WorleyParsons has just announced a profit downgrade that's sent the share price down to levels not seen since March 2009. I thought it would be worth republishing what we said earlier this year to see if anyone has any thoughts.
- 04 Jun 13
- ISSUE 369
- STOCKS IN DETAIL
Avoiding mining services (for now)
Nathan Bell explains why we're prepared for even lower share prices in the mining and engineering services sector.
|Company||ASX||Price at Review||Current Price||Change since review||Our View|
Prices correct as of 2:02 PM, 20-Nov-13. Price data provided by Paritech Pty Ltd
Aside from the gold sector, mining services stocks are probably the most hated on the ASX and some contrarian investors are piling in. At this stage, we're not one of them. One of the biggest investing pitfalls is anchoring your valuations to higher historical prices, believing you'll turn an easy profit when things return to normal.
- Share prices have fallen rapidly
- No margin of safety yet
- Consider taking a portfolio approach to the sector
Worley Parsons was virtually unknown in 2000 when it reported revenue of just $187m. Today, it's a global business billing over $7bn. Accurately forecasting what a business like this might earn over the next five years is where things get tricky.
To explain why, consider this example. You work for Woolworths' in the finance department. Your job is to prepare the budget for the next five years. That's not as hard as it sounds. Woolies is a mature business so estimating the key variables is straightforward.
To calculate revenue, you'll need to estimate sales from existing and new stores. While pricing strategies, inflation, population growth and the strength of the economy will have an impact, your estimates should be reliable given Woolworths sells everyday food and grocery items.
Next, you need to estimate the company's cost of goods sold and gross margin. That's been fairly consistent over a long period. Again, easy. Then you estimate the costs of running the business, which you can collect from the various divisional managers. You forecast the depreciation and amortisation expense according to the methods used in the company's asset register, then calculate interest and taxation costs to derive profits.
Finally, you calculate the company's capital expenditure budget and work out how much cash is left after paying dividends and whether the company's debt levels are in check.
Then you get a job offer, from Worley Parsons. You move out west on a much higher pay packet, with a cushy life amid the quokkas stretched out before you.
But the first day is a bit of a nightmare. The boss asks you to put together a five year budget. No worries, you think. Sales revenue is basically contract value. Trouble is, while some recurring contracts contain regular price increases, revenue is highly dependent on the company's ability to win new work. And who knows what that might be.
When you build in the assumption that mining expenditure will fall from 8% of GDP currently to the long term average of just 2% (see Chart 2), you realise that forecasting is more like guesswork.
But Worley is one of the smarter operators you reason. It protects itself from cost blowouts by charging 'cost plus', a margin on top of whatever it takes to complete the project. But if the number of projects dries up, the balance of power switches to the clients, and they don't like this kind of project costing.
Worley might then be forced to accept lower prices and fixed-cost contracts to secure work. All sorts of risks follow. You think of Leighton, which endured cost blow outs on the Airport Link project in Brisbane and the Victorian desalination plant. What might that do to Worley's margins and return on equity?
As for estimating costs, including staff expenses that swing wildly with the company's order book, well, you just pick a number. This is a company that must choose between letting skilled staff go to protect margins or bleed cash while it waits for activity to pick up, one of those choices you'd rather not have to make.
So here's the deal: calculating costs is difficult, estimating revenue even harder. There's a giant risk of overestimating profitability, cashflows and the health of Worley's balance sheet. Blowouts in working capital could turn a trivial amount of debt from a murmur into a financial health scare. That job back east is looking good again, although the quokkas are very cute.
It's the same for investors. Estimating the intrinsic value of Worley Parsons, or any other mining services business, is tricky in the extreme. If you're going to buy in, you need a far higher certainty about troubles in the sector than exists right now.
A parallel might exist with the listed property market crash starting in 2008. Rapidly falling earnings (or losses) would lead to higher debt levels and dividend cuts. Fewer large projects would be announced, capital raisings would ensue, as might one or two bankruptcies.
Right now, there's no need to rush in, a lesson I learnt when I recommended GPT Group on a 9.2% yield in 2008 after its share price had halved. The downturn had only just started and there were plenty of opportunities even after the upswing gathered pace.
The Goodman PLUS securities more than doubled after we re-recommended them in Goodman cash grab leads to speculative buy on 17 June 09 (Speculative Buy – $36.00), for example, well after the lows were in. The A-REIT sector has returned 45% in the past 18 months alone, four years later. So, no rush folks.
Chris Prunty, recently named the 14th best buy-side analyst in the world and a contributor to one of our upcoming special reports, tends to agree; 'Mining services and resources are as cheap as they've ever been [but] I'd be extremely cautious on mining services. Most of them are value traps.'
If and when we do step in, we'd probably adopt a portfolio approach, as we have with gold and oil, to reduce our risk. We'd avoid companies with large overseas exposure (though a lower Aussie dollar might offer a little protection) and seek out businesses with high recurring revenues not completely exposed to mining.
Fleetwood, with its caravan business, is a good example, although it's not cheap enough yet. If we saw takeovers in the aftermath – as we did in the A-REIT sector – that would be another bullish sign.
Monadelphous is one company we'd love to own, perhaps below $10. It has plenty of services vital to the ordinary functioning of its customer's key assets and could cut plenty of staff to protect margins and cashflow. We're currently digging through several other names, big and small, and will let you know if we discover one we can recommend.
Right now, this sector is best avoided. After the graft required to rebuild our model portfolios since the GFC, we'd rather miss any rebound if it also meant missing the pain from overpaying and buying in way too early.
If you work in the mining and engineering services industry or simply have a contrarian view, please enlighten us in the comments section below (just avoid publishing anything that could be construed as a recommendation).