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In last week’s Broker Buys for the Week feature on TheBull we saw Australian mining services and chemicals provider Orica Limited (ORI) make the list, courtesy of financial analysts at Macquarie Brokerage.

Analyst coverage data provided by Reuters shows that most analysts agree with the brokers at Macquarie.  Five analysts have a Strong Buy Recommendation for shares of Orica; 6 have a Buy Recommendation; and 4 have a Hold Rating.  No analysts see ORI as underperforming and none have placed a Sell Recommendation on the shares.  

Orica Limited is one of the world’s largest suppliers of explosives to the mining industry.  While they still operate in the Chemicals market, they have recently shed some of their consumer-oriented chemical and fertilizer operations to concentrate on expanding their product and service offerings to the continuing mining boom.

This continues the trend they began a few years ago when they expanded the range of products and services they market to the miners by acquiring mining services provider Minova, a supplier of drilling and exploration equipment.  

The company is organised into three business units:

1.    Mining Sector

2.    Minova

3.    Chemicals

The share market of late has been engulfed in a wall of global worries.  Despite this fact, most experts see a continuation of China’s economic growth, albeit at a more modest pace.  While there are those who predict the “sky is falling” and Australia will disappear from the face of the earth as Chinese growth grinds to a halt, the general consensus appears to be that the resources boom here in Australia will continue for at least several more decades.  Some point out even if China runs out of economic fuel, India is right behind her.  Either way, Australians should fare well.

Mining giants like BHP and RIO are making substantial investments to increase production and distribution capabilities.  If you believe in the maxim that a rising tide lifts all boats, you have to ask yourself if ORI is really worthy of 11 Buy or Strong Buy Recommendations from an analyst community enamored with the Australian mining boom.

To begin researching that question, let us look at some market valuation ratios for ORI to see how actual share market participants view the shares:

Market Valuation Ratios

 ORIASXXMJ
P/E13.2112.312.29
P/B2.791.511.47
P/S1.411.9523.81
P/EG4.261.09.67

 

The only striking number here is the outsized P/EG Ratio for ORI.  When you couple a 4.26 P/EG – which is substantially higher than the ASX and the XMJ – with the slightly larger P/E Ratio, you get the hint that these shares might be overvalued.

However, as you know it is actual share price performance that returns a profit to investors so let us now look at a 1 year share price movement chart comparing the price performance of ORI against the overall Materials Sector – the XMJ:

#FOTO:1302:400#

Although the shares of ORI generally moved in parallel with the overall Materials Sector (XMJ) the Sector outperformed ORI over the course of the year.

At this point it would appear that something is going on here that keeps Orica Limited’s share appreciation from matching the high opinion of the analyst community.

ORI does not report annual results till 30 September, 2011.  For that reason, we will look at some half-year results reported in May by division rather than looking even further back to the 2010 annual report.

Half-Year over Half-Year Comparison

In this table we will compare sales revenues and earnings before interest and taxes (EBIT) for each of Orica’s three operating business segments.  The comparison is for the half-year in 2011 against the half-year in 2010.

 Mining Services
2011/2010
%
Change
Minova
2011/2010
%
Change
Chemicals
2011/2010
%
Change
Revenue $Am1,825/1,661+10411/395+4749/711+5
EBIT $Am335/331+155.4/66.1-1695/94+1

 

While these numbers only represent 6 months of operations and were impacted by weather conditions in some of their facilities, it is hard to look at this kind of performance and explain why so many analysts are so high on this company.

There is probably a good explanation for why their largest business segment – Mining Services – only managed to turn a 10% increase in revenue into a 1% increase in earnings before interest and taxes.  The same could be said for the Chemicals business segment.

The most puzzling results come from Minova.  How does a 4% increase in revenue translate into a 16% decline in earnings before interest and taxes?

The answers could be found in further analysis of the company’s financial statements and the management discussion of operating results.  Considering the number of other companies in the resources and materials sector, it seems hardly worth the effort.  While some investors might be willing to dig deeper and find some other rays of light here, a recent chemical leak at one of Orica’s facilities should be cause for concern to all investors.

Perhaps you have seen the news.  In August the company reported a leak of hexavelent chromium from its Koomerang Island facility.  This chemical is potentially carcinogenic to humans.

Less than one month later, the company reported another problem from the same facility – a discharge of over 1 million litres of an effluent laden with arsenic into the Hunter River.  The company is continuing with efforts to contain the arsenic leak.

To complete the trifecta, Australian Mining reported the company has been unsuccessful in its efforts to clean up toxic mercury at its site in Botany Bay and has suspended operations at that site.

Finally, Orica had received approval for a major expansion of the Koomerang Island facility and later filed modification plans to the original request.  Concerned local residents are asking that the expansion be stopped and government agencies are reviewing the matter.

Even those who believe in Orica’s future might we well advised to consider keeping their powder dry until these recent environmental issues are resolved.

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Please note that TheBull.com.au simply publishes broker recommendations on this page. The publication of these recommendations does not in any way constitute a recommendation on the part of TheBull.com.au.You should seek professional advice before making any investment decisions.