Incitec Pivot (ASX:IPL, Financial) suffered the largest price decline during the recent quarter and has been a disappointing investment to date for the Fund. At that time, we were attracted to Incitec’s leading positions in the two most attractive markets for mining explosives and services globally, North America and Australia. We also believed Incitec’s Australian fertilizer business was desirable, even though it had little overlap with the rest of the business.
Unfortunately, the company’s intrinsic value growth has fallen short of our expectations over time because of various factors, both within and outside of management’s control. Dramatic increases in domestic natural gas prices in Australia have raised the cost of production across all of Incitec’s manufacturing footprint in Australia and left its second-most important fertilizer plant in the country potentially uncompetitive long term. The dislocation between the local gas price and fertilizer prices, which are set globally, resulted in a significant profit squeeze. In addition, actions by competitors led to oversupply in the Australian explosives market and aggressive price competition, leading to contract losses in Western Australia and significant financial ramifications. The company has also experienced an unusually high number of production issues at its continuous manufacturing plants. Finally, Incitec took a rather cautious stance with relation to Covid-19 and the anticipated impact on the company’s business and, as a result, it raised A$600 million of equity via a rights offering in May 2020.
Despite this history, we believe that Incitec represents compelling value for Fund shareholders at current prices. It is currently benefiting from a recovery in prices for commodities that it sells, and the oversupply in the Australian explosives industry is abating. In addition, adoption of Incitec’s differentiating blasting and detonator technology is boosting the company’s earnings. Incitec’s CEO Jeanne Johns has named manufacturing reliability a top priority and has made impressive gains at several plants. We believe she also will improve conditions at the recently troublesome Waggaman ammonia plant. Finally, we find Incitec’s current valuation to be rather compelling. We estimate a nearly 8% free cash flow yield this year, despite interim production issues, and expect this yield to reach double-digits in fiscal year 2022.
From David Herro (Trades, Portfolio)'s Oakmark Global Fund second-quarter 2021 commentary.
