Analysis of Orica: Acquisition Opportunity
The memo is aimed at evaluation of Orica as a potential acquisition option for entering the Asian market. It will be examined in terms of financial strengths as a separate entity as well as in relation to economic and political risks. The memo will also provide a conclusion on the attractiveness of the corporation as a merger candidate for interested parties.
With over 140 years of history and headquarters located in East Melbourne, Vic, Australia, the corporation is among the largest companies traded on the Australian Stock Exchange (”History”, 2015). After a series of successful mergers and acquisitions started in 1998, today the group employs about fourteen thousand people and conducts operations in over fifty countries worldwide. More than 370 million of the corporation’s shares are traded at above 20 Australian Dollars (AUD; approx. 16 USD) and provide the group with over AUD 7.5 billion of market capitalization (Australian Stock Exchange, 2015). Moreover, shares of the group are included in the S&P/ASX 200 Materials Index that indicates strong position of Orica in the global financial market.
Orica is the global leader in producing mining chemicals (mainly, blasting equipment and explosives) and providing related mining services in construction and infrastructure development sectors. It also manufactures general chemicals (cosmetics and food markets), offers ground support, and heads the list of sodium cyanide suppliers which is a specific chemical needed for the gold extraction process (”About Us”, 2015).
Segment analysis of Orica shows that most of the group’s revenues in 2014 and 2013 were provided by mining services with nearly one-third of them was earned in Australia/Pacific. Other important markets are North America (23.7 per cent of total sales in 2014), EMEA (Europe, Middle East and Africa; 15.1 per cent), and Asia (19.9 per cent). Chemicals and other products provided almost 17 per cent of the group’s revenue in financial year 2014. Chemicals sector was sold in late 2014-2015 and, thus, cannot be accounted as a segment of the corporation in future analysis.
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The main strengths of Orica are its leading position in the explosive chemicals market, size and volume of market capitalization. At the same time, the group has lost its diversification advantage by selling its Chemicals business to a group of funds. Besides, the corporation has significant production facilities in Russia which might be affected by sanctions imposed at the moment due to the specifics of Orica’s business. Along with that, the group bears significant environmental risk due to the high probability of causing negative effects on the nature by its production of chemicals or rendered mining services.
The most influential persons in the group’s management are Russell Caplan (Chairman of the Board, former Chairman of Shell) and Ian Smith (Chief Executive Officer, former director of Newcrest Mining and Australian Chamber of Commerce and Industry). They have formulated vision of Orica as “Clever Resourceful Solutions” aimed at satisfying customer needs and reducing probability of accidents on explosive works to zero (”Vision and Values”, 2015).
Financial year of Orica is ending on September 30, 2014. The annual reports are supported by the independent auditor, KPMG, and presented in millions of AUD. The financial statements of the group are reported in accordance with the Australian Accounting Standards and comply with the Corporations Act 2001 (required in Australia) and International Financial Reporting Standards.
Performance Evaluation: Profitability
Reviewing performance outlook of Orica over the past five years, one can note that the group enjoyed positive financial results each year in this period (Orica Annual Report 2014, Orica Annual Report 2012, and Orica Annual Report 2010). Besides, the ratios of return on assets and return on equity remained close to those preferred by risk-neutral investors. Except for the bad year 2012, ROA of the company was perceived around 7 per cent which is close to the nominal rate of return on long-term low risk financial securities. ROE has shown an outstanding value in the year 2011 when the company attained outstanding profits. In the rest of the period Orica had ROE in the range of 13-15 per cent which is a quite common level of this ratio for large and stable companies.
At the same time, net profit and operating profit margins were varying considerably every year. If we consider that the sales revenue remained relatively at the same level across the period, this volatility might indicate problems with establishing cost efficiency system in the corporation. The positive sign is that profit margins were not too high or low in any of the years. Consequently, Orica has demonstrated strong ability to generate profits and increase its sales and assets proportionally.
Table 1. Internal profitability ratios of Orica for the period 2010-2014.
Source: calculated from Orica Annual Report 2014, Orica Annual Report 2012, and Orica Annual Report 2010.
Investors are also cautious about market profitability of the entity. Obviously, Orica has positive and growing (except for the year 2012) basis and diluted earnings per share. Moreover, in spite of lower financial results in 2012, the corporation managed to earn the same level of dividends per share which resulted in higher dividends pay-out ratio in that year. Further, the company increased the sum of dividends per share in years 2013 and 2014 and satisfied part of them (15 per cent in 2013 and 23 per cent in 2014) by issuing new ORI shares. Along with that, the share market prices and price to earnings ratio have declined considerably in 2013 and 2014 due to low profitability and losses reported on Chemicals and Other segments of Orica. For this reason, Chemicals segment was sold to a group of funds in 2015. Current quote of ORI share is above 20 AUD and continues to grow up.
Table 2. Market profitability ratios of Orica for the period 2010-2014.
Source: calculated from Orica Annual Report 2014, Orica Annual Report 2012, and Orica Annual Report 2010.
Performance Evaluation: Liabilities
Orica appears to have adequate solvency position that did not change a lot in the past five years. Large portion of its liabilities is composed of short-term (12.2 per cent in 2014) and long-term (44.1 per cent in 2014) interest bearing debt. Besides, liabilities include trade payables, provisions, derivatives and current and deferred tax obligations. The financing structure of the corporation shows that Orica combines external (liabilities) and internal (equity) finances in merely equal portions. The debt-to-assets ratio of about 50 per cent and debt-to-equity ratio almost equal to 1 bring the company to the safe side in terms of solvency. Besides, the corporation can cover its interest obligations with the earnings before interest and taxes by more than six times and has attained cash coverage ratio of 10.37 in the last financial year. As a result, in general, the group has strong solvency outlook.
Table 3. Solvency ratios of Orica for the period 2010-2014.
Source: calculated from Orica Annual Report 2014, Orica Annual Report 2012, and Orica Annual Report 2010.
Performance Evaluation: Liquidity
Like most of large corporations, Orica does not perceive too high liquidity ratio. Although, current ratio is often recommended to be held around 2, the company’s figures demonstrate that its current liabilities can be covered only by using all of its current assets. The best value of current ratio was achieved in years 2011 and 2012 when it equaled to 1.36 and 1.29 respectively. Since then, the ratio has fallen down considerably to 1.09 in 2014.
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Deeper analysis of liquidity shows that things get worse if the corporation accounts for only cash on hand to pay off its current obligations. We can see that in the last financial year the company could cover only 13 per cent of its current debt with cash and equivalents. Acid test of the group demonstrates better results with current monetary assets covering nearly two-thirds of its short-term debt. It is also important to note that Orica’s current liabilities are mostly built of trade payables and short-term interest bearing debt. Together they represented 90 per cent of current liabilities in 2014 and 86 per cent in 2013. This means, that the company will need cash (or at least monetary assets) to pay on them. So, the group has risky liquidity position.
Analysis of the working capital shows that the corporation has positive sign on this ratio, i.e. current assets are higher than current liabilities each year. However, the net working capital has declined considerably since the year 2011 relatively to total assets and constituted only 2 per cent in 2014. It means that there is a possibility that the group will have to sell part of its long-term assets in case it needs to pay off current debt immediately. The good news is that Orica is a stable corporation with strong reputation. There is indeed very low chance that all external debtors will require paying off the short-term debt just after the balance-sheet date. This fact was evidently used by the corporation to maintain as low liquidity position as possible.
Table 4. Liquidity measures of Orica for the period 2010-2014.
Performance Evaluation: DuPont Analysis
DuPont identity allows dividing the return on equity (ROE) ratio (that is one of the most interesting for investors) into component parts influencing its value: “operating efficiency, asset use efficiency, and financial leverage” (Ross, Westerﬁeld and Jordan, 2010). We can see that high value of ROE in 2011 was achieved, primarily, with the operating efficiency as the profit margin rose to 10.73 per cent while equity multiplier (and, consequently, the debt financing) also increased from 1.92 in 2010 to 1.97 in 2011. Next year, ROE declined considerably with low operating efficiency overweighting even the higher financial leverage influence. In the last financial year, Orica’s ROE decreased compared to the year 2013 mainly due to the low asset use efficiency: total asset turnover fall down from 0.80 to 0.77. However, part of the decline in ROE occurred due to the lower financial leverage in 2014 (Orica has less debt in its financing structure in 2014) that is a positive sign. Moreover, operating efficiency increased in 2014 which offset part of the ROE’s decline last year.
Table 5. DuPont analysis of Orica for the period 2010-2014.
Performance Evaluation: Cash Flow
Analysis of the company’s cash flows indicates that Orica had positive cash flows from operating activities each year over the past five years and negative cash flows from investing and financing activities in almost every of them. As expected, low financial results in the year 2012 led to insufficient operating cash flows and negative net change in cash position of the corporation. During last financial year, Orica has spent almost all of its generated operating cash flows on investments and paying off debts and dividends, so, the net change in cash constituted only plus AUD 15.3 million.
Table 6. Main cash flow figures of Orica for the period 2010-2014.
Source: Orica Annual Report 2014, Orica Annual Report 2012, and Orica Annual Report 2010.
The corporation has efficient cash flow position. The OCF to Sales ratio of 0.13 in 2014 indicates that the company preserves credit policy so that to receive proceeds from trade accounts receivable just enough to cover its needs in cash. Besides, it enjoyed positive free cash flows in all years except for 2012 that allowed paying off part of its external debt and provided funds for cash dividends. At the same time, the group’s operating cash flow covers only half of its current liabilities that signals of the possible need to attract external funds to pay off Orica’s short-term debt if required immediately.
Table 7. Cash flow efficiency ratios of Orica for the period 2010-2014.
Overview of the Local Economy: Australia
Australia is a large developed and industrialized country listed in the top twenty economies of the world and the fourth-largest one among Asia-Pacific countries (U.S. Commercial Service, 2014). With only 23 million of population, the state occupies 10th position in the World Bank list of the best places to do business. It has enormous consumption potential with GDP per capita being more than 60 thousand US Dollars and continuing growth of the economy. Manufacturing facilities of Australia are enhanced by supported private investment climate and significant exports of commodities, mining products and services in the USA and Asian markets.
Most of the Australian industries are naturally monopolized by large corporations due to the huge area of the country and low population along with the continent’s distance from other developed world. However, its favorable legislation considerably lessens barriers to entry this market. Despite rich natural resources, the largest portion of GDP is provided by service sectors that indicates high level of personnel sources. At the same time, most local corporations are closely linked with other countries in the Asia-Pacific region and, thus, have direct access to the low cost labor force in these countries. This enhances competitive strengths of Australian products and services in terms of price in the global arena. Besides, Australia is an exporter of mining products (explosives), energy, food, and precious metals.
Australia has strong banking system and heavily attracts foreign direct investments as well as sends enormous amount of own investment funds abroad. The international credit rating of Australia as a country is AAA indicating its access to the best financial sources in the global money markets. It has four large and very high ranked banking institutions, its own stock exchange and internationally traded currency. Australia obtains more than AUD 2,000 billion of foreign direct investments every year most of them coming from the USA (near one-fourth), the United Kingdom, Japan, the Netherlands, Singapore and Hong Kong. At the same time, the country invests over AUD 1,200 billion overseas in the United Kingdom, New Zealand, Canada, Japan and France. Corporate bonds and shares issued by local corporations are highly valued on both the local and international stock exchanges and are readily acquired by a range of investors.
In general, the economic outlook of Australia provides positive impression. The country has enjoyed years of continuing economic growth, inflows of foreign capital and improvement of the standard of living. Combined with favorable investment conditions and established links to the Asian-Pacific region, this allows concluding on the attractiveness of Australia as the location factor of a potential merging company.
Economic outlook of Asia has changed considerably over the past decade with China transforming to one of the leading manufacturing and consuming countries and other markets developing positively from year to year. The International Monetary Fund (2014) projected growth of the Asian economies to be around 5.5 per cent in years 2014 and 2015. The main risk related to the region is related to its volatility and tight monetary policies. Nonetheless, credit rating of these countries enhances from year to year that leads to lower interest rates and better access to financial sources.
At the same time, industrial development and growth of the GDP per capita improved attractiveness of Asia as a consuming market due to its population size (take only India and China) and emerging stage of economy. Analysis of the export trends indicates that five years ago most of the exports from Asian region were transferred to the U.S. and European countries. Still, in the past two years the region became more “self-consuming” with most countries in the region exporting to China, India and Japan with consumption constituting 30-40 per cent of their total GDP. One more attractive sign is the level of inflation which remains relatively low (2-4 per cent) in most of the countries. The only exceptions are Indonesia and Vietnam with 6 per cent in 2014 and India with 10 per cent in 2013 and projected 8 per cent in 2014 (International Monetary Fund, 2014).
Population size in the region provides not only consuming force to the economy, but also acts as an extensive labor market. Lower cost of labor allows companies to develop faster by utilizing higher profit rates and cost efficiency. As a result, Asian markets indicate healthy demand and supply development due to their labor sources and inflows of foreign direct investments. Relief of the legislation terms further facilitates closing gaps between local supply and demand sides, especially for commodities.
Problems of the Asian and Pacific markets relate, mainly, to their volatility and low developed infrastructure. However, they are gradually overcome in the past years and the situation is expected to become much better in the nearest future.
Australia has low political risk, favorable fiscal policy and investment climate, high level of GPD per capita resulting to very low poverty rate due to the low population of the rich country. The legal system of the country is one of the most developed. It prioritizes equal handling of all parties (individuals and legal entities) by the law with strong regulatory tools enacted to prevent any bias or unfairness from the government authorities (U.S. Department of State, 2013). Expropriation of private property can be only conducted in terms allowed by the international law and must be compensated in adequate form and amount.
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General trend in the local policy to enhance competition led to the high level of privatization in all sectors of economy. There are still several government-owned enterprises, but their number is very small. In most cases, public and state-owned companies are not provided with special competitive terms and conditions by the requirements of local legislation.
The tax system in Australia is also one of the most attractive among developed countries. Still, some international investors suffered from the recent change in the tax law. The amendment allowed tax inspections of the backward periods up to the year 2004 and led to additional and unexpected tax obligations of several international corporations conducting business in Australia. Nonetheless, companies with strong tax records and adequate provisions were not affected by this change at all.
Another strong point in the local legislation is the strict protection of intellectual property rights. Being concentrated mainly in the service sectors of economy, Australian companies require high level of protection to remain profitable. The procedures of patenting and recording other property rights are quite complicated to ensure uniqueness of every property. Still, the option to sue companies for breaking property rights is rather expensive and cannot be allowed by small companies and private persons.
The risk of political violence virtually does not exist in such country as Australia. First, meetings and demonstrations are allowed there but occur mainly on cultural events and do not transform to violent actions. Second, there are no overland neighboring countries and that eliminates probability of violence from the rest of the world. Besides, Australia has a range of bilateral and plurilateral economic and political agreements with other countries that facilitate investment inflows for local corporations.
Political stability of Australia is further enhanced by low rate of unemployment (5.3 per cent in 2012) supplemented by growth in average earnings of individuals (by 3.5 per cent in 2012) and favorable inflation level (2.5 per cent in 2012). Personal rights of labor force are protected by a range of international conventions signed by the government of Australia and local legislation (The National Employment Standards). Pensions of employees are guaranteed by 9 per cent annual contributions from the base salaries paid out by all resident companies. Significant part of the labor force is represented by immigrants who are steadily attracted by various government programs.
To sum up, a merging agreement with one of the largest Australian corporations Orica group is an attractive option. It will provide immediate access to Asia/Pacific region in terms of production facilities and consumption of mining products and services. The company has advantages of constant profitability, strong solvency and cash efficiency positions. At the same time, the analysis of its financial statements indicates riskiness of liquidity ratios and loss of diversification in 2015 due to the sale of Chemicals segment.
Economic and political overview of Australian and Asian markets demonstrates attractiveness of Orica’s location in the most issues. There are some certain risks related to the volatility of Asian economies and natural monopolization of several sectors in Australia (due to the low population). However, recent trends show strong and stable economic growth, favorable investment climate and supportive local legislation.
Political risk of doing business in Australia is low. The country has rather stable legislation which provides favorable tax environment for investors, protection of their rights and virtual elimination of the expropriation risk. Besides, the state has in disposal skilled labor force with high standard of living and low risk of violent events. International engagement contracts of the government level facilitate commercial links with other countries in the region and across the globe.