An explosive outlook for shareholder returns

Incitec Pivot (ASX: IPL)  is a key holding in the Firetrail Absolute Return Fund. Incitec Pivot consists of two businesses:

1. Explosives – Incitec Pivot operates integrated explosives manufacturing and distribution businesses in Australia and North America. Explosives are essential to breaking rock and are primarily supplied to mining, quarrying and construction customers. Surface mines in the coal, metal and non-metal sectors rely on these explosives to uncover mineral deposits.

2. Fertilisers – Incitec Pivot is Australia’s largest supplier of fertilisers with a dominant share of the Australian east coast market.

Both explosives and fertilisers share common nitrogen-based chemistry. Ammonia (NH3) is a key ingredient in both manufacturing processes. However, the two businesses have very different earnings profiles. Explosives provides a stable earnings stream given customer volumes and margins are locked in under three-to-five-year contracts. Fertiliser earnings are linked to the agricultural price cycle and are more volatile as a result.

Figure 1: A Dyno Nobel (Incitec Pivot’s explosives business) engineer watches on as Dyno explosives break up rock at a mine site.

Path to value creation

The conflict in Ukraine and subsequent impact on global agriculture, energy and gas markets provided a major boost to global fertiliser producers over the last two years. Prices for everything from oil, gas, corn, and fertilisers such as ammonia increased substantially.

Incitec Pivot’s earnings surged, led by its Fertiliser manufacturing assets in Queensland and its ammonia plant in Waggaman, Louisiana (WALA). Incitec Pivot only uses about 25% of the ammonia produced at WALA for its explosives business in North America, selling the remaining 75% at a small discount to market prices, mainly through commodity traders.

In March 2023, Incitec Pivot reached an agreement to sell its WALA ammonia facility to CF Industries for a total value of US$1.675 billion. The transaction is positive for shareholders for the following reasons:

1. The sale has been secured at the top of a decade-long pricing cycle. We estimate the sale amount implies a long-term ammonia price of US$500 per tonne versus a long-term average of US$300 per tonne.

2. As part of the deal, Incitec Pivot has secured a 25-year supply agreement from CF Industries at equivalent producer cost allowing it to capture the full manufacturing margin.

3. Incitec Pivot no longer faces the capital and operating risks associated with running the plant.

4. The transaction reduces the volatility of group earnings and simplifies earnings exposure.

5. Incitec Pivot will have substantial scope to undertake capital management initiatives such as buybacks.

Figure 2: Incitec Pivot’s WALA sale is taking place while fertiliser prices are near decade highs

Figure 3: Based on our estimates, the sale of WALA results in net proceeds of A$1.25 billion available for debt reduction and buybacks.

Buybacks coming

The WALA transaction is expected to take around six months to settle. Incitec Pivot will have a net cash balance sheet post-settlement. The company has a leverage target of between 1x-1.5x. As a result of the excess cash, management will have scope for additional shareholder returns such as buybacks.

The company already has a $400 million buyback program underway. Using the low end of its leverage target and assuming no free cashflow, we estimate an additional $1 billion capacity for buybacks over FY24-25. We estimate 25% of Incitec Pivot’s current market cap could be returned to shareholders.

Our strong preference is for the Board to return the WALA sales proceeds to shareholders. We believe buybacks provide the most prudent use of shareholder funds for the following reasons:

1. If full net proceeds were applied to a buyback, we estimate 7% value accretion for shareholders.

2. Incitec Pivot shares are trading very cheap below 1x Price/Book value – it is hard to see alternative uses providing similar value.

3. Buybacks are a low-risk use of capital without the execution issues associated with M&A.

Figure 4: We estimate the WALA transaction will be 13% accretive to earnings per share if 100% of net proceeds are applied to buybacks.

Positive earnings outlook

Incitec Pivot’s earnings outlook continues to look favourable due to three key drivers:

1) Energy costs are bottoming:

The disruption to global energy markets from the Ukraine conflict will impact the fertiliser and explosives industries until at least the middle of the decade. Gas is a key input in the production of fertilisers and explosives.

The disruptions to Russian exports of cheap gas to Europe have shifted the competitive landscape in Incitec Pivot’s favour in key end markets. Incitec Pivot has long-term gas supply arrangements in Australia and accesses cheap gas in the US, providing a major cost advantage when global energy prices are rising.

At the height of gas prices in late-2022, over 60% of European nitrogen supply was either idled or permanently shut due to prohibitive gas costs. That figure still sits at 30% despite an 80% retracement in gas prices from last year’s highs.

European gas price futures are still indicating higher prices over 2023 and 2024.

The recent gas price weakness appears temporary and driven by high storage levels after a mild European winter. We expect gas prices to begin to rise again through the September quarter as storage levels are replenished. Higher gas prices will lead to higher fertiliser and explosives prices as high-cost producers again feel the pinch of rising input costs.

2) Soft commodity inventories remain supportive of elevated prices:

Global grain stocks remain near decade lows. As inventories are built back up, this will support the prices of corn, wheat, and soy. Higher crop prices allow farmers to pay more for key inputs such as fertilisers.

Figure 7: Grain and oilseed stock-to-use (world excluding China)

3) Explosives earnings at the start of the upcycle:

Once the WALA sale is completed the focus will shift back to the Explosives division. We see a supportive backdrop over the medium-term driven by a tighter explosives market in Australia. Supply and demand are now well balanced. This compares to a period of oversupply over the past five years due to new large-scale capacity additions by both Orica and Wesfarmers’ CSBP business.

A more balanced market will be supportive for pricing as Incitec’s contract book, which has an average tenure of three years, comes up for renewal over the next several years. We are expecting solid earnings growth from this business.

Undemanding valuation

Incitec Pivot’s valuation remains undemanding despite the value-accretive WALA deal. We have undertaken a simple exercise below to highlight inherent value at the last closing price:

· We have adjusted enterprise value for the WALA proceeds plus a further 12 months of WALA cash before settlement of the sale to CF Industries.

· We have then deducted the value of Explosives using main ASX-listed peer Orica’s multiple.

· The implied value of Fertilisers is just 2x our FY24 estimates.

At today’s price, investors are paying a fraction of what the Fertilisers business is worth. Should this valuation gap remain, we believe it sensible for Incitec Pivot to demonstrate the sum-of-the-parts value by de-merging the Fertilisers business in the future.

Figure 8: At today’s share price, investors are paying a fraction of what Incitec Pivot’s Fertilisers business is worth

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