Bradken back on buy list

Bradken's share price has fallen 24% since we downgraded the business to Hold following the release of its full year results (see Bradken: Result 2014 (Hold - $5.05)). Those results confirmed that the downturn was hurting – revenue fell 14% and net profit plunged 43% – but capital expenditure and debt were lower while free cash flow grew. The investment case outlined in Time to buy mining services part 3 was on track then and it's on track now.

The consumables business, about 60% of revenue, has been relatively resilient; revenue fell slightly but margins actually rose. It is the capital goods business, responsible for about 40% of revenue, where pain is being felt. Bradken's customers are on a capital strike, delaying projects and new expenditure. As the company declared at its annual meeting, this could go on for some time.

In a cyclical business, the downturn is no time to panic; this is the time to be opportunistic. Bradken is paying off debt, lowering costs and increasing cash flow. Management is adjusting to a world of less work. Although a headline PER of 30 doesn't appear cheap, it includes impairments and one-off charges making the PER a poor valuation metric in this case.

Instead, we look at cash flow. Bradken generated just over $100m in free cash flow last year. We expect this to fall as revenue declines further but the company should still generate between $70-$100m in free cash flow, implying a free cash flow yield of over 10% at today's price. That is a fair margin of safety, although, in this troubled sector, we should demand one. We continue to recommend taking a portfolio approach and industry exposure of no more than 5%. If you're tempted to lay down cash, take some time to read part 1, part 2 and part 3 of our series on mining services. We're upgrading Bradken to SPECULATIVE BUY.