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Orica strikes gas deal, lowers earnings estimate

Orica (ASX: ORI) made two key announcements last week — the announcement of a gas supply deal on Tuesday and an earnings downgrade on Friday.

Orica announced on Tuesday that it had struck a deal with Strike Energy (ASX: STX) for Strike to supply Orica with up to 150 petajoules of below market price gas over the next 20 years. The deal aims to shore up reasonably priced gas for Orica’s chemical factories by making pre-payments of up to $52.5 million by 2016 to fund drilling and development of Strike’s gas project in the Cooper Basin. The success of the investment will only be known in coming years if the project produces the current gas volume estimates.

The deal was labelled an ‘innovating risk-sharing arrangement’ and follows a similar deal in recent months between Aloca (NYSE: AA) and Empire Oil and Gas (ASX: EGO). Strike’s share price jumped on the news, extending gains since July 1 to over 55%, while Orica’s share price dropped around 2.5% on the day.

Orica, which services the mining industry by supplying chemicals and explosives required for mine creation and maintenance said in a statement that “[the] agreement has the potential to provide a future new source of gas supply to our Australian east coast manufacturing plants at an affordable price”.

On a more downbeat note, Orica on Friday announced a shock profit downgrade which at one point dragged the share price down over 16%. The company forecast that reported net profit after tax (NPAT) would be around 10% below the $650 million reported last FY. The company had previously given guidance that NPAT would be higher than 2012.

Orica blamed the result on weak global conditions leading to slower demand for explosives and chemicals than expected. Orica’s explosives business is linked closely to volumes, rather than price, indicating that the recent productivity and volume expansion push by miners should have aided Orica’s profitability.

It is expected that some of the NPAT weakness is attributable to the group’s Minova mining ground support business, which is expected to post a net loss due to weakness in Europe and America.  The company expects Minova’s earnings to break even before interest and tax (EBIT) this financial year, compared with EBIT of $109 million during the previous period.

The announcement caps a poor year for Orica, where the company had to deal with a change in management, ammonia emissions and carcinogenic chromium leaks from its Kooragang Island plant, and general shareholder backlash as the company’s market value dropped more than $3 billion since Ian Smith was made CEO in February.

Foolish takeaway

Orica’s poor performance over the past 12 months has pushed its share price to levels not seen since the recovery from the GFC in mid-2009. The company has signed an important deal with Strike Energy to give the company access to cheaper gas in the future but shareholders will be concerned that the company has performed so poorly in a year where outperformance compared to peers was expected.

Foolish investors will know that prior performance is no guarantee to future success and Orica is proving that sentiment. Investors may be wise to wait for the official earnings release in August or September to see what initiatives are being put in place to improve profitability before investing in the company. Long-term growth drivers are in place which may benefit the company if management can implement a successful turn-around strategy.

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Motley Fool contributor Andrew Mudie does not own shares of any companies mentioned in this article.

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