Key points
- It’s going to remain tough for WA-based mining service, engineering, contracting, industrial service, equipment hire and consumer facing companies.
- In mining services, diversified Seven Group Holdings (SVW) is the only company that has value.
- The big miners – BHP, Rio, Fortescue and Woodside – look cheap – with their dividend yields to provide a floor.
Once upon a time a stockbroker, an investor and a company director went for a trip to the seaside.
Two thousand kilometres from Perth, 100 kilometres from the nearest town, no food, no water, no shelter, no mobile coverage, tide rising quickly, sun setting even faster, snakes in the bushes and tiger sharks in the water… what happens next?
Amazingly, Bear Grylls style, the stockbroker, investor and company director managed to light a fire.
Then, like a scene from Apocalypse Now, just when it seemed we might have to settle in for a long night on the desolate beach, the distant whoop, whoop, whoop of helicopter blades could be heard.
A cattle mustering helicopter swoops onto the beach in near pitch dark, the three financial types jump in, and within 20 minutes are having an ice cold beer back in civilisation.
Welcome to Western Australia, land of risk and reward.
The West Coast story
I have always enjoyed visiting Perth and greater Western Australia. Investors and companies always warmly welcome you because you’ve “made the effort” to come over from the East Coast, while I also feel the degree of entrepreneurialism and risk taking is higher on the West Coast and something to be admired.
WA now moves into a major step up in iron ore and gas production, yet the capital intense construction phase and its massive multiplier effect through the economy are over.
WA unemployment is rising, GDP growth slowing, house prices flattening/falling, office vacancies rising and overall the mood is quite sombre.
Infrastructure upgrade projects such as the Queen Elizabeth dock area, new Perth Stadium, international airport terminal upgrade and freeway upgrades are underway, but are far less capital intense, materials intense, and labour intense than the major iron ore and gas projects were. The multiplier effect through the economy is also less.
What we all need to remember is production assets are far less labour intense than during their construction phase. I think this can best be summarised by a regional Qantas 737-800 flight I was on. Only 44 of 180 seats on the Karratha to Perth flight I was on were taken. Rewind three years ago and RIO’s/ WPL’s expansions in Karratha meant you were lucky to even secure a business class seat on this flight.
People-less power
One of the most stunning features of visiting large scale WA resource projects/assets nowadays is just how few humans you see. Driverless 200t trucks (CAT/SVW) and automation of the production chain are structurally lowering demand for labour. At the big gas plants you hardly see anyone outside of a relatively small control room. It’s quite amazing relative to the scale of export revenue they produce.
Wage deflation is real in WA as demand for skilled labour drops. As the big resource construction phase ends you will see skilled labour head back to the East Coast to work in the new housing and infrastructure construction sectors.
The mobility of Australian skilled labour is another reason I think Australian interest rates will remain low for an extended period. It’s highly unlikely under this mobile skilled labour scenario that wages will move significantly higher. If anything it will put a cap on any broader wage pressure, which also puts a cap on inflationary pressure and in turn interest rates.
I do have sympathy for Western Australia. They deserve a greater share of the GST pie. The WA resource sector investment cycle almost certainly saved Australia from a post GFC recession (and a much higher national unemployment rate), while moving forward, slackness in the labour market will play a role in keeping interest rates low. Similarly, the WA-based supply response in iron ore and gas will play a role in keeping global inflation readings low, ensuring global and domestic interest rates remain relatively low.
The iron ore and gas supply response, and associated lower spot prices, are playing a role in lowering the Australian dollar. Again, WA can claim some role in this very important development for the broader Australian economy.
Doing it tough
Unfortunately I think it’s going to remain tough for WA-based mining service, engineering, contracting, industrial service, equipment hire and consumer facing companies. I can’t see yet what ends the down cycle in both volumes of work, prices and margins. It may not get much worse, but I can’t see it getting significantly better anytime soon.
There does seem to be some sort of view forming in WA that the downturn is all “BHP & RIO’s” fault. I think that’s very harsh. All we are seeing is the end of a once-in-a-generation mining investment boom and the major producers switching from ramping up production to sweating their assets as hard as possible. It’s simply a cycle, one that has been seen before (albeit a bigger one than ever seen before).
I wrote in these notes a few years ago that the resource company/mining services relationship was no different to the fund manager/broker relationship. In up cycles the “middle men” see volume, price and margin uplifts, and vice versa in the down cycles. For the “middle men” in WA it’s going to remain tough. That’s the unfortunate reality of the situation.
The only one I recommend is the diversified Seven Group Holdings (SVW). Seven is trading below NTA, 9.1x FY15 consensus earnings, and offers an 8.4% grossed up annual yield at current prices. There is an active on-market buyback program and, from my observation, Caterpillar equipment, particularly autonomous trucks, are playing a crucial role in the big miners getting their C1 costs down. I am also currently reading the Kerry Stokes biography “The boy from nowhere”. It’s a great read and quite frankly makes you want to invest in the stock he controls nearly 70% of. A bit like backing Gerry Harvey and Solomon Lew in the retail downturn, I’d be backing Stokes over all others in this mining services downturn.
Good value
There are two WA sectors I am interested in from an investment perspective. Resource companies that have invested in low cost production growth and inbound tourism.
I think large scale, low cost, long life, WA-based iron ore and gas producers are now cheap. They have turned up low cost production, turned off capex, driven down operating costs and the result will be a greater share of profits to investors. Prospective dividend yield alone will now start putting a floor share price under BHP Billiton, Rio Tinto, Fortescue Metals Group and Woodside Petroleum. Below are current consensus prospective grossed up yield forecasts.
Investors have been campaigning for resource companies to turn down the capex tap and turn up the dividend payout ratio tap. Yet resource stocks have been de-rated in P/E terms due to falling commodity prices, partly driven by the low cost supply response they are delivering to market.
I think these big WA based, low cost, large scale, long life, resource names who have previously invested in production growth are cheap. From here I think we will see commodity price stabilisation, cash costs lowered further, yet the Aussie dollar continuing to head lower on interest rate differentials with the USA. I also think that we will see large scale M&A.
No doubt Glencore has started the “bear hug” on Rio Tinto. The day will come next year when Glencore bids for RIO and it might just be hostile. When that day comes, investors will positively reassess the value of remaining large scale, low cost, long life, WA production assets.
The increasing likelihood of a medium-term takeover bid for Rio Tinto is another reason I am recommending buying BHP, Rio, Fortescue and Woodside at current prices. It’s always darkest before the dawn and that could well be right now in these names.
The travellers
In terms of inbound tourism, Perth/WA should see a recovery from here as the Aussie dollar fall increases the relative attractiveness of WA’s strong tourism offering.
The way to play this theme is firstly through Crown Resorts (CWN) which is investing heavily, upgrading the former Burswood site to a world class destination casino offering. When completed in late 2016, Crown Perth will be the destination of choice for business and leisure travellers. Crown will have Perth’s best accommodation, best restaurants and best entertainment. And it’s close to the airport, which is important as most Perth taxi drivers don’t seem to know where they are going! There is clearly a business opportunity in selling Perth taxi drivers GPS.
In summary it all feels a bit flat over in Perth and as I said above the mood is quite sombre. However, it is just a down cycle not a depression. It is only a matter of time before the broader business community gets its entrepreneurial mojo back and starts riding the next cycle.
In the interim I believe the way to play WA is via large scale, low cost, long life resource stocks (BHP, Rio, Fortescue and Woodside), Seven Group Holdings as a contrarian value and yield play, and inbound tourism stocks for earnings growth.
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.
