Mining services and the China syndrome

Mining services companies riding on China’s coattails will fall off ... and I'm avoiding them.

PORTFOLIO POINT: Mining services companies have been riding on the Asian tiger for some time, most notably China, but a slowdown in resources demand will hurt them.

There is a computer at my company that is always on. Despite our community-driven desire to turn everything off at the switch, this computer must always run.

It is a bit special because each week it fires itself up to run a scan for companies that meet our criteria – some of which I have written about here before. Every Monday at about midday a list of 100 companies drops onto my desk and I look through the new names – those that we don’t already own or those that have not previously been rejected.

Somewhat surprisingly, I noticed this week that nine of the top 10 stocks are mining services companies. Names like Forge, Decmil and MACA are on this list and there is a very great temptation to buy them because the model that selects them has a pretty good track record. So why aren’t we buying?

If you have been reading my missives, one of the things you know is that I require varying margins of safety before I am willing to invest. For example, I won’t buy gold companies until I can obtain a margin of safety of at least 20%. For most retailers, the discount is at least 10% and so forth.

For mining services however, I need very large discounts and there are a number of factors, both macro and company specific, that drive this requirement.

Of the company-specific reasons, experience has taught me that mining services are capital intensive. Now, the managing directors of these companies will explain that they’re ‘not as capital intensive as XYZ’, but really such suggestions merely demonstrate that even the finest hair can be split. Not only are these businesses capital intensive, but many run the risk of being unable to cover their cost of capital in all but the most bullish of resource booms.

And finally, under such circumstances, even with the most capable management running businesses in this space (Decmil comes to mind) companies are beholden to much larger customers when it comes to setting prices. Clearly, if the number of jobs available declines, pricing competition can become fierce and even irrational. Long-term relationships between the supplier and customer can go some of the way to ameliorate the latter concern, but our concerns extend also to the macro picture.

Many of our politicians and resource company managing directors point to China as a long-term driver of prosperity for Australia and I would like to agree. But I cannot. All this talk about engaging with Asia makes me sometimes wonder if, on many fronts, we are offering too little too late.

Through our company analysis system, I have the ability to look in detail at just about every listed company in the world. When I look at the balance sheets of large Chinese steel makers, shipbuilders and banks I am noticing deterioration in the quality of their reported financials. What I have noticed is that manufacturers are engaging in looser credit provisions to customers, which brings forward sales revenue but not the cash. It’s called “channel stuffing” and Chinese companies are engaging in it because they are being pressured, I believe, in some instances to report solid sales numbers.

In the past I have reported that I have seen a blow-out in the level of receivables and days receivable numbers. The practice of delivering goods without collecting payment is rife and ultimately it will lead to higher defaults. More importantly, during the recent ‘recovery’ in iron ore prices, I have not seen any improvement in this situation. Indeed, the much larger drop in commodity prices overall is a reflection that all is not well.

I just had lunch with a good friend who is an institutional strategist, and when I pitched my bear case he said that the ‘official’ stats from China show a recovery is underway. Everyone who wants to believe quotes the official GDP growth numbers, but the Chinese statistical office collects data from provinces and cities that are “coerced” to produce favourable figures. GDP growth – as officially calculated – also is believed to have a faulty inflation adjustment, and GDP growth would be much lower if real inflation were taken into account.

When I look at the numbers underlying the “Chinese Economic Miracle”, I see there is something to be less than sanguine about. Back in 2010, WikiLeaks published a leaked diplomatic cable written by Li Keqiang (who may replace Wen Jiabao as premier) saying he looked at data on power, rail cargo and loans because the GDP numbers were “man-made”. Qinwei Wang, an economist with Capital Economics in London who used to work with the People’s Bank of China, wrote 10 days ago that his analysis of construction and freight data revealed a weaker Chinese economy.

According to some reports, bad loans at Chinese banks have tripled in the six months to September 30. Recent analysis of the shadow banking system (wealth management products that have ‘invested’ funds in unused infrastructure and empty buildings) suggest up to 10% of the banks’ collective $21 trillion in assets (loans) have been allocated to these endeavours and investors believe that their funds are safe.

Additionally, electricity consumption has plunged and output has slowed to 1.5% per annum from 2.7% in August. And the fall is much sharper than that which could be explained by any switch from capital intensive steel production and infrastructure development to less energy-intensive retailing and consumption activities.

Corporate bankruptcies, bad debts and scams are rising, steel prices have collapsed by as much as half, and car sales have crashed. Property prices have stalled.

But most of the reports we read suggest China is on the improve or that the recent loosening of monetary policy will trigger a rebound. But, of course, monetary settings have been loose for all of 2012 and it hasn’t helped.

Ask yourself, what can China do to get growth back up? Building more bridges and freeways that nobody uses or cities that nobody lives in won’t help and, if anything, will only serve to entrap more people, cities and provinces with assets that generate no income.

The only thing China can do is export its way out of trouble, but there is not a country in the world that can be the growth engine it needs to import the cheaply made plastic items that China is notorious for copying.

So, while Quantitative Easing Infinity may continue to see cheap money flood into stocks generally, I reckon the outlook for mining services companies and the bigger customers they serve may just be the reverse.


Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.

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