Two stock buys in an outperforming sector

Investment Committee, Switzer Dividend Growth Fund
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The sweet spot for local earnings has been the mining services sector and the expectation is that it should once again outperform in 2012, backed by the extraordinarily large capital expenditure pipeline in the mining and energy sector. Investors should continue to have mining services as a core portfolio theme in the years ahead. It is an ideal way to gain exposure to a sector that has seen some solid expansion in earnings at a time when Australia is undergoing an unprecedented boom in the mining and energy sector.

Investment should result in strong growth

In 2011, mining services as a sector outperformed the Small Ordinaries Index by around 12%. While the sector has been a good relative outperformer versus other sectors, it is important to reflect that it remains a small weighting to the overall domestic index. The earnings of the broader ASX200 Index are predominately influenced by the large Miners, Industrials and Banks. So basically, this sector cannot drive broader earnings upgrades for the Index by year-end. While I still anticipate further strengthening in mining services in 2012 versus the broader index, I would expect the outperformance in 2012 to be lower than last year.

The expectation is that the high level of investment should result in strong growth across the industry. Valuations remain compelling and with demand robust and capacity tight, the sector should witness margin expansion that should lead to further positive estimate revisions. The outlook for the mining services sector remains exceedingly strong over the short to medium term.

For example, committed capital expenditure (CAPEX) of over $210 billion for Oil & Gas (predominately liquefied natural gas), Iron Ore, Coal, and Other Minerals will be spent in the next three financial years. That is a little under 20% of gross domestic product (GDP), a significant driver of Australia’s positive terms of trade.

Note, exposure to this sector is not a yield play but rather a growth exposure. Also, keep in mind that the sector is very cyclical. There are many different types of companies in this sector, with large variations, but it comes down to the quality of their contracts, their ability to deliver in an environment with capacity constraints and their management team. They also range from large-cap companies to small-cap companies, with implications on the capital intensity of their balance sheet structures.

The tables below goes through a broad coverage of mining services companies in our local market. We go through some basic metrics (the multiple), look at the UBS rating versus the consensus rating across all brokers on the street, and compare the price targets for each stock.

Table 1: Mining Services – the crowded trade to continue

Consensus ratings

Two key quality names:

WorleyParsons (WOR) provides professional services through alliance and integrated service contracts to the energy, resources and complex process industries. Services include sectors such as oil and gas refining, petrochemicals and chemicals, minerals and metals, power and water, and infrastructure. The company reported earnings recently and the result was broadly in line with expectations (no surprise margins up on minerals/metals in line with others in this space), so it is very much about the hydrocarbon guidance provided for 2012 (a large positive). WorleyParsons is a true global player with earnings linked to the energy cycle and global mining and metals, which is what I would be looking for. I would expect to see continued growth in minerals and metals in both Latin American and Africa (a good global diversifier).

NRW Holdings (NWH) has also been part of our private client portfolios. The company provides services to the mining resources, energy and government sectors. NRW will continue to be a direct beneficiary of large CAPEX underway in this sector over the coming years. Over the next three years, the estimate is that NRW will deliver compound earnings per share (EPS) growth of 30.7%. This strong level of growth will be driven by a combination of end-market strength and NRW’s increased service capabilities. The operating environment remains exceedingly strong, with NRW having a contracted order book of $1.7 billion and actively tendering on $3.2 billion worth of work.

Note: As always, a diversified approach is encouraged. The tables go through the basic metrics and there is value. But it is a crowded space and the performance has been strong.

George Boubouras is the Head of Investment Strategy & Consulting at UBS Wealth Management.

Important information: 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. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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