPAT for 1H18 came in at just $7.6 million compared to $152.1 million in 1H17. The sharp drop was due to net individually material items expense of $139.5 million. That represented a non-cash write-down of $236 million on the goodwill of the DNAP business after the company lost contracts from BHP and Roy Hill and other factors, partially offset by one-off non-cash benefit of $96.5 million from the restatement of the US deferred tax liabilities.
Turning to the daily chart and the technical outlook has improved with resistance at $3.63 surmounted again in July. This could now act as support and a foundation for a push higher. A bullish moving average crossover (where the 50 day (green line) crosses above the 200 day (red line) moving average) developed last month and adds to the positive charting outlook.
Regarding the monthly chart, support was respected at the $2.66 region in September 2016 as marked by the horizontal blue line. This key confluent level of support has managed to also offer a firm floor previously in May and October 2014. In-turn, a healthy and progressive recovery in share price has since followed. At present, upward momentum remains intact, and for this reason, the probability swings towards further upside aimed at the 78.6% Fibonacci retracement of $4.03 (red set of retracements). Looking ahead, if prices were to close (on a monthly-basis) above the 78.6% Fibonacci retracement of $4.03, then two additional broader upside targets would then be triggered. The initial target is seen at the 127.2% Fibonacci extension of $4.87, followed by the 161.8% Fibonacci extension of $5.48.
Summary
The statutory 1H18 results were marred by a non-cash write-down of the Dyno Nobel Asia Pacific business. Shares of Incitec Pivot have however staged a recovery in recent months as the company reported a contract win in West Australia that will mitigate the earlier loss of two other contracts. We also view the prospects for its end markets as picking up.
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), the company is well positioned to benefit from a further recovery in commodity prices. The Waggaman Louisiana ammonia (WALA) plant delivered above nameplate capacity in 1H18 and should continue to make a solid contribution to the group.
Incitec Pivot (ASX:IPL) is trading on circa 19.1 times forecast earnings for the financial year ending this month, while the projected dividend yield is 2.6%, expanding to 3%.
With a robust outlook for the international explosives business and an improving supply and demand balance in the fertilizer market we recommend the shares as a buy for Members without exposure.
Disclosure: Incitec Pivot (ASX:IPL) is held in the Fat Prophets Concentrated Australian and Small & Mid-Cap Models.
