Popular stocks aren't necessarily the best investments. Just because the company is familiar or has a large market cap isn't sufficient to make an investment case (in fact some of the most profitable investments have come from smaller companies, but that's a story for another day).
One large, popular company that you should be careful of is Orica Limited (ASX: ORI).
Orica is a global explosives and industrial chemicals manufacturer and supplier. In fact, its mining services division is the world's largest supplier of commercial explosives. It also used to own a paint and coatings business – before de-merging Dulux Limited (DLX) in 2010.
With revenues of more than $6 billion, and Earnings Before Interest and Tax (EBIT) of over $1 billion in 2011, and 2012 is forecast to be even better, what's not to like?
It's when you take a deep look into Orica's financial statements that you see several potentially explosive (sorry!) issues. The company's EBIT margin has fallen every year since 2010, as new entrants into its markets place pressure on it to reduce selling prices to remain competitive. Several expensive acquisitions that haven't turned out as well as management had hoped have also dimmed its star, and then there are other issues.
Debt
Net debt as at the end of March 2012 stood at $2.3 billion, compared to shareholders equity of $3.3 billion, quite a size-able chunk of debt. Generally, I prefer companies to have a net debt to equity ratio of under 40% — just as a safety margin, Orica's ratio is 70%. Debt has also risen significantly in the last year – it was just $1.3 billion at the end of March 2011. The problem with debt is if we faced another GFC, the banks may refuse to rollover those debt facilities or may stipulate they will only be rolled over on condition that the company does an equity raising. You only have to look at what happened to Billabong International Limited (ASX: BBG), to understand the consequences of that.
Cash flows
Looking at the cash flows over the past several years shows that Orica is highly capital intensive. Free cash flow after capital expenditure and acquisitions was just $4m in 2011. For the six months to March 2012, the company generated just $38.8m in operating cash flow, then spent $254.2m on property, plant and equipment. No wonder that the company had to increase its debt by an additional $330m in the period.
Regulatory concerns
As if that isn't enough, Orica has also received several negative media reports. The Kooragang Island ammonium nitrate plant, north of Newcastle, NSW, was forced to shut down in November 2011 following a chemical discharge, and only re-commenced production at the end of February 2012.
Then the company received complaints from Queensland's Department of Environment and Heritage Protection about Orica's sodium cyanide facility in Yarwun, Queensland. The company believes that there's no environmental harm or risk to human health from these complaints, but these two government interventions coming in quick succession highlight the regulatory risk that is ever-present in Orica's business.
Price
Orica is currently trading on a trailing P/E ratio of around 15. At those prices, the company appears to being treated as a growth company, rather than as a cyclical company, subject as the company is to the cycles of commodities prices and the health of the resources companies it services. Its competitor Incitec Pivot Limited (ASX: IPL) currently trades on a much more undemanding P/E of around 11.
The Foolish bottom line
Should the mining boom turn down, Orica shareholders could find themselves in a company that may struggle to make a profit — or even worse, stay afloat.
The great thing about sharemarket investing is that you don't have to take a position on every company in the index. If the odds aren't in your favour, there's nothing wrong with simply passing, and waiting for the next opportunity to come along.
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Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. The Motley Fool's purpose is to help the world invest, better. Take Stock is 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. Click here now to request your free subscription, whilst it's still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
