Investors chasing hot returns this year have favoured risky lithium stocks, emerging gold producers and speculative tech companies. Not mining services, a sector that supposedly has been on life support as the resources investment boom fades.
But several mining service stocks have rallied this year, off a low base and after horrendous share-price falls in the past three years.
Diversified mining service provider, Ausdrill (ASL), has returned 150% over one year. Western Australia’s Maca (MLD) has delivered 116%. Lycopodium (LYL), and the much-larger Cimic Group (CIM) have returned about 60%.
Switzer Super Report’s analysis of 31 mining service stocks, including some transport companies with resource-sector exposure, shows some strong returns. Contrarians who bought the best performers earlier this year, when the sector was friendless, have prospered (see table below).
The gains, of course, will be little solace to investors who bought at the peak in late 2012, when the Initial Public Offerings market was crowded with mining services floats. Nor are gains widespread: many mining service stocks are still badly in the red over one year.
Still, there is enough to suggest that experienced investors who can tolerate higher risks, and who allocate part of their portfolio to small-cap stocks, should look closer at the sector. They will need high conviction given the likelihood of continued bad news in mining services.
Crunched by commodity bust
To recap, the mining services sector was belted when the commodity boom ended and resource companies killed or deferred new projects and mothballed others. Explorers and producers squeezed capital expenditure and costs – and mining service companies, which suddenly had less bargaining power, saw work orders and profit margins decline.
Ominously, National Australia Bank said last month that Australia’s mining investment downturn was only half complete. New investment in coal and iron ore projects is scant and the liquefied natural gas infrastructure boom is nearly done.
NAB predicted mining capital expenditure would fall to 1.5% of gross domestic product by late 2018, from 4.5% now and 8% at its peak. If NAB’s forecast is correct, the mining services sector has years of pain ahead.
At a micro level, mining service companies have given little joy in their earning guidance in the latest profit reporting period. There’s plenty of guff about “positioning for recovery”, but most outlook commentary pointed to ongoing tough times in the sector.
Anecdotally, the mining services sector is still in a steady downtrend. I recently visited North Queensland – an area that was bursting at the seams when coal prices boomed and now is struggling as mining projects are axed or downsized.
There were more vacant stores in previously thriving shopping centres; depressed property markets; talk of people without work, or having to accept fewer hours or lower wages and conditions to keep their job in the mining services sector.
Of course, that’s not true of all areas or all workers. But anybody who buys mining services stocks must understand the sector’s serious challenges. The question is whether depressed valuations have factored in too much bad news.
Greenshoots of activity
There is some glimmer of hope. The gold sector has rallied this year amid expectations of “lower for longer” interest rates in the United States and elsewhere, and as investors buy precious metals for their safe-haven qualities. A lower Australian dollar against the greenback has lifted the all-important A$ gold price.
As reported recently this report, I am bullish on gold’s medium term prospects. A rising gold price would encourage more mining companies to expand existing operations and revisit old ones, giving a small boost to the mining services sector.
Iron ore prices have rallied this year and some investment banks are raising their forecasts for the bulk commodity in 2017. But it will still take years for excess iron ore supply to be absorbed and a catalyst for a further re-rating is hard to find in a gloomy global economy.
An increase in infrastructure investment is another much-needed bright spot for mining service companies. Several have increased their exposure to infrastructure at the expense of their mining service operations, to capitalise on stronger conditions.
Then there are valuations. Former mining services star, Monadelphous Group (MND), for example, trades on a forecast Price Earnings (PE) multiple of 11.5 times 2016-17 earnings, according to consensus analyst estimates. Energy services provider, WorleyParsons, trades on 12 times; CIMIC trades on 21 times and UGL is on 10 times.
Remember, higher-quality mining service companies still have long-term contracts with blue-chip clients, albeit usually not as favourable as in years past. And there is still plenty of mining maintenance work to partly offset the decline in new projects.
Astute fund managers, such as Wilson Asset Management and Perpetual, have increased their exposure to select mining service stocks this year and more fund managers say value is emerging in the sector.
However, I cannot get excited about small mining service stocks, particularly after price gains this year in higher-quality companies. Those with pure resource sector exposure, especially in bulk commodities such as coal, have a challenged outlook.
Expect further falls in bulk and base metals prices in the next few years as the global economy slows and commodity oversupply persists. Record-low interest rates and currency wars have provided respite for the resources sector, although are symptomatic of worsening structural problems in the global economy that will take commodity prices lower.
How to play the sector
My preference is for resource service companies with stronger exposure to the infrastructure and energy sectors. I included WorleyParsons (WOR) as an acquisition target in the Switzer Super Report takeover portfolio, and retain a positive view. WorleyParsons has rallied from a 52-week low of $3 to $7.50, but remains well down on peak prices.
Chart 1: WorleyParsons
Source: Yahoo
I outlined a favourable view on UGL for this report in May. UGL provides outsourced engineering, asset management and maintenance in transport and utilities infrastructure, and about 40% of its revenue is in rail and defence projects.
UGL, a sometimes volatile stock, disappointed in June after announcing further delays at the Ichthys construction projects. A protracted dispute is possible and the uncertainty could weigh on UGL’s share price in 2016-17.
But UGL looks a touch undervalued at $2.10 . The popular share valuation service, Skaffold, has UGL’s intrinsic value rising from $2.73 in 2017 to $3.22 in 2018. The median share price target for UGL is $2.32, using consensus analyst forecasts.
Chart 2: UGL
Source: Yahoo
Among smaller stocks, RCR Tomlinson (RCR) is worth watching. RCR has rallied from $1.13 in February to $1.71, but remains well down on prices of late last year.
The diversified engineering and infrastructure company announced several contract wins in May and in a recent presentation said its order book is up 15% to $821 million. It has a strong balance sheet with low net debt relative to equity and good cash-flow conversions.
I like how RCR is increasing its focus on rail, transport and power infrastructure and growing its presence in renewable energy and water projects. It decision in April to cut unprofitable local and foreign branches, and reduce corporate overheads, is another belated positive.
RCR has growing exposure to sectors with good medium-term prospects, and less leverage to the struggling mining services sector compared to other providers. But the valuation does not fully reflect that at $1.71.
Skaffold values RCR shares at $2.26, rising to $2.56. Macquarie Equities Research has a $2.31 price target and an outperform recommendation.
Chart 3: RCR Tomlinson
Source: Yahoo
Tank infrastructure group, Saunders International (SND), and the fly-in/fly-out airline, Alliance Aviation Services (AQZ), are also worthy of further investigation. More on them in a future column.
A selection of ASX-listed mining services or mining-related stocks
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Source: Morningstar
* ranked by one year total return
** total shareholder return includes capital growth and dividend. One year to July 5, 2016.
- Tony Featherstone is a former managing editor of BRW and Shares magazines. The information in this article should not be considered personal advice. The article has been prepared without taking into account your objectives, financial situation or particular needs. Before acting on the information in this article you should consider the appropriateness of the information, with regard to your objectives, financial situation and needs. Do further research of your own or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at July 6, 2016.
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.