A mining services revival?

Quality mining services stocks are back on the menu for portfolio managers keen to have more sector exposure.

A good number of fund managers are probably sweating in their seats, as the sky isn’t likely to fall this reporting season.

That may sound like a contradiction, but volatile prices and predictions of a collapse in commodity prices have forced professional investors to dump anything resource related and huddle in defensive high-yielding stocks.

These investors have been waiting for the impending capitulation in mining and mining services stocks before wading back in, and that investment psychology was underpinned by a number of high-profile strategists prophesising the imminent plunge in BHP Billiton (BHP) to under $30 a share.

However, investors didn’t get that buying opportunity as the sector bottomed well above those dire levels (BHP only went as low as $30.81 in June before rebounding close to $37), leaving many underweight on miners and engineering contractors at a time when the outlook for commodities is improving.

The fear now among fund managers is shifting from owning a mining disaster to the fear of underperforming as the S&P/ASX 200 Resources Index charges ahead 16.8% since July compared with a 9.5% gain by the broader market.

While it’s early days, the results and outlook statements from the current reporting season are giving rise to confidence that these sectors are finally on a sustainable path to recovery. Some examples of stocks rallying on pleasing earnings news include Rio Tinto (RIO), Bradken (BKN) and Downer EDI (DOW). See Tim Treadgold’s article on Downer EDI today, Downer's big recovery drive.

This doesn’t mean the sector is without risks. But the poor-quality result from crane hire company Boom Logistics (BOL) that was lodged after the market closed on Tuesday isn’t likely to hurt sentiment towards other contractors. There is still enough good news out there to offset the earnings miss and sombre outlook from Boom (more on Boom at the end of this article).

From that perspective, I suspect there will be a “supply” issue for quality mining and mining services stocks due to strong demand and a lack of sellers if the reporting season continues to unfold to my expectations.

The strong demand won’t only come from portfolio managers scrambling for stock, but it will also come from a “short-squeeze” where short sellers have to buy back a stock they have borrowed to sell as they look to profit from falling prices.

Mining and mining services stocks make up half of the 20 most short-sold stocks on our market, according to the latest data from Australian Securities & Investments Commission, which is a week old.

While there is value to be found in both miners and contractors in the Uncapped 100, I’ll focus on the latter in this article as I believe they have broader appeal to both growth investors and dividend junkies.

Except for Boom, these contractors have yet to report their full-year results, although a number of them have effectively pre-announced their numbers in updates issued over the past few weeks. Energy and mining services firm WDS (WDS) is one example when it did the unthinkable at the end of July – it issued an earnings upgrade saying that net profit will come in a little ahead of its guidance of $6 million to $8 million, thanks to its liquefied natural gas (LNG) contract in Queensland.

WDS has since rallied around 60% to a nine-month high of 59 cents, but that still puts the stock on an attractive 2013-14 price-earnings multiple of around 8.5 times with consensus forecasting tipping earnings per share (EPS) growth of 21% and a gross-up yield of close to 9%.

I rate the stock as “outperform” as WDS is likely to be well supported on dips, and I see another 15% to 20% upside.

However, the stock that I think has even more upside is NRW Holdings (NWH). Its earnings have been de-risked since it released an update on Monday stating that its full-year result was expected to match its June guidance when it said contract delays would see group revenue come in around $1.3 billion and net profit between $73 million and $76 million.

This implies only a slight downgrade to its February guidance, but the stock had crashed below $1 on fears of further earnings cuts given that NRW is exposed to construction work, which implies a bias towards new projects. Miners have shelved plans to build new facilities and are instead looking to increase production from existing mines to cope with a drop in commodity prices.

Further, NRW has traditionally a bigger exposure to civil infrastructure construction, and the outlook for the sector remains downbeat, although state and federal governments have been talking up a number of new transport projects around the country.

The question now is the shape of NRW’s order book for the current financial year, and I suspect its outlook statement will be similar to Bradken in that management will indicate continuing challenges in the first-half but a pick-up in activity in the six months to June 2014.

While the stock has rallied 15% on the profit update, it is still down about 60% over the past year, which puts it on a low 2013-14 P/E of a little over five times and an unbelievable yield that’s over 13% once franking credits are included.

The crazy yield and low P/E reflects investors’ belief that NRW’s earnings will fall off sharply, but I think its results next Thursday will reassure the market and trigger a re-rating in the stock, and I recommend investors buy the stock ahead of the result.

On the flipside, I think it is better to stay away from Boom Logistics as its results look bad no matter how you look at it.

The company’s posted a $2.5 million statutory net loss compared with 2011-12’s $19.7 million profit due to one-off impairments, restructuring and other costs; but its operating earnings before interest and tax (EBIT) of $26 million represent a 27% fall from the previous year and were 10% below consensus forecasts.

EBIT margins have also fallen by 2 percentage points to 8%, and are likely to remain under pressure due to competition and Boom’s material exposure to coal, a commodity that is doing it tougher than most.

There aren’t many bright spots to its result, although Boom has a net tangible asset of 51 cents a share compared with its current share price of 15 cents, and is planning on selling surplus assets.

The company is looking to use its free cash to buy back shares on-market, and that may offer some support to the stock. Boom may also be a takeover target as the industry is ripe for consolidation, but I think investors should be selling into any rallies.

After all, there are plenty of other higher-quality value buys in the sector.

Think big, go smalls!

Brendon Lau holds shares in NRW Holdings.

Uncapped 100 - Australia's most interesting small cap stocks

Small cap stocks covered by the Uncapped team
CodeNameRationaleMarket cap ($m)Total return 1-year (%)Sector (GICS)
MTU M2 Telecommunications Group Amazing growth story and well run company. High free float and strong insto support.1,194.16105.44Telecommunication Services
NHF NIB HoldingsOnly listed health insurer. Widely held. Good performer.972.3941.89Financials
BRG Breville Group Well covered but good candidate for core holding due to good track record.965.9652.94Consumer Discretionary
ARP ARB Corp Well covered but good candidate for core holding due to quality management.964.7343.37Consumer Discretionary
MRM Mermaid Marine Australia Its strategically located facility on WA coast gives it a key advantage over competition in servicing Gorgon & Pluto projects.899.1534.68Industrials
MMS McMillan Shakespeare One of the best performers since the GFC, but change to FBT rules is threatening growth.822.00-2.2Industrials
GEM G8 Education Only listed childcare operator. Acquisition strategy paying off with stock delivering solid gains.743.08186.81Consumer Discretionary
SRX Sirtex Medical A shining star in the biotech space and one of the best performing stocks in 2012. Great product (liver cancer treatment) and bright outlook.711.0967.43Health Care
AAD Ardent Leisure GroupWidely held stock. Earnings more defensive than anticipated. Good yield. Potential core holding.673.2834.76Consumer Discretionary
AUB Austbrokers Holdings The insurance broker is a strong performer. Widely held and well liked by small cap investors.649.5258.8Financials
SGN STW Communications Group One of few companies able to benefit from online shift. Widely held and good insto support.617.8657.65Consumer Discretionary
BDR Beadell Resources Will be a very big FY14 for miner as it has to prove it aims to produce 200,000 ounces of gold a year.605.00-2.85Materials
ACR Acrux One of the most successful Australian biotechs in recent history. Widely held by instos.547.86-16.72Health Care
BRU Buru Energy Substantial size but not often covered by press. Widely held with good insto support.534.56-42.9Energy
RFG Retail Food Group Owns a number of well know franchise brands. Widely followed by instos.531.6364.75Consumer Discretionary
CCV Cash Converters International Strong performance is attracting investors. It's Australia's only listed pawn shop and pay day lender.530.8977.05Consumer Discretionary
AMM Amcom Telecommunications Well covered junior telco but good candidate for core holding.492.7877.51Telecommunication Services
NXT NEXTDC The cloud computing company is an IT sector darling. Fairly widely held and followed.478.5836.71Telecommunication Services
SEA Sundance Energy Australia Analysts have a favorable take on the oil & gas explorer, but stock is still under radar of most. Sundance provides exposure to prospective Eagle Ford shale.474.18138.37Energy
SLX Silex Systems Its uranium enrichment technology could become one of Australia's best innovations given its potential to change the nuclear power industry.473.29-29.44Information Technology
CCP Credit Corp Group Strong price run attracted good investor interest. Leveraged to any rise in loan defaults. Not well covered by press.459.3373.41Industrials
CWP Cedar Woods Properties Property developer with good ROE and earnings growth track record.444.5669.32Financials
HZN Horizon Oil One of better regarded small energy stocks that doesn't receive much media attention.441.1325.33Energy
FGE Forge Group One of the better performers in its industry. Good track record and potential core holding.426.5413Industrials
BGA Bega Cheese Corporate interest in Australian food companies makes the cheese maker worth following.417.6367.32Consumer Staples
MYS MyState Well regarded and could make good alternative to bank stocks. Has good yield and earnings growth over past few years.407.0049.55Financials
TOX Tox Free Solutions Widely held stock in the waste solutions business. Its unique because it operates in a defensive-growth niche.401.5419.2Industrials
UXC UXC Company has turned corner and enjoyed re-rating. What's next?364.51101.26Information Technology
RCR RCR Tomlinson Good first half FY13 result and outlook, but will its fortunes change this year with the mining capex slowdown?347.6369.13Industrials
MOC Mortgage Choice Has a good track record and is leveraged to any housing recovery. The stock is also liquid with good insto support.332.03101.79Financials
MYX Mayne Pharma Group Sizeable generic drug maker with interesting board members.326.81116.15Health Care
TGA Thorn Group One of few retail stocks that is performing well. The Radio Rentals chain owner is also well supported by instos.323.1140.37Consumer Discretionary
NWH NRW Holdings One of the better regarded mining & civil contractors with good track record in delivering on projects.310.96-57.06Industrials
RKN Reckon Fierce competition for cloud base accounting software puts it in firing line.310.7716.47Information Technology
UNS Unilife CorpThe developer of one-use prefilled syringes is close to an inflection point as the market is expecting the company to announce a major contract with a pharmaceutical giant in the coming weeks.288.837.45Health Care
SPL Starpharma Holdings Noteworthy for its good pipeline of innovations. Well run, widely followed.284.43-32.3Health Care
AEU Australian Education TrustWell performing childcare centre property owner. Good yield story and outlook. 270.2254.78Financials
RIC Ridley Corp High corporate interest in the sector and the shrinking pool of agri listed stocks make Ridley worth following.255.49-15.29Consumer Staples
BNO Bionomics One of the larger cancer treatment developers in this market.254.95144.57Health Care
GID GI Dynamics IncLargely forgotten by investors but could attract attention this year as it looks to gain US approval to use its intestinal shealth on diabetics.249.69-17.82Health Care
SIV Silver Chef Strong jump in the share price of the equipment financing group has attracted a good following.243.05140.32Industrials
IMF IMF Australia Litigation funder is unique stock. Stock not liquid but its outlook appears promising given the number of potential class action lawsuits.242.7235.36Financials
MXI MaxiTRANS Industries Transport equipment maker posted good interim result. Has appealing yield and growth.239.1994.32Industrials
AJA Astro Japan Property GroupStrong leverage to Japanese economy makes this an interesting stock to watch.229.1924.62Financials
NAN Nanosonics A successful medical tech story. Should be close to turning in maiden profit with its disinfection device.228.1081.25Health Care
SHV Select Harvests Noteworthy for turbulent past and exposure to soft commodity market.220.66202.29Consumer Staples
IPP iProperty Group Worth watching as it is trying to be the REA Group of Asia.214.0524.21Information Technology
DWS DWS Will be a big beneficiary if governments start spending on IT again.213.1011.9Information Technology
CLH Collection House In similar space as Credit Corp. Strong stock performance has attracted a following and the stock appears to be well placed to run further207.79115.72Industrials
PFL Patties Foods Illiquid stock but has suite of well recognised consumer brands. Defensive yield.200.25-6.13Consumer Staples
GXL Greencross Acquisitive vetinary group. Good profit growth and share price performance, but gets little press.195.98122.83Health Care
NWT Newsat Potential large cap if it can launch its own satellite in 2015.191.55-29.7Telecommunication Services
IFM Infomedia Interesting tech play in the car parts market. Strong share price gain but gets little air play.187.02220.41Information Technology
WBB Wide Bay Australia The building society is trying to turn its fortunes around. Also worth watching for its exposure to Queensland housing market, particularly around major resource projects.184.82-21.27Financials
DTL Data#3 Well respected IT company that receives little press coverage.181.692.36Information Technology
GXY Galaxy Resources Good upside potential if it can get its problem-prone Jiangsu plant back on track. Won't be easy to right this ship.177.43#N/A N/A#N/A N/A
HSN Hansen Technologies Operates in a high potential/growth industry but is not covered by press or brokers.172.8018.71Information Technology
VOC Vocus Communications Telecom stocks are in favour but Vocus is one of the least covered172.0229.11Telecommunication Services
CKF Collins Foods One of the few food franchise listed companies.167.4066.85Consumer Discretionary
IMD Imdex Drilling company is well supported by instos and should benefit from any rebound in exploration activity.164.17-50.13Materials
SFH Specialty Fashion Group In early stages of turnaround. Can the women's apparel retailer sustain the momentum?163.4080.68Consumer Discretionary
TGS Tiger Resources Future lies in its Kipoi copper mine expansion in the Congo but miner is fully funded with DRC govt holding 40% stake in tenement. Next 12mths will be interesting.155.20-22.03Materials
MLB Melbourne IT A perennial underperformer could be interesting turnaround story as management is in midst of restructuring the business.151.7523.82Information Technology
RCG RCG Corp The footwear retailer is one of the best performing consumer stocks as online competition is not a big threat. Company has a good yield as well.145.9066.94Consumer Discretionary
SAR Saracen Mineral Holdings Emerging gold producer that is widely held by instos. Hitting milestones and looks cheap. Key asset is close to gold majors, which makes it a potential takeover target.132.45-40.67Materials
REX Regional Express Holdings Well run airline that is overshadowed by Virgin and Qantas.131.0111.87Industrials
MCP McPherson's The personal care and household products supplier had been relatively insulated from volatile discretionary spend and online threat, but its latest profit warning shows it's not immune.130.37-13.6Consumer Discretionary
TFC TFS Corp The sandalwood products company offers exposure to both the agri and cosmetics industry. It will start commercial harvest this year.128.636.98Materials
UBI Universal Biosensors IncWell regarded biotech and one of few that's successfully manufacturing in Australia. Struck deal with a few global medical companies.125.7918.03Health Care
NEA Nearmap A stellar performer with an Interesting business that offers high quality ariel maps to companies & government.121.151109.68Information Technology
AZZ Antares Energy Liquid with good insto support. Already in production with exploration upside in Texas.118.5819.23Energy
ACL Alchemia /AustraliaOne of the few biotechs with revenue stream. Good pipeline of oncology treatments.116.66-35.14Health Care
ESV Eservglobal Mobile money transfer company that has been gaining traction. Widely held by instos but low press coverage109.58137.84Information Technology
POH Phosphagenics Sizable biotech with a game changing FY14 year ahead. Good insto following but questions of poor audit and governance standard could dog company.107.15-25Health Care
BGL BigAir Group The wireless microcap has gained strong following over past year or two but is often overlooked by investors and the press.105.7649.88Telecommunication Services
LCM LogiCamms Strong price performance and reasonable valuation attracting interest.104.6345.74Industrials
AMA AMA Group Good turnaround story but under the automotive services group is radar of most.104.4098.47Consumer Discretionary
DRM Doray Minerals Widely held by instos. One of the more favored gold explorers by brokers.94.34-8.58Materials
CLV Clover Corp One of the star performers in 2012. Operates in growing but relatively stable niche.94.1538.04Health Care
PEN Peninsula Energy Widely held by instos and large free float. It's the only uranium miner on the list.88.80-3.23Energy
WDS WDS Widely held with strong insto support. Engineering contractor diversified across mining, energy and infrastructure.85.4017.61Industrials
JIN Jumbo Interactive Innovative small cap facing off industry dominated by giants. Worth watching to see if it can carve out a profitable global business.79.2750.96Consumer Discretionary
AOH Altona Mining Noteworthy copper play with Xstrata pullout of Roseby project in Australia and the good ramp up of its Finnish project.76.70-50.85Materials
RUL RungePincockMinarco IT company to resource industry. Facing tough operating climate with new CEO trying to restructure and turnaround company.73.5049.25Industrials
CAA Capral An aluminium manufacturer that is actually holding up relatively well given that manufacturing is on the nose. 71.0628.57Materials
BOL Boom Logistics Crane hire group is riding out the downturn in construction.  It's widely held by instos and is very liquid.70.59-52.38Industrials
TAN  Tandou The only direct equity exposure to cotton prices. Also trades water rights and receives little press.70.1539.79Consumer Staples
CKL Colorpak The small cap packaging company has grown via acquisitions over past few years.68.0860.74Materials
CUV Clinuvel Pharmaceuticals Interesting skin disorder treatment developer that has done reasonably well over past year64.9713.33Health Care
TSM ThinkSmart Potential turnaround story worth keeping eye on.62.4997.44Financials
YTC YTC Resources Next 12-mths will be eventful after YTC secured funding for its projects from Glencore.57.790Materials
LGD Legend Corp Electronic parts supplier to utilities and other industries. Stable earnings with good yield. Often overlooked.57.07-11.84Information Technology
KOV Korvest The construction products and services supplier has been hit by project delays and deferrals. But its relatively high yield could give it some support.51.665.16Industrials
UML Unity Mining Growing Tassie gold producer with high free float. Valuation looks compelling too.51.25-30.48Materials
OTH Onthehouse Holdings Alternative small cap to online property leader REA Group. It is trying to use more timely housing data as a compeitive edge against REA.39.4424.16Consumer Discretionary
EBT eBet Potential alternative to star performer Ainsworth Tech. Has exclusive deal with US poker machine maker WMS.30.95169.33Consumer Discretionary
NTC NetComm Wireless Under appreciated small IT hardware maker that is punching above its weight. Hardly covered by press.25.7081.82Information Technology
MBO Mobilarm Unique product that could change global maritime safety practices with its man-overboard location beacon.17.97114.29Information Technology
PGC Paragon Care Emerging hospital equipment supplier that has been ignored by market.14.2960.98Health Care
ISS ISS Group ISS delisted on Aug 9 after being acquired by by P2ESn.a.n.a.Information Technology
Source: Eureka Report, Bloomberg
Updated 14 Aug 13

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