Is it time to get back into mining services?

Financial journalist
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As worries have mounted over the potential slowdown in Chinese economic growth, it isn’t just commodity prices and mining stock prices that have taken a hammering.

The mining services companies, too, have been pounded.

With capital expenditure in the resources space set to peak this year, and big miners announcing plans to severely curtail costs, delay projects and cancel others, next year could be even worse for the mining services sector.

Almost $20 billion has been stripped from the value of the stock market’s listed mining services companies since February – nearly two-fifths of the combined value.

The sector was already reeling in late 2012 from project deferrals by miners and a surprise slump in the iron ore price. But the 2013 carnage still appeared to catch both companies and brokers by surprise.

Dramatic rewrite

As recently as the end of April, UBS and other brokers had “buys” on stocks across the sector, arguing that the bad news was already factored in to the prices.

But the earnings downgrades (and job cuts) have come thick and fast, from all corners of the businesses that supply services to the miners and oil and gas companies: from engineers UGL, Worley Parsons, Transfield Services (two downgrades), Cardno (two downgrades); engineering and project management services provider Ausenco; drilling fluids supplier Imdex; mining contractors and service providers Ausdrill (two downgrades), Lycopodium, NRW Holdings, Calibre Group, GR Engineering, Sedgman (three downgrades), Macmahon (three downgrades) and Mastermyne; earth-moving equipment company Emeco (three downgrades); crane provider Boom Logistics (two downgrades); and pumping, dewatering, power generation and air-compressor supplier Resource Equipment (two downgrades).

It is hard to pick out the worst performer: probably mining services provider Allmine Group, which was suspended from trading in May, while it undertook a financial review, and entered into administration in June, after its shares fell 80% this year.

But only its actual collapse puts Allmine Group ahead of the likes of mining accommodation provider Fleetwood, which has given the market four profit warnings in the past year, and drilling services provider Boart Longyear. Boart has slashed its earnings outlook twice in two months, had its credit rating cut and went to its bankers for permission to reschedule debt, in exchange for higher interest and the banks taking security over a range of assets.

It’s a bloodbath

Even the companies that have not cut their earnings guidance have seen their share prices taken down by the market, because the market expects them to come out with earnings downgrades. In this group are mining contractor Monadelphous, laboratory testing group ALS, which does most of the assay (examination and analysis) work for Australian miners, and Decmil Group, which specialises in building accommodation and offices at remote mining and energy sites. Decmil and ALS have not been marked down as heavily as Monadelphous, and in fact have seen their share prices recover recently.

When a sector is attacked like this, the share price falls rapidly expose what appears to be great value. But this can just as easily be a classic value trap – that is, where the prospective price/earnings (P/E) ratio is low, and/or the dividend yield high, for a very good reason: namely, that the market does not expect the earnings and/or dividend to come through as high as expected.

With that in mind, I checked through the excellent database at FN Arena to look at the forward (FY14) P/Es and dividend yields – and the difference between the share price and the brokers consensus target price – for a range of mining services stocks.

Clearly, to an investor accustomed to looking for low P/Es and high dividend yields as indicators of value, there is plenty in this sector. But the corollary of this is that the stocks could be value traps – the earnings estimate is still too high, and the P/E is artificially low. For the dividend yield, think in reverse.

As for the steep – and juicy – discounts on offer to the consensus target price, the problem is that the second part of this comparison might not yet have been adjusted downward.

Value take

I asked David Buckland, chief executive officer and portfolio manager at Montgomery Investment Management – one of the best value investors in Australia – what he thought of the sector. His response: “yes, the space is cheap, but it deserves to be!”

Buckland’s biggest issue with the resource services sector is the “savage decline” in the anticipated work on hand. For example, says Buckland, the Bureau of Resources and Energy Economics (BREE) expects the value of current and likely project investment to decline 75%, from $270 billion in 2012 to $70 billion in 2017.

“If this proves correct, then the sector’s revenue will be under significant pressure and margins will probably be slashed,” he says. “You only have to look at the degree BHP and RIO are aggressively cutting their capital expenditure and exploration budgets, as well as their dependence on contractors.”

Buckland says the standout stocks in the sector are those with very good business positioning, recurring earnings and strong balance sheets – such as Monadelphous, Worley Parsons and Decmil Group. (For example, Decmil recently won a $137 million contract to build a village at the federal government’s controversial Manus Island detention centre in Papua New Guinea: government work diversifies Decmil from its traditional customer base of mining and energy, which is scaling back spending.)

But even then, the best that Buckland can say about these stocks is that they “may do less bad.”

Gary Stone, managing director of ShareWealth Systems, has a different perspective on the market. ShareWealth Systems uses a mechanical software system that employs criteria based on price, volume and relative strength – the relative comparison of a stock’s price action against the S&P/ASX All Ordinaries index – to trigger trading signals. Stone says the signals from Share Wealth Systems are totally objective: they ignore commentators’ views, brokers’ opinions, stock announcements and geopolitical news, which they consider to be “noise” as all this is discounted into the price movement at any given time.

Looking at the mining services stocks, Stone says “none of them are even showing the early signs” of turning around. He says the sector looks very over-sold, but on price action, none of the stocks are establishing higher lows and higher highs, a key precursor to a breakout.

“It is still too early to go into these stocks,” he says. “The only reason to do so would be as a purely contrarian play, in an over-sold market. But on price action and relative strength, there is no evidence of a potential turnaround, so expecting any move in the mining services sector is a guess,” says Stone.

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.

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