The adage that “one company’s cost is another’s revenue” rings true in mining services. As resource giants face cost pressures, the mining-services sector is benefiting from higher revenues and profit margins – a key theme from the latest earnings season.
The mining-services sector has had a remarkable recovery in the past 12 months as higher commodity prices encourage greater resource-sector activity and services demand. Companies that looked almost dead a few years ago have roared back to life.
Sector leaders, such as CIMIC Group, Monadelphous Group and Downer EDI, kickstarted the recovery in the second half of 2016. The smart money stuck to higher-quality providers that could weather the mining downturn and were well placed to recover.
The optimism spread to mid-tier players in 2017 and now several smaller mining-services companies are rallying. The Australian Financial Review this week reported speculation of corporate activity at small-cap Emeco Holdings – a sign perhaps that some players can see much bigger profits in the next year or two and want to cash in near the peak.
Further to run
My sense is the mining-services recovery has a way to run. Good judges I know, some of whom have annual meetings with mining-services CEOs to gauge industry conditions, believe there is still about 20-30% excess capacity in the sector.
Put another way, the sector, in aggregate, can continue to take on more work without having to raise slabs of capital to buy more equipment – a move that inevitably crushes weaker players when the resource sector turns and they are left with idle, depreciating equipment.
Mining services look to be in an earnings sweet spot. Demand is rising, and profit margins appear to have bottomed. Cost and funding pressures that accompanied the last mining boom are not as intense. That should equate to rising profit and high valuations across the sector.
Two other factors have had less consideration in mining-services commentary. The first is the move by many service providers to diversify their operations into infrastructure and renewables. Commentary on many mining-services profit results in the interim reporting season noted upcoming work in infrastructure and solar/wind farms – two high-growth sectors.
The second factor is corporate memory. The sector is still sufficiently scarred from the previous mining downturn. Several service companies are paying down debt, rationalising operations, restructuring and ditching lower-margin work. The sector is in its best shape in years and several smaller mining-services companies look better managed these days.
That doesn’t mean investors should chase mining-services stocks higher or be seduced by hype. My preference has been the high-quality providers, CIMIC, Monadelphous and Downer EDI – a position I outlined for the Switzer Super Report in 2017 and 2018.
After strong gains, each has pulled back this year, despite reporting healthy profits. CIMIC topped its earnings guidance, Monadelphous has a solid report and Downer EDI continues to impress.
Rather than chase small-cap and micro-cap mining-services providers higher, my preference is to buy the high-quality players – CIMIC, Monadelphous and Downer EDI – on the dips. They offer more than resource-sector exposure, given the breadth of their operations.
That’s not to say smaller mining-services stocks, such as Imdex, Boom Logistics, Emeco Holdings and Ausdrill, cannot rally further. After a long lull, mining exploration is improving and that means higher demand for service providers in this part of the sector.
I have also outlined a positive view on RCR Tomlinson, principally for its exposure to solar farms, several times in the past two years. I covered resource-sector airline Alliance Aviation Services; and North Queensland coal-services specialist Mastermyne last month. [1]
One must be prepared to trade micro-cap and small-cap mining-services stocks during rallies. These are not set-and-forget investments (is any stock these days?). As such, they suit active investors rather than long-term portfolio investors seeking mining-services exposure.
If you fall into the latter category, focus on CIMIC, Monadelphous or Downer. Laboratory-services provider ALS is another larger player that looks interesting after recent price falls.
- ALS (ALQ)
The Queensland company has strong leverage to a recovery in resource-sector activity. More exploration and production means greater demand for minerals testing in laboratories. ALS covers the full spectrum of mining activity, from exploration to site rehabilitation.
The business, however, is much broader than resources. The life-sciences division accounts for about half of ALS’s revenue and has been a drag on its performance. The commodities and industrial sectors, which cover the mineral and energy sectors, make up the rest.
ALS staged an almighty rally from mid-2016, soaring from a seven-year low of $3.20 to $8.39 late last year as the market looked to faster earnings growth from the commodities and industrial division. ALS fell to $6.50 earlier this year and has recovered to $7.37.
That’s still a long way from the stock’s peak of about $12.50 in 2011. ALS increased almost eightfold from peak to trough during the previous mining cycle. It is, of course, foolish to focus too much on the past or assume ALS will do the same again. But it’s obvious that the company can move a long way when resource-sector conditions favour it.
ALS’s first-half result, reported in November 2017, was a touch below market expectation. The life-sciences division was the main headwind because of flat trading conditions in ALS’s life-sciences laboratory operations offshore.
The commodities operation starred. Mining sample flows in to the ALS geochemistry business rose 34% in the half. The company said it remained optimistic about a continued recovery in the geochemistry business and was investing more in it to drive growth.
ALS’s actions say a lot. The company in November announced a $175 million share buyback, for about 4.3% of its issued capital. That’s reasonably aggressive and suggests management believes the company’s shares are undervalued.
In another good sign, managing director Raj Naran has been buying ALS shares. The company said in February that Naran snapped up $126,920 worth of stock. Other directors have bought ALS shares in the past six months, suggesting insiders are positive on the outlook.
Growth in the commodities operation should underwrite further gains in ALS shares in the next 18 months. Exploration budgets are increasing and there is growing evidence that miners are paying higher prices for services, which makes it easier for ALS to lift prices for mineral assays and other lab services.
The life-sciences division should perform better in the next 18 months, after the delayed integration of its November 2016 acquisition of AL Control, a UK food, water and environment business. But I don’t expect the life-sciences division to drive the next leg of the ALS rally.
The well-run company has guided for full-year net profit of $135-$145 million. It would not surprise if ALS comes in at the higher end of the range, given resource-sector strength, when it reports in May.
An average share-price target of $7.74, based on a consensus of nine broking firms, suggests ALS is slightly undervalued at the current $7.37. Price targets range from $6.50 to $9.20.
Macquarie’s 12-month target of $8.25 looks feasible. The investment bank argues ALS is trading at a 20% discount (on a Price Earnings multiple) to its global peers, which compares to an average discount of 13% over the past five years.
If Macquarie is right, ALS should deliver a total return (including dividends) of about 14% over one year. It could do better again if resource-sector activity strengthens and sample volumes in ALS laboratories keep rising.
Chart 1: ALS
Source: ASX
- Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor All prices and analysis at March 14, 2018.
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