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Stock: Incitec Pivot Ltd

Code: IPL

Market Cap: $3.8 bn

Recommendation: ‘None’

As Incitec Pivot shares soared from 66c in 2005 to last year’s highs of $8.90, few would have thought that fertiliser could smell so good. But a combination of falling fertiliser prices, a large, top of the market acquisition, and concerns about its debt levels, have subsequently triggered a dramatic fall from grace to current levels around $2.50. Attracted to its historic upward tendencies, many bottom fishing investors are no doubt wondering whether the stock will once again emit a pleasant whiff in years to come?

Before considering the company’s future, it’s worth taking a closer look at its past, particularly what drove the stock’s meteoric rise from 2006-2008. The story begins with Orica (ASX: ORI). Around the turn of the millennium, this diversified industrial had fallen out of favour with the market. The ‘dot com revolution’ was in full swing and Orica’s ‘old industry’ businesses which varied from chemicals, paints, explosives, fertilsers and plastics, were experiencing malignant demand. Costs were blowing out, weakening cash flows and stressing the balance sheet. With its share price flailing 70% below its peak, action was taken in 2001, when Malcolm Broomhead was appointed to head a ‘clean up’ of the company as new Managing Director. And so a major restructuring program began, one of the targets of which was the company’s majority (77%) stake in Incitec, Australia’s leading fertiliser producer.  

Operating within an inefficient, cyclical industry, the Incitec fertiliser business wasn’t part of Orica’s growth strategy, which was focussed on explosives. And so in 2003 the business was merged with fellow fertiliser producer, Pivot, before being ‘spun off’ as a separate listed company. Orica maintained a 70% stake in the newly formed Incitec Pivot (IPL), which remained a relatively obscure, thinly traded stock during its first few years of life. On one front, IPL’s newly found scale was generating cost synergies, but on the other it was still battling the impact of the drought on its mostly eastern seaboard farming customer base.

Who would have known a tsunami was lurking on the horizon that would push the stock up 10 fold through to 2008? Merger synergies laid the foundations for this rise, revolutionising what was previously an old, inefficient industry. Production costs were brought down even further following the acquisition of BHP’s fertiliser business, Southern Cross Fertilisers (SCF) in 2006. SCF was the largest domestic producer of ammonium fertilisers. These consolidation manoeuvres couldn’t have come at a better time, particularly the SCF deal. Fertiliser prices were about to shoot through the roof, and with an increased production profile and a lean mean cost base, IPL was positioned to reap maximum rewards. Diammonium Phosphate and Urea, key fertiliser benchmarks, increased 2-3 fold from 2006-08. Positioned as the only domestic producer of Diammonium Phosphate (DAP) after the Southern Cross acquisition, the pricing strength was good news for IPL. During the period, earnings per share increased from 4c to 51c, underpinning the meteoric rise in its share price.

Orica’s vision of consolidating the fertiliser sector had finally delivered….or had it? Unfortunately by the time IPL took off, Orica was no longer around to share in the spoils. It had sold down its 70% stake in IPL earlier in the year, booking a profit, but incurring huge opportunity cost. Orica’s sell down provided another, albeit less powerful, share price catalyst. It had opened up enough liquidity for institutional funds to buy into the stock.

So with the share register open to ‘smart money’ for the first time, an unprecedented rise in product prices, and the benefits of a once in a generation industry drive towards economies of scale flowing through – IPL rose to glory. Near its peak, the company took advantage of it valuable scrip to launch a take over for explosives business, Dyno Nobel.  

However with the takeover falling at the top of the mining cycle, the stock’s subsequent fall from grace has been as equally stunning as its rise. Although the potential for cost savings by combining the businesses is significant, the debt taken on board to fund the deal has dominated sentiment. So as opposed to 2006, where IPL was about to reap massive rewards from the bottom of the cycle acquisition of Southern Cross, the company is now in a rush to maximise merger synergies to simply justify the Dyno purchase. Recent reports suggest the integration is going smoothly, but whether the synergies are enough to rival the economies of scale benefits from earlier years remains to be seen.  

The other key variables that drove the stock into the stratosphere – fertiliser prices – are now back to pre boom levels. Earnings in the fertiliser business have fallen accordingly, down 38% to $75m in the last half year, reminding investors that the business remains cyclical despite improvements on the cost side. So where to from here? Consolidation has yielded the company a very strategic position in the global fertiliser industry. However in forecasting future growth, the ‘one off’ factors which drove the stock’s previous meteoric rise require discounting. Fertiliser prices remain the unaccounted variable. The rise in DAP prices from a decade long range of $US150-250/tonne to last years peak of $US1225/tonne was unprecedented. Prices are now back to pre boom levels, but have yet to settle. Should we be banking on a return towards ‘boom town’ pricing when the economy recovers? Let the crystal ball gazing begin. As what ever trend (or there lack of) stgelops, IPL’s earnings leverage is likely to remain, which carries both up and downside risks.    

Tim Morris is an analyst at wise-owl.com, one of Australia’s leading independent stockmarket research houses. Click here for your complimentary report.

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