Mining services' steady performer

PORTFOLIO POINT: Mineral Resources is posting steady, strong returns without the exposure to the US that has dented WorleyParsons.

The strength of emerging market economies such as China has underpinned the rebound in Australian resource stocks and, as a result, the fortunes of mining services companies. However, the shock of an earnings downgrade from the highly regarded WorleyParsons (WOR) will reverberate through the sector for some time.

WorleyParsons downgraded its previous NPAT guidance of $320–335 million to a new range of $280–320 million. This was unwelcome news in a market impatient for more upgrades and the stock was promptly sold down by 11%. The company attributed the downgrade to two factors:

• Power operations, particularly in the US, have been adversely affected by decreased demand; and
• The market for WorleyParsons’ services in the US domestic refining and petrochemicals industries has weakened.

Couple these with an appreciating Australian dollar and there is potential for further downgrades. While the US economy may be recovering there are still many risks for companies operating there, as well as the ever-present currency risk. Investors seeking a safer approach should consider backing companies operating primarily in Australia.

Casting an eye over the industry we can rule out companies such as Boart Longyear (BLY), United Group (UGL), Transfield Services (TSE) and Ausenco (AAX), all of which have a large exposure to the US.

While Monadelphous (MND) has a high return on equity and is also well managed at current prices, its valuations appear stretched.

At the more speculative end, two companies worthy of consideration are Clough (CLO) and Forge (FGE), both of which have strong growth prospects. Clough and Forge and also both solely focused on Australian operations and will benefit from the development of the Gorgon gas field as well as other LNG projects.

An alternative to these is Mineral Resources (MIN). Capitalised at $1.1 billion, Mineral Resources captures upside from the increasing volumes of iron ore and manganese without having exposure to the US.

As investors breathlessly await the outcome of iron ore price negotiations with China in the first four months of the year, Mineral Resources is one company profiting from increasing volumes right now. Currently trading at a reasonable valuation, Minerals Resources is our preferred pick for the sector.

Operations

Mineral Resources generates revenue though three main divisions:

• Crushing services.
• Pipeline and site infrastructure.
• Mining operations.

The crushing division has contracts with several major mining companies, including BHP Billiton, Rio Tinto, Fortescue and Brazilian major Vale.

In providing crushing operations for the iron ore divisions of these companies, Mineral Resources has found itself in a sweet spot this year, with the company being paid for the volumes it crushes without respect to the price paid for the ore.

Through its wholly owned subsidiary PIHA Pty Ltd, Mineral Resources provides a multi-disciplinary pipeline construction and civil engineering service. It has carved out a reputation as an industry-leader and innovator in some of the most technically challenging and advanced areas in this highly specialised field. This business is expected to grow and become increasingly profitable in the years ahead.

At the same time, the company has evolved away from being a pure services company. Using its expertise in both site infrastructure and crushing, the next logical step for the company was to start its own mining operations. This started with manganese and has recently expanded into iron ore. Last year it shipped 220,000 tonnes of manganese and 300,000 tonnes of iron ore.

A recent capital raising should enable Mineral Resources to increase this significantly over the next 18 months and several new projects have been identified. Another particularly pleasing aspect of the company is the percentage that management owns. This currently stands at 47% (or $490 million) after a recent sell down of 6%.

Outlook

The next 18 months looks like a period of strong growth for Mineral Resources. Management have stated they expect contract crushing to achieve record tonnages in 2010. This is on the back of a number of new contracts brought into operation recently as well as major iron ore producers targeting volume growth. The company recently undertook a capital raising at $6.75, to raise $52 million in order to develop several new production ventures.

These are:

• Gaining access to Utah Point Export Terminal (WA) by October 2010.
• Export stockpiled iron ore, commencement January 2010 (4.0 mt).
• Poondana Iron Ore Production, by June 2010 (1.5 mtpa).
• Nicholas Downs Manganese production, by April 2010 (0.5 mtpa).
• Borroloola Manganese Production, by September 2010 (0.5 mtpa).
• Mt Marion Lithium production, by August 201 (0.2 mtpa).

New production will make Mineral Resources a more significant producer in iron ore and manganese and will enable the company to take advantage of a likely increase in iron ore contract prices in early 2010.

In addition to those projects, Mineral Resources is actively involved in a takeover of Polaris Metals NL, an iron ore explorer with several projects across Western Australia. In its last resource statement, Polaris had an indicated resource of more than 600 million tonnes. Through a combination of scrip and cash, Mineral Resources has secured more than 50% of Polaris. Over the next few years, this will provide Mineral Resources a number of expansion options.

Valuation

From the history, we can see that Mineral Resources has had a strong normalised return on equity (NROE) since listing in 2006-07, with the NROE consistently above 40%. The company has paid a healthy dividend (the current forecast 2009-10 yield is 3.6% or 5.1% grossed up), has retained capital and reinvested this at high returns. The only blemish on the track record is the decline in NPAT from 2007-08 to 2008-09, due to impairment charges taken on iron ore stock piles.

Looking forward, management has provided NPAT guidance for 2009-10 of $49–62 million. This indicates a NROE range of 37–45%. Adopting this NROE range gives a valuation range of $6.63 to $9.09. Our current valuation is based on conservative assumptions and values the company at the lower end of this range.

If we move our attention forward to 2010-11, we potentially see rapid growth. If Mineral Resources manages to bring on all the additional projects that it has indicated, it could report NPAT of $100 million. Broker forecasts currently range from $89 million to $100 million. This gives a NROE range of 48–54% and makes our current assumptions look conservative. Investors should, however, factor in the uncertainty surrounding the new projects in terms of cost and timing as well as the price risk involved with commodity markets.

Source: Clime Asset Management

Mineral Resources is well positioned to take advantage of a growing Chinese economy. Through its contract crushing it is exposed to increased volume from the majors in terms of iron ore production with little exposure to price. In the medium term, the commodity prices will become more relevant and we do expect benchmark prices for iron ore to increase next year and Mineral Resources should also be well positioned to take advantage of this.

Currently the stock is trading around our conservative valuation and as a result is worthy of consideration by patient investors at current market levels.

Guy Carson is an analyst with Clime Asset Management, which uses StockVal. For Eureka Report subscribers, StockVal is offering a free two-week test drive. Click here.