The adage of buying companies that sell the “picks and shovels” during a boom rather than those doing the digging is apt for ALS (ASX: ALQ), a leading laboratory service provider. But the market sees it differently, irrationally so, at ALS’s current price.
ALS provides testing services for global mining companies in geochemistry, metallurgy, mine-site service and inspection. A gold explorer, for example, might use ALS to test exploration samples. Coal and gas explorers test samples through ALS’s energy division.
In life sciences, ALS laboratories test environmental, food and pharmaceutical, electronics and animal health services. In industrial services, ALS provides laboratory work across industry.
ALS starred during the mining investment boom. It raced from $1.55 in early 2009 at the peak of the Global Financial Crisis to almost $12 in early 2012. Soaring commodity prices encouraged resource companies to raise capital and lift exploration.
That meant more laboratory samples, supercharged earnings for ALS and a galloping share price. The market loved ALS’s expanding global footprint and emerging status as one of the world’s largest and most profitable laboratory testing companies. It couldn’t put a foot wrong.
Industry diversification was another plus. ALS’s push into life sciences diversified earnings and reduced the company’s exposure to volatile commodity cycles. Expansion into pharmaceutical and food testing would create a more stable, visible earnings profile for ALS.
I identified ALS for The Switzer Report in March 2018 in a feature on mining-service stocks, at $7.37 a share. ALS rallied to $9 within six months of that story, then trended lower
ALS tumbled 4% in May 2019 as the market fretted about a slowdown in sample volumes. ALS’s reported after-tax net profit ($181 million) for FY19 beat guidance ($170-$175 million) but the market was spooked by a 5-7% fall in geochemistry sample flows. The stock hit a 52-week low of $6.40 earlier this year, only to bounce to $7.24 in the past few weeks.
Chart 1: ALS (ASX: ALQ)
Source: ASX
Exploration the key
Although ALS is far more diversified these days, the minerals division still provides almost a third of revenue and geochemistry is its biggest contributor. Within that, gold exploration is critical as the commodity accounted for half of global minerals exploration in 2018.
The chart on page 18 of ALS’s latest investor presentation shows the relationship between the US-dollar gold price, global exploration and ALS sample volumes. It’s useful data for investors who want to understand ALS’ relationship to the gold price.
Simply, a rallying gold price encourages more gold companies to raise equity capital (and more investors to provide it) to explore projects. That means more samples analysed at ALS and higher profits margins as laboratory demand rises.
For ALS, a higher US-dollar gold price and rising global exploration spend has accompanied a modest lift in sample volumes since 2016. Volumes are still a long way off peak levels in 2012 and the fear is the recent samples downturn turns into something larger and prolonged.
The macro outlook is okay. Global mining capital expenditure is expected to deliver compound annual growth (CAGR) of 6.8% over 2018 to 2020, notes ALS. That’s down from CAGR of 12.2% over 2015-18.
The good news is that “greenfield” capital expenditure – projects in unchartered territories – is expected to almost double between 2016 and 2020 to just over US$50 billion, albeit off a low base. Stabilising commodity prices should encourage higher gold exploration.
As such, contrarians in ALS must have a positive view on the gold price and the volume of capital raisings that fund gold exploration.
I outlined a positive view on gold in November 2018 for this report and again in January 2019 in “golden opportunities for investors”. I wrote this year: “Portfolio investors should cautiously increase their allocation to gold bullion (5-10% for most) and that speculators keep an eye on gold equities in 2019. Gold bullion and gold equities are rallying and more gains are likely.”
US-dollar gold has rallied from about US$1,300 an ounce in January 2019 to US$1,418 –a six-year high. In Australian dollar terms, the gold price is flying. The S&P/ASX All Ord Gold index (XGD) is up 28% this calendar year and also at a six-year high. Yet for all the interest in gold, ALS is languishing.
I’m not overly bullish on gold from here, although expect the US dollar gold price to trend modestly higher as investors hold “safe-haven” assets amid trade wars and political crises. I don’t see a rapid rise in US interest rates, which would be bad for gold.
ALS’s share price has tended to track the gold price, but the relationship has broken down over the past two years. ALS rallied in early 2018 when the gold price fell and has tumbled this year with a higher gold price. Perhaps the market is more concerned about ALS’ life-science division.
Forecasts of a 5-10% increase in exploration budgets this year, mostly from large miners, based on S&P Global research look feasible as global growth and commodity prices stabilise. But there is a lag between higher commodity prices, capital raisings, exploration and ALS sample volumes.
Valuation
The market believes ALS’s days of halcyon growth are behind it and that it will struggle to deliver the same rate of earnings growth from a larger asset base. Growth in mining exploration is well down from peak levels and there is intense competition in life-science laboratory testing.
An average share-price target of $8.29, based on the consensus of 10 broking firms, suggests ALS is undervalued at $7.24. Analyst targets range from $6.85 to $9, meaning ALS is trading only a little higher than the lowest broker targets at the current price.
Morningstar, not included in the consensus forecast, values ALS at $4.50 and says it is “substantially overvalued”. Morningstar believes the market is factoring in too much growth and basing its view on historic growth rates, which are unlikely to be delivered as the ALS asset base expands and more revenue is derived from the life-science division.
It’s always good to read bearish views on stocks when you have a positive view, to test your thinking. Average price targets are interesting, but extreme bearish or bullish views – where analysts are prepared to stick their neck out –warrant extra attention.
On Macquarie’s numbers, ALS is trading on a 28% discount to the average Price Earnings (PE) multiple of its global peers, when it usually trades at an average discount of 10%. In absolute terms, ALS’s forward PE multiple of 16 times earnings compares to its 10-year average of 17.5 times, on Macquarie numbers.
Compared to the broader market, ALS’s PE is in line with the S&P/ASX 100 despite trading at a 25% premium over the past 10 years. Moreover, the ALS share price has fallen sharply in the past 18 months, despite consensus earnings forecasts for the company rising.
Something has to give. Either analysts are too positive on ALS and need to lower their earnings forecasts or the market is too bearish and overlooking the link between a rallying gold price and ALS (through higher exploration and laboratory samples). I favour the latter scenario.
My sense is the market has over-reacted to a few months of lower sample volumes for ALS and that the downturn is more of a mid-cycle pause or aberration, than the start of a longer decline. Gold-company capital raisings were terrible in late 2018 and early 2019 and ALS may be suffering from a lagged effect. Capital raising picked up in March and April and the latter was one of the strongest months in two years, including other capital raisings. I suspect the latest downturn in ALS sample volumes will be short-lived or shallow, similar to the blip in late 2015 and early 2016 when there was a small decrease in growth.
As the market loses interest in ALS, its Return on Equity (ROE) has risen from almost 13% at the end of its reporting period in FY18 to 17% in FY19, Morningstar data shows. That’s down on ALS’s peak ROE above 20% during the mining boom, but ahead of single-digit returns in 2016 and 2017.
A rising ROE is a good sign as it leads to a higher intrinsic or fair company value and higher share price over time. ALS management is doing a good job to lift returns in a tough market.
ALS extended its share buyback program for the 12 months to December 2019 by $225 million – a sign that it believes its stock is significantly undervalued. The balance sheet is strong and there is excellent cash-flow generation to help fund acquisitions.
From a charting perspective, ALS has held support around $6.50 thrice in the past 18 months, which is encouraging.
As a mid-cap company leveraged to the commodity cycle, ALS suits experienced investors. Companies that rely on hard-to-predict commodity prices have an element of uncertainty and do not suit risk-averse investors.
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 25 June 2019.
