Benjamin Graham, one of the most influential investors in history, once stated that in the short term the stock market operates like a voting machine, with investors casting their ballots in what some might term a popularity contest. In the long run, in Graham’s view, investors eventually get around to “weighing” the true value of a company’s growth prospects and investing accordingly.
Regardless of your point of view, it is hard to deny that in the short term, earnings releases could be likened to election days, when investors express their opinion by buying or selling based on the results. Newcomers might think what drives the price of the stock up or down is positive or negative reported revenues and profit. Most quickly learn that there is more to the reaction to an earnings release than the raw numbers of past performance presented.
We have a stellar case in point in the recent earnings releases of two similar companies, Orica Limited (ORI) and Incitec Pivot Limited (IPL). Although both operate in the Materials Sector providing blasting explosives and related mining services, Incitec also operates in agriculture as a supplier of fertilizers.
Orica describes itself as the world’s biggest supplier of explosives and blasting systems for use in mining, quarrying, oil and gas, and construction. The company also offers mining support systems. While the price of iron ore rallied in early 2016, the boom in mining construction and expansion requiring extensive use of explosives and blasting services is now only a distant memory.
Incitec may be more diversified but the company has also suffered from weakening prices for fertilizers. Orica reported Half Year Results on 8 May with Incitec reporting two days later. Both companies reported revenue declines as well as declines in statutory net profit and underlying net profit. Both had sizable one-offs eating into profit.
Orica’s statutory net profit dropped 33% including a tax settlement. Without the one-off profit dropped 10% and earnings before interest and taxes (EBIT) declined 4%. Revenues were off 9%.
Incitec’s statutory net profit fell a heart-thumping 78.5% due to an asset write down at one of the company’s manufacturing facilities. Without the one-off charge, underlying net profit fell 6.4% while revenue declined 4.4%. Earnings before interest and taxes (EBIT) fell 8.5%.
Compare the two and there appears to be little difference, with Incitec reporting a smaller profit loss but also a larger drop in EBIT. Based on that kind of weak historical performance one would expect the share price of both companies to fall. Indeed the earnings acted as a catalyst for both stocks, but surprisingly in opposite directions. Here is the chart.
Although impossible to speculate with 100% certainty, it appears the investing community’s “votes” in response were influenced by forward looking issues.
First, Orica announced it would cut its dividend payment roughly in half while Incitec not only maintained its dividend but also its 50% payout ratio.
Second, although management of both companies referred to their financial performance as “resilient” in the face of challenging times, Orica cast a very bleak forward-looking picture, cutting its revenue guidance and stating challenging market conditions will remain in the “foreseeable future.”
Incitec management pointed to its positive efforts to deliver approximately $100 million in cash savings in FY 2017. In addition, the company’s US based ammonia plant is expected to complete within budget guidelines and begin producing sometime in the third quarter of this year.
Third, search the Internet for opinions on long-term “mega-trends” and you are not likely to find mining among them. You will find population growth, urbanization, and emerging middle classes, all of which translate to a need for more agriculture and more efficient agriculture. It appears investors ignored the negative numbers and surprised by voting in favor of the stock with the bright growth prospects.
Finally, there is another factor that may have influenced the stark contrast in share price movement post reporting – diversification. Orica may be the world’s biggest, but investors might wonder how they can profit from owning stock in a company operating in one sector, with that sector in decline. Analysts have pointed to a deadly “Achilles Heel” in Orica’s business – the coal industry in the US. While iron ore and oil and gas prices will recover in time, the future of coal is in doubt.
Incitec has an analyst consensus rating of Outperform and has the benefit of operating in a sector with strong long term tail winds – agriculture. As noted, expanding middle classes around the world are looking for healthier foods and more of them and fertilizer is essential to plant growth.
To further make the case for diversification, let’s add another agricultural chemical stock to the discussion – Nufarm Limited (NUF).
Fertilizer makes for healthy plants but offers no protection against invasive weeds, plant diseases, and hungry insects. Nufarm is in the crop protection business, offering products that product plants against weeds, pests, and a variety of plant diseases. In addition, the company operates a specialist seed division.
The following table includes some share price information, historical performance, and future earnings forecasts for the three companies.
It was 2013 when the chatter about the death of the mining boom began to pick up steam. The troubles for Orica shareholders began in earnest around that time. Here is a five year price movement chart for ORI, compared to the ASX 200 and the US DJIA (Dow Jones Industrial Average) over the same period.
Based on total shareholder return, it appears Orica shareholders got little benefit from the mining boom, despite the size and global reach of Orica.
In contrast, Incitec Pivot managed to yield a healthy return to its shareholders over ten years, but the impact of the reduction in mining expansion can be seen in the meager five year returns.
Nufarm has a solid historical record of shareholder return and double digit two year earnings growth forecast. While hard commodities such as coal and iron ore have grabbed the lion’s share of bearish headlines, soft commodities – those that are grown – have also suffered. Despite this, Nufarm reported Full Year 2015 results that showed a 35.5% profit increase and a 4.4% revenue increase.
Nufarm has restructured its operations for greater cost savings and improved margins. However, the real compelling case for this company is the fact its herbicides, fungicides, and insecticides have the potential to increase crop yield per acre, something that is sorely needed in a world with increasing populations and decreasing arable land.