The previous resources boom showed how far mining services stocks can rally when rising sector activity puts a rocket under earnings. And how far they can fall when conditions turn.
Higher commodity prices encourage miners to develop projects and improve production economics for mothballed mines. The upshot is stronger demand for mining services providers that help the sector with drilling, production, mine maintenance and logistics.
Falling commodity prices can stop the party in its tracks. More miners cut exploration and production, often leaving mining services companies with expensive idle equipment and high fixed-cost bases. That is why mining services stocks are volatile: they can crash and die in downturns, faster than many investors expect.
The industry’s economics are relatively poor. Mining services providers usually need considerable capital expenditure, returns on equity can be inconsistent, competition is high and bargaining power with big mining companies is low. Then there’s commodity price uncertainty.
Investors must play mining services companies through the cycle; they are not set-and-forget investments. They do not suit conservative, portfolio investors or those seeking reliable dividends. This is a sector for active investors who understand resource volatility.
The outlook
On that score, the mining services recovery still has a long way to run. Global economic growth is improving and there is synchronised growth in major economies for the first time in years. Extra supply will eventually dampen prices, but the major metals will head higher this year.
That’s good for resources sector profits; witness share price gains in BHP Billiton and Rio Tinto and a host of other miners in the past 12 months. It’s also good for mining services providers: look at the strength of several interim profits in the sector in the latest reporting season.
Sceptics will argue that mining services stocks have already rallied in anticipation of better resources sector activity and that it is too late to buy. Across the sector, many stocks have doubled or more from their price lows, surprising the market.
Kudos to contrarians who had the guts to buy mining services stocks when they were on their knees in late 2011. Some companies at that stage were going into voluntary administration as a rapid cutback in new contracts and profit margins crushed the sector.
Share price gains will be a lot slower from here, but three factors suggest the mining services recovery has further to run.
First, the backdrop of higher commodity prices, improving resources company profits and higher sector activity is the best in years.
Second, several mining services companies in the interim profit-reporting season noted an improving outlook with more contracts up for grabs. The quality of mining services profits was a highlight in the season and among the more interesting trends.
Third, the mining services sector collectively looks better managed and more robust than in was in the lead-up to the previous boom. Several companies diversified into infrastructure services during the mining boom and are reaping the benefits of that strategy. They will benefit from two growth engines this time around; higher mining activity and an infrastructure project boom.
If the resources and infrastructure sectors fire together, key mining services companies will be in an earnings sweet spot: rising demand without a commensurate increase in costs because of excess capacity in the industry. Cost pressures will inevitably come: skyrocketing salaries in the last mining boom are an example. But the sector is some way from those heady conditions.
A few small-cap mining, energy and infrastructure service providers stood out in the profit-reporting season. I emphasise again that they suit experienced, risk-tolerant investors who have a more active portfolio approach. Here are three favoured small-caps.
1. RCR Tomlinson (RCR)
I first outlined a positive view on RCR Tomlinson for the Switzer Report in July 2016 when it traded at $1.71 [1], principally because of its exposure to solar farm installations. Rising demand for solar energy is a tailwind for RCR, which has a strong position in solar installations.
RCR rallied to $4.65 in September 2017 then drifted to $3.60 earlier this month amid the broader market sell-off. RCR’s strong half-year report last week pushed its price to $4.21.
A 63% lift in underlying net profit for the first half of FY18 beat market expectations. Revenue doubled on the same time last year.
The infrastructure division starred, thanks to its solar projects, and RCR’s energy operation was stronger than expected. RCR’s resources sector earnings were a little softer because of a few problem contracts, but it was an excellent result overall.
RCR shows the benefits of investing in service providers with diversified operations. It has excellent leverage to growth in renewables and major rail and infrastructure projects. The resources division should eventually benefit from higher expenditure in iron ore projects.
Rail could be the next re-rating catalyst for the share price. RCR has been shortlisted for some huge rail projects in New South Wales and New Zealand and should win at least one of them. I see the stock tracking towards $5 in the next 12 to 18 months.
Chart 1: RCR
Source: ASX
2. Alliance Aviation Services (AQZ)
During the previous mining boom, regional airports were full of people in fluorescent vests – the fly-in, fly-out workers who went back and forth every few weeks. Alliance Aviation Services, a small airline that specialises in the resources sector, benefited from this trend.
The Queensland-based company raised $74 million through an initial public offering (IPO) and listed on ASX in December 2011 near the peak of the mining boom.
Alliance’s $1.60 issued shares traded above $2.30 in April 2012. But like most mining services stocks, Alliance tumbled in 2013 as commodity prices sank and the resources investment boom slowed. The stock hit 46 cents in late 2014 after profit downgrades and amid fears of sharply lower demand for mining aviation services.
The market forgot about Alliance for the next 18 months, its shares tracking sideways until mid-July 2016. Alliance has since rallied to $1.71, amid rising demand for it services.
Some will argue Alliance has had its run, even though it is trading only slightly above its 2011 issue price after recent price gains.
Certainly, a share-price pullback or correction would not surprise given the strength of its rally. Extra selling after the recent half-year result could create an opportunity for patient investors who can watch and wait for better value.
Alliance deserves a spot in portfolio watchlists for those who like micro-caps. The company reported 16% revenue growth to $117.2 million and 19% growth in pre-tax profit to $10.3 million in FY18. Total flying hours – the best indicator of demand – soared 34%.
Management said Alliance had “seen a substantial increase in activity over the last six months and this is expected to continue”. The company expects rising demand for the resources sector.
I like how Alliance is paying down debt – it needs to do much more here – and sensibly expanding its fleet. The company’s exposure to northern Queensland is another positive as that region continues to improve after a few tough years.
Chart 2: Alliance Aviation
Source: ASX
3. Mastermyne Group (MYE)
It is easy to overlook the Mackay-headquartered mining services company. The micro-cap, which provides services to key coal mines in north Queensland, has a low market profile and is barely followed by stockbroking analysts or the media.
Mastermyne listed in April 2010 near the peak in the mining boom, raising $40 million at $1 a share. Its stock soared to around $2.50 within two years of listing, such was the demand for its services.
Like most of its peers, Mastermyne shares slumped as work dried up. The stock hit 11 cents in mid-2016 as fears about the mining downturn and coal weighed on it. Mastermyne has since rallied to 87 cents and has further to run over the next 12 to 18 months.
Mastermyne delivered 60% revenue growth to $91 million and 344% growth in underlying earnings (EBITDA) to $6.7 million in the first half of FY18. Contract wins, growth in project scope in existing contracts and stronger equipment demand, underpinned the result.
The company is a good example of leverage to higher mining activity: Mastermyne’s overheads stayed flat and fleet capacity utilisation hit 85% in the latest result. The company can sweat its fixed-cost base harder when resources sector activity improves, rapidly improving margins and profitability.
Management said Mastermyne has “emerged from a deep cycle in excellent shape”. It is hard to disagree with that assessment from the latest result. The company’s contract book looks the healthiest in years and the pipeline of tender work it is bidding for is now around $1.1 billion.
Also, don’t write off coal, despite never-ending gloom and controversy around Adani’s proposed Carmichael coal mine in north Queensland. Mastermyne expects a strong outlook for coal to drive continued demand for its services. Coal supply restrictions and rising demand from emerging countries, particularly India, suggest there is plenty of life in the commodity yet.
That is good news for services providers such as Mastermyne that are leveraged to coal.
Chart 3: Mastermyne Group
Source: ASX
- Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. All prices and analysis at February 28, 2018.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.