Here’s why the warning bells are ringing for Orica Ltd investors

Orica Ltd (ASX:ORI) could soon face a similar problem to that of the iron ore miners. The results won’t be pretty.

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Some investors have not been paying much attention to recent warnings about the fallout from the slowing mining sector.

The impact of the crash in commodity prices will be felt well beyond the borders of the mining sector with experts warning that the big banks will be feeling the second-hand effects of lower capital investments from this key industry.

Bank stocks have continued to soar. Commonwealth Bank of Australia (ASX: CBA) and Westpac Banking Corp (ASX: WBC), which arguably have the largest exposure to the domestic economy, have jumped 15.7% and 11.9% over the past six months.

But there is another stock that is likely to feel the impact of the mining slump even sooner. I am referring to the world’s largest explosives maker Orica Ltd (ASX: ORI).

ORI

The challenges facing Orica are two-fold. The first and most obvious, its major clients are miners as explosives are used to develop mines.

This risk is somewhat factored into analysts’ forecasts with consensus estimates tipping around a 3% drop in earnings per share to $1.59. That seems a little skinny given the well-publicised pain being felt by the mining community and its share price performance (as seen in the chart above) does not seem to have registered this risk to any significant degree.

The other problem is potential oversupply of ammonium nitrate, a key ingredient used in explosives. Orica’s problem is starting to sound eerily similar to iron ore producers.

Morgan Stanley estimates that the local ammonium nitrate market will contract by 4% as supply of the chemical ramps up in 2015. This means the market may be oversupplied by more than 30% in 2016, which would lead to significant margin pressure due to Orica’s high operating leverage.

Operating leverage refers to companies with high fixed costs as they would most acutely feel changes to demand for its products because they have limited ability to vary their cost base.

The broker is urging investors to sell the stock today as Orica is likely to be under selling pressure for the short-term at least. It’s hard to argue with this view.

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Motley Fool contributor Brendon Lau does not own shares mentioned in this article. Follow me on Twitter - https://twitter.com/brenlau The Motley Fool’s purpose is to help the world invest, better. Click here now for your free subscription to Take Stock, The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead.  This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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