The Australian Engineering and Construction (E&C) sector has experienced explosive growth over the past 12 years. Activity in 2012 was estimated to be some 600% above that of 2001, and the industry has grown to represent 7% of GDP; a record for Australia.
Quality-listed businesses, with blue chip clients exposed to this thematic, have shown even more impressive growth numbers. Monadelphous Group Limited (MND), which we regard as the sector’s highest-quality company, has experienced share price appreciation of 3,100% over the same period.
That return figure was higher, until management suggested recently that their outlook will become challenging in 2014. Our interpretation was that business will find it challenging just to stand still in the coming financial year. For a market used to operating at breakneck speed, this has come as a big shock to many loyal investors, and naturally the share price slumped.
The outlook
Investors have had a lot to digest over the past six to 12 months. After continuously achieving 10% to 30% annual growth rates for the past 12 years, a severe and prolonged decline in Australian E&C activity has been estimated by a number of leading research and economic houses. Many of these forecasts indicate that we are about to enter a period of double digit declines.
According to one firm, this is unprecedented in 27 years of data collection and analysis. Morgan Stanley’s forecasts are illustrated below.
While these are merely forecasts, signs of deterioration are already observable for those willing to look a little deeper. Profit downgrades and deteriorating outlooks have dominated the recent trading update season.
Some have argued the stock market’s reaction has been overdone and that shares are now cheap. But mine-expansion activity has slowed sharply and billions of dollars worth of projects have been mothballed or cancelled. By way of example, RIO has recently announced that it will be putting a renewed focus on cost cutting to help counter falling revenues, so we would argue that future pressure on service providers is only just gathering pace.
A cautionary tale
We expect competition in tendering for a declining pool of projects will intensify and the discounting will put pressure on margins. In anticipation of this, we are already seeing rising unemployment and slumping job advertising. Although there are approximately 80 listed businesses that service the mining sector, we estimate there are 800 companies in total, and all are bidding for an ever-decreasing pool of work.
The result is poor earnings ‘visibility’, and hence we continue to be wary of the sector and will watch the recent bounce in commodity and share prices from the sidelines.
Will others come around to our way of thinking? This year’s reporting season will be one to follow closely. Our expectation is that companies will generally report well, given full order books secured back in 2012, when the market was buoyant. Revenue targets are all but locked in, and contracts have been secured on historically attractive margins.
But herein lies the rub. In the past, service providers have been able to point to their pipeline of future work to reassure the market that they will be able to meet expectations. But the pipeline can dry up quickly for companies at the mercy of projects being deferred or cut back.
Outlook statements by the sector’s incumbents will be heavily scrutinised for encouraging signs. Generally, however, we prefer to avoid businesses that only cover their cost of capital during booms.
Given the long lead times required to mobilise labour and equipment, we’d prefer to see at least 60% to 70% of a business’s order/revenue book contracted and underway at the result, with the balance secured and underway by the second half. This gives us a reasonable level of confidence that the business will at least tread water.
Coffey and Bradken
Two businesses have already reported in the mining services space, and despite their share prices bouncing afterwards, we are generally underwhelmed by how we see the next 12 or more months playing out for them.
Coffey International Limited (COF) locked in a favourable 12-month turnaround to 30 June 2013, with total revenue of $688.4 million, but its contracted fee revenue is just $100 million in Geosciences, $14 million in Project Management, and $73 million in International Development for 2014. That’s less than 30% of its revenue contracted. Management states “there is no doubt, conditions remain tough, particularly for Geosciences in Australia, so it is prudent not to provide any specific earnings outlook at this time”.
That’s hardly encouraging.
Bradken Limited (BKN) reported a result that seemed to impress the market, with its business strategy remaining unchanged for FY14. Bradken plans to focus on its key strengths on the design, manufacture and supply of consumable products to the mining, energy and rail industries. Which is perhaps what you would expect.
The fact that Bradken expects FY14 to be broadly comparable with FY13 doesn’t sit well after some thought is given to its future. While it might be achievable, we see considerable downside earnings risk in FY14 and beyond.
Can Bradken have a hero 12 months? RIO might provide the answer, as it has already highlighted the huge price savings it is getting on consumables. Given that RIO and others are continuing to focus on cost-cutting measures, RIO doesn’t seem as confident as Bradken’s outlook statement. We find it curious that investors focus on the statements of one company without considering those of related companies.
Rising share prices are evidence of a few investors being lured back into the sector recently – the short-term ‘voting machine’ in action – thanks to optimism about a turnaround in China.
Over longer periods however, the market is a ‘weighing machine’ and with outlooks hardly enthusiastic or confident, we remain of the view that the risks are still firmly to the downside.
Given earnings generally drive share prices over the longer term, falling earnings are unlikely to produce a satisfactory return outcome for our portfolios. We will continue to steer the Montgomery funds away from mining services.
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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- Tony Negline: Deferred lifetime annuities – expensive waste of time?
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