Incitec Pivot Ltd's (ASX: IPL) shares crashed on Thursday following broker downgrades from leading investment banks Credit Suisse and UBS.
The broker downgrades follow competitor Orica Ltd's (ASX: ORI) disappointing half-year 2016 results reported in May. This sets up expectations that Incitec will disappoint when it reports earnings in November this year (due to market conditions).
Broker downgrades
As reported in the Fairfax Press, Credit Suisse analysts believe the manufacturer of fertiliser and chemicals used in industrial and agricultural production faces a tight ammonia and phosphate market (Incitec's largest business unit), with supply-side capacity driving spot prices lower.
Credit Suisse forecasts supply to outstrip demand in 2017 and 2018, causing a market glut and squeezing Incitec's margins. Accordingly, it sees organic growth as an unlikely feature in the medium term.
UBS analysts paint a similar story, based on the assumption that spot fertiliser prices are maintained. It regards Incitec's ability to use free cash flows (based on current spot prices of ammonia and phosphate) as being unable to satisfy the widely expected $500 million buy-back later this year, without increasing debt levels.
As such, UBS downgraded its expectation of a buy-back to $200 million on conservative estimates and revised its price target to $3.10 (from $3.80).
Nevertheless, I remain upbeat about Incitec's prospects and think it's a buy for the following reasons.
Growth engine
Incitec is constructing a state-of-the-art ammonia production facility in Louisiana, U.S., which is expected to come online in the third quarter of this year.
The completion of the plant comes at a time when gas prices, which make up 75% of the cost of ammonia production, are hovering near all-time lows.
Although gas prices have rebounded slightly in recent months (and ammonia prices have moderated somewhat), analysts at Deutsche Bank believe the plant will generate earnings (EBITDA) of US$98 million in the 2017 financial year, targeting an internal rate of return of 15%. Any further depreciation of the Australian dollar against the U.S. dollar should increase the return from this project, boding well for results (and capital management).
Capital management
I believe Incitec's strength lies in the quality of its balance sheet.
Despite dwindling commodity prices, the market expects Incitec to conduct a buyback, placing it one step ahead of Rio Tinto Limited (ASX: RIO) and BHP Billiton Ltd (ASX: BHP) in my books (who both scrapped their progressive dividend policies in a similar scenario).
Moreover, even with its ongoing investment in the U.S. and decreased spot prices for its products, Incitec was able to slash net debt in 2015 to $1.3 billion using free cash flows. Analysts at Deutsche Bank expect this trend to continue, forecasting an impressive net debt/EBITDA ratio of 2.0x by the 2017 financial year.
Foolish takeaway
In my opinion, Thursday's slump in share price is driven by market sentiment and does not necessarily reflect management's long-term strategy of reinvesting in its core fertilisers businesses.
Incitec's strong balance sheet should see it through prolonged periods of lower commodity prices, whilst paying dividends and pursuing other capital management strategies. This, in my view, makes it a compelling investment today.
