The biggest, most complex issue facing institutional investors in 2016 is when to buy resource stocks. It is also the toughest challenge facing resource companies that have balance-sheet firepower to buy ailing competitors. After years of neglecting resource stocks, some of the market’s better judges are starting to re-enter the sector.
Respected stock picker John Sevior of Airlie Funds Management has started buying resource stocks again, despite reservations about the capital allocation record of BHP Billiton and other large miners.
PM Capital is another that has resource stocks on its radar. The prominent international equities manager has been among the biggest bears on resource stocks over the past few years. It sees value returning but is yet to make a move on mining or energy shares.
As valuations tumble, a turning point for resource stocks is getting closer. Certainly, the near-term outlook for resource stocks is horrible as China slows, deflation fears rise and panic grips financial markets. But such conditions are often an opportunity for contrarians.
The key question, of course, is how much of the outlook is factored into valuations. The S&P/ASX 300 Resources Index (capital only) shed 25% in calendar year 2015. Share prices of the big diversified miners and energy stocks crashed. Santos, for example, which was trading above $12 for much of 2014, has plunged to $2.93.
These are interesting times for offshore resource companies and sovereign wealth funds that can acquire mining assets at a fraction of their peak valuations. However, going in too early – like this column did last year when it included Santos (STO) as a takeover target – is dangerous.
Picking takeover targets in this market is hard enough. A trickier challenge is timing. Buying stocks on the basis of takeover alone is foolhardy because such deals often do not eventuate or fall through, take longer than expected to occur, or have less upside than imagined. But the timing of takeovers in the energy sector looks more favourable, after the oil price carnage in the past six months.
The price has fallen so far that OPEC and non-OPEC producers will surely have to collaborate to normalise oil prices as best they can. If they do not, many oil producers – and oil-exporting countries for that matter – will be insolvent.
The supply response to lower energy prices is coming. More producers are shelving investment plans or curbing production in the face of weak prices and lower demand. In time, lower supply will lead to a better equilibrium in energy prices. Does that mean oil will not fall further or that incredible volatility will subside in the near term? I doubt it.
There’s too much uncertainty to suggest that a floor is being built into price at current levels before inevitable gains. There is, however, enough to suggest that the largest energy stocks look more attractive at current prices for long-term investors and that takeovers in the energy sectors will emerge if prices continue to fall and market behaviour becomes increasingly irrational.
WorleyParsons in firing line
Few industries have been hurt more by commodity price falls and the end of the mining investment boom than resource service companies. They were the first to sink as investors recognised a once-in-a-generation capital expenditure cycle in the mining and energy sectors was abruptly ending. Even at current valuations, takeover volumes in resource service stocks have been relatively low. Predators are, understandably, reluctant to move.
Energy and infrastructure services provider WorleyParsons (WOR), a former market darling, has slumped from above $30 in 2011 to $3.31. Its one-year total return is -64% and over three years, the annualised return is -47%.
Chart 1: WOR
Source: Yahoo!7 Finance, 11 February 2016
As one of the world’s largest providers of engineering and professional services to the energy sector, WorleyParsons is highly leveraged to the downturn. Its main business, providing engineering and project management services to hydrocarbon customers, contributes more than 70% of revenue. Services for infrastructure and mining projects provide the rest.
Lower energy prices have decimated WorleyParsons. The withdrawal of new energy projects and cutbacks in existing ones crunched its earnings and reduced market visibility in its order book and future revenue. It seems likely that WorleyParsons’ cycle of downgraded earnings will continue as the commodity slump intensifies and capital expenditure budgets – a reliable, leading indicator of WorleyParsons earnings – fall.
Concerns about WorleyParsons’ balance sheet, and potential for a dilutive equity capital raising, should earnings deteriorate more than expected, add to the negativity. This is not a stock for conservative investors or the faint-hearted to buy in the current volatility, or for those who cannot withstand further share price falls in the short term. But every company has its price.
As investors remain on the sidelines because of uncertainties around WorleyParsons’ earnings, offshore suitors will find the company more appealing at current valuations – particularly if they believe that most of the oil price damage has already occurred. WorleyParsons’ leverage to the oil price works both ways: a medium-term recovery would significantly boost its fortunes.
WorleyParsons is well aware of the takeover threat. Its board said at the annual general meeting last year that the company had prepared its takeover defences when it traded at higher prices than now. Speculation was rife in 2015 that WorleyParsons would be taken over, but the conjecture seems to have faded, despite a sharply lower valuation and lower Australian dollar. Its share price spiked 14% in April 2015 on takeover rumours.
For all of its immediate problems, WorleyParsons has a strong global footprint, blue-chip client base and excellent exposure to favourable long-term trends as developing economies, such as India, spend more on their energy and infrastructure markets.
It also has a valuation that arguably has priced in further earnings downgrades, asset write-downs and continuing bad news in the energy sector. But the market has mixed views: four out of 12 broking firms that cover WorleyParsons have a buy recommendation, five have a hold and three have a sell, based on consensus analyst forecasts.
Share price targets, ranging from $3.09 to $8.92, reflect the uncertainty in WorleyParsons’ valuation, and a median price target of $7.90, which looks far too high, suggests it is significantly undervalued compared to the current $3.35. Macquarie Equities Research’s $4.75 price target looks more realistic. It has a neutral recommendation and suggests investors wait on the sidelines because of the uncertainty.
Even the most bearish analyst forecasts have WorleyParsons trading near fair value at the current price. A forward price-earnings (PE) of 4.9 times 2016-17 earnings based on consensus estimates, shows how far the market has downgraded WorleyParsons’ prospects.
The PE could rise, if WorleyParsons’ expected earnings downgrades are larger than expected. More will be known when it reports its half-year earnings later this month. But even in the troubled energy sector, the PE looks low for a company that had $8.7 billion in revenue in 2014-15 and delivered an average 14% return on equity (ROE) in the past five financial years during the resources downturn. My main hesitation in nominating WorleyParsons as a takeover target is identifying an obvious offshore buyer.
Larger energy services companies might be reluctant to take on greater debt to acquire WorleyParsons in such an uncertain sector, and its global footprint could replicate services the acquirer provides in other markets.
It is not a simple bolt-on acquisition for an offshore predator. The prospect of an even lower valuation for WorleyParsons in the next few months could also deter suitors.
But WorleyParsons looks like an interesting takeover play for predators, who believe the oil price collapse has been overdone and that the world economy, while slowing, is not heading for recession. And who are prepared to pounce when everybody else is running for cover.
Takeover update
There was more pain for takeover targets this month as market volatility drove prices lower and scared off takeover attempts. Ansell (ANN) was particularly disappointing after a nasty earnings downgrade. WorleyParsons joins the takeover targets lists this week.
Source: Morningstar (one-year return), Standard and Poor’s (S&P/ ASX 200 total return).
* assumes dividend reinvestment
Tony Featherstone is a former managing editor of BRW and Shares magazines. The column does not imply any stock recommendations. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at 10 February 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.
