Investing in mining services: Finding gems among stones

A boom, a bust and a resurgence, as market conditions show signs of improvement, we are now able to analyse why investing in the mining services sector isn’t as disastrous as first thought.
By · 29 Oct 2019
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29 Oct 2019
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It’s far from the most appealing sector to invest in and in fact, five years ago our colleagues at the Intelligent Investor went so far as to recommend steering clear completely. For the most part, it was sound advice, however there were some hidden gems.

Cyclical in nature and highly volatile, the mining services industry screams red flags. Its existence, however, is imperative to the pulse of the Australian economy — the mining and resources sector, whose inhabitants often choose to outsource specific mining activities such as drilling, blasting, equipment and maintenance to companies that have technical expertise.

The mining services industry is therefore comprised of a variety of companies, ranging from highly specialised services to simpler outsourcing operations, rendering it difficult to generalise on the overall attractiveness of investing in it as one single ‘sector.’

What can be concluded however, is companies operating under this diverse umbrella are highly responsive to activity in the mining industry, which this year, is thriving off surging commodity prices.

It marks a transition of sorts, where mining companies begin to demand more services as they look to explore new deposits or expand on current operations according to EY’s Global Mining and Metals Leader, Paul Mitchell.

“Due to stronger project pipelines, and bullish commodity prices we are seeing equipment utilisation rates increasing, and lead times for new equipment in excess of 12 months, and hence market power is moving back to the contractor miners and hire fleet owners,” he says.

“Labour and maintenance are also tightening, with major infrastructure and construction projects competing for resources.”

For most players, this is welcome news following a five-year period in which recession gripped the mining industry, with the knock-on effects permeating through the services sector.

IBISWorld Senior Industry Analyst Jason Aravanis tells Eureka Report the magnitude of such downturns are exacerbated given the susceptibility of the services industry to macroenvironmental changes.

“Mining services companies are even more responsive to change than those in the mining industry because they have higher exposure to small fluctuations,” Aravanis explains.

“For example, external contractors are the first to go when mining companies need to cut costs, because they can bring activities performed in-house to gain more control over spending. When things turn good, the demand for mining services will jump.”

As previously recommended by our friends at the Intelligent Investor, the time to buy in the mining services industry is in the teeth of recession, and even then, it is a decision that comes with considerable risk.

“You obviously wouldn’t want to invest in an upswing, or late in an upswing but at the same time, you don’t want to invest in the middle of a downturn, as there is no guarantee the share price will go up anytime soon,” Aravanis says.

“As seen at the end of the mining boom, most services companies went out of business and if they did survive, they had to rely on debt finance.”

With the beauty of hindsight on our side, it's now possible to analyse the near full cycle of the mining services industry from the mining boom earlier this decade, to the crippling bust and then its recent resurgence, and the results aren’t as pitiful as first anticipated.

We can start by reflecting on the major players in the contract mining services industry, a major segment in the services sector, who supply machinery and skilled labour for mineral extraction.

The companies within this segment have experienced varying degrees of success as they grappled with declining capital expenditure in the mining industry throughout the middle part of this decade.

We can reflect on the success of these players by comparing the share price growth of a handful of mining services companies operating under a range of categories, with the ASX200 average growth of 25 per cent (at time of writing) over the past five years.

Let’s start with the largest player, CIMIC Group Limited, who has a predicted market share of 27.7 per cent according to IBISWorld and a market cap of $10.4 billion.

The project and development company went from the pits of the bust period at a share price of $20.13 in November 2014, to a decade-high of $52.12 in December 2017. It now sits at the $32.15 mark.

This represents a five-year growth of 59.7 per cent, over double the average of the ASX200 average and a five-year average dividend yield of 3.46 per cent. Far from disastrous…

The glory days came off the back of a hostile takeover of UGL and acquisition of Sedgman in 2016, leading to a surge in revenue in 2017 at a time when almost the entire contract mining services industry was in red.

Indeed, across the contract mining services sector, industry revenue declined at an annualised rate of 8.8 per cent over the five years through 2018-2019 according to IBISWorld.

Another major player, Downer Group, which IBISWorld estimates has a 13.5 per cent market share, has experienced similar five-year success, albeit the standard share price drop in the middle of the decade.

The company’s highest share price of $8.52 around the beginning of 2010 coincided with the peak of the mining boom, before a sharp decline ensured that it bottomed out at the start of 2016 where investors could grab shares at just $2.93.  It is now back above $8, reaching a near-10 year high of $8.21 in October this year.

Despite the company’s volatility over the past decade, Downer’s five-year growth is a whopping 97 per cent, which blows the ASX200 out of the water. Combine this with a market cap of $4.7 billion and a five-year average dividend yield of 4.56 per cent and buying this stock during the downturn looked like a worthwhile punt.

Another major segment of the services industry is mining support services. One of the largest players, blasting services giant Orica, has also outperformed the market over the past five years and this year, has gone from strength to strength since rebranding itself as a tech company.

In mid-October BHP Mitsui Coal completed the world’s largest wireless blast using Orica’s WebGen technology, which is the world’s first wireless initiating system.

This success is reflected in the company’s share price growth this year, beginning at $16.90 and now sitting at $23.14, a growth of 37 per cent.

Over the five-year period, growth has been steady at 27.8 per cent, again, ahead of the market, and Orica now boasts a market cap of over $8.7 billion.

Investing in the major players in the services industry has been far from a flop.

Conversely, investing in small and mid-cap mining services companies hasn’t been easy going, as the initial low barriers to entry earlier this decade prompted an influx of new entrants, leading to an oversupply within the market.

Forge Group was one of many victims who went under in 2014, failing to get financial support after a significant drop in profits. Bluestone Global was another, who failed to receive adequate shareholder support to repair their balance sheet in the same year.

Even those that did survive the downturn, are only just beginning to recover.

An example of this is drilling company Mitchell Services which floated on the ASX in August 2011, capitalising on the booming mining market and opening at a share price of 11.9 cents.

CEO Andrew Elf admits the going is still tough for new entrants and junior companies given banks aren’t readily lending, making generating capital difficult.

“The market is steadily improving, but I don’t think it's anywhere near the previous highs in the last cycle,” he tells Eureka Report.

“The market was down for some time so I think what we’ve seen in the drilling space, with regard to competition, is a number of players exited the industry and gave it a good clean out, so the companies that survived are here to stay.”

Indeed, Mitchell Services is a prime example of a company whose share price took a hit during the bust and is only just beginning to recover, projecting an upwards trend of share price growth which currently sits at six cents.

Elf, who has been CEO of the company since 2014, has guided the company through the dark times and now believes the industry has made it through to the other side.

He views demand in the drilling sector as a four-part process which begins with utilisation, where mining companies begin to need more equipment as they look to expand operations.

This leads to the second stage where the rigs start working more shifts, productivity increases, and the drilling seasons become longer.

As a result, the third stage involves a price increase on rigs as demand from mining companies begins to outweigh supply from mining services companies. The final stage is, of course, a booming mining services market, or a “red hot stage”, in which there is a shortage of rigs.

For Elf, the market is at the beginning of the third stage, where the prospect of increasing prices is a possibility given the activity occurring in the mining sector at the moment.

In line with the resources sector’s recovery since bottoming out between 2015-2017, the Australian Bureau of Statistics has reported a trajectory of growth in mineral exploration expenditure, with its latest report indicating a 6.9 per cent seasonally adjusted rise in the June quarter this year.

This coincides with capital expenditure beginning to steady, particularly among the world’s top 40 mining companies, with PWC’s 2019 mine report indicating an increase for the first time in five years.

Indeed, market fundamentals seem to be just beginning to recover. If one was brave enough to invest in the mining services sector during the pits of the bust period and had the nerve to hold through the volatility of the last five years, there may be just a glimmer of hope. But even then, it remains tentative.

Hence, consensus for investment in the industry remains severely high risk, based on analysis of the latest cycle that just now, seems to be beginning to come full circle.

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Alex Gluyas
Alex Gluyas
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For more information on the companies discussed in this article, please click on the company of interest... CIMIC Group Limited (CIM) | Downer EDI Limited (DOW) | Mitchell Services Limited (MSV) | Orica Limited (ORI)
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