|Summary: The slowdown across the general mining sector, including the mothballing of some major projects, has hit the mining services sector hard. But some listed stocks have better prospects than others and, despite profit downgrades, analysts are recommending them as buys.|
|Key take-out: Mining services operations with the most flexibility in terms of earnings diversification and balance-sheet strength will be the first to recover and consolidate their position.|
|Key beneficiaries: General investors. Category: Shares.|
It’s the jigsaw piece that no longer seems to fit anywhere into the economic puzzle.
With the resources boom rapidly heading to phase II – production rather than construction – and commodity prices engaged in an orderly retreat, mining services companies have borne the brunt of the transition sweeping through the economy.
In the past month, one by one, they have been hammered by investors as the sudden halt to expansion of projects by the big miners resulted in a wave of earnings downgrades.
Mining services companies existed long before the resources boom. They will continue to exist long after the boom ends. And, in a market desperately short of value opportunities, it would seem logical now to cast an eye across the sector to hunt for a few bargains that may deliver medium- to longer-term gains.
Berkshire Hathaway founder, Warren Buffett, built his fortune on buying stocks when the pack was selling. It is a simple philosophy, but one from which he has never wavered and which generally has worked in his favour.
But buying into any market in free-fall is fraught with risk. As a sector, mining services has been outdone only by gold as the best place to lose money in the past few months. And the nadir may still be some time off.
In the past few weeks, the list of earnings downgrades reads like a roll call of the sector: Boart Longyear, WorleyParsons, UGL, Transfield Services, Fleetwood Corporation, Sedgeman. That’s just a taste of those lining up in the downgrade brigade.
Several major players, such as Monadelphous, are yet to report on their earnings outlook. Even though all have ridden the equity avalanche, further negative news around the sector is likely to maintain pressure on all members.
Added to that is the China factor. How the Chinese economy performs in the next few months will be crucial to the investment and construction plans of the big miners for 2014. Further project cancellations and delays will provide even more heartache for mining services investors.
What to look for
Bearing in mind those considerations, the pace and scale of the share price declines provides a potential for investment opportunities.
In a downturn such as this, the best option is to scour the ranks of major players, preferably those with solid balance sheets and diversified earnings, either by geography or industry.
For those looking for exposure, but not a pure mining services play, Leighton and Downer EDI are the two companies to consider.
Leighton has been beset by troubles in recent years. Management upheavals, a raging battle within the board ranks of its major shareholder Hochtieff – now controlled by Spanish group ACS – and continual earnings surprises have taken the gloss off what once was the nation’s premier construction group.
With the fires gradually being extinguished at the upper levels, investors at last can turn their attention to the bottom line. The first quarter profit of $123 million was a vast improvement on the previous corresponding period loss of $80 million.
Management also indicated that any downturn in mining revenue would be offset by renewed focus on Asian construction. Leighton shares have fallen from $24 in February to $19 now, but most analysts are lukewarm on the group.
Downer EDI, once an accident-prone basket case, has clearly turned the corner in terms of management and performance. As such it is a favourite of most analysts, who overwhelmingly rate it a buy.
Trading at $5.60 in March, the stock is now down to $3.75, which most consider to be undervalued despite a sharp drop in non-residential and engineering work. UBS has a target of $6 on the group and considers it “compelling value”.
As expected, Boart Longyear, which lays claim to the title of the world’s biggest mining services group, delivered its long-awaited earnings downgrade a week ago.
In 2008 it traded above $17. But after a major capital raising to strengthen its balance sheet, it settled into low single digits. In February, it was trading around $2.25 but now has plumbed 66c.
The company, with operations around the globe, has reduced its workforce from 11,000 last year to 8,000 now. Debt has crept higher in the past year and an equity raising appears to be priced into the stock. UBS rates it a sell but has a price target of 70c on the group, above the current price.
Deutsche, Citi, JP Morgan and BA Merrill Lynch all rate it a hold, with price targets way above the current level. Credit Suisse, CIMB and Macquarie rate it a buy.
WorleyParsons, another global operation with strong exposure to oil and gas, also has been caught in the maelstrom affecting mining services after recently cutting its earnings guidance.
Given its earnings diversification, however, its price fall has been less severe than others and hence is not trading at the kind of discount to forecast earnings that now is a feature of the sector. With a price tag of $27 in February, the stock can now be purchased for $19.70.
It is a clear favourite among the analysts, who regard it either as a buy or a hold, with only JP Morgan holding a negative view. Among the legion of fans, however, few hold tremendous upside for the share price, with Macquarie among the most optimistic at $24.13 and CIMB holding out for more than $30.
Among the smaller players, Transfield has been hit particularly hard. From north of $2 in March, it now is trading below 90c. While its earnings multiples are attractive, its debt position is a concern and will continue to weigh on the stock price.
Ausdrill has been another casualty of the resources construction downturn. Fetching $3.10 in February, it now can be bought for a mere $1.20. But with 35% of earnings before interest, tax, depreciation and amortisation denominated in US dollars, as a result of its African operations, it could benefit from further falls in the Australian dollar.
It too is a favourite among brokers, most of whom believe the selling has been overdone.
Source: Broker estimates for 2014 earnings
The dust is yet to settle on the mining services sector. Clearly, however, opportunities will arise. In the inevitable shakeout, operations with the most flexibility in terms of earnings diversification and balance-sheet strength will be the first to recover and consolidate their position.