Is it time to buy mining services? Part 2

Let’s be clear, we are not tending roses. Peering through the ranks of beaten down mining services stocks is closer to shovelling dirt than gardening. As we explained in Part 1, hunting for bargains often means investigating sectors that are downtrodden, difficult and downright dangerous. We search here precisely because others do not.

Such a strategy is not a license to gamble. Aware of the risks, it is our task to tame them. We do this with a three-prong approach.

Instead of recommending one or two stocks we aim to select a basket of several stocks to construct a mini portfolio. We expect some to do badly and others to do well. Hopefully, the gains outweigh losses. Portfolio limits should be suitably low for this end of the market, perhaps 5-6% allocated to the sector. Lastly, we know what we are looking for.

Part 1 introduced four qualities that increase the odds of success; cheapness, resilience, quality earnings and prudence. We’ll now test our shortlist against these filters.

Is it cheap?

How do we know when a business is cheap? Investment is, at its core, an attempt to answer that question. The nature of the business determines the tools we use for valuation. For mining services, that means making a distinction between firms that provide equipment and those that provide services.

The providers of heavy equipment are, in effect, rental firms. It is difficult for these businesses to generate above average returns on capital over time. High returns will encourage competitors to enter the market or miners to buy rather than lease assets. Since we expect modest returns from assets leased, asset value is a decent value benchmark.

That brings us to our first filter. Asset heavy businesses in the sector should trade at a discount to net tangible assets (NTA) before we consider them cheap. While we’re prepared to pay more for a business that can earn higher returns, we suspect this is unlikely.

For businesses that offer engineering services, asset based valuations mean little. Businesses such as Ausenco and Decmil carry few balance sheet assets; their greatest assets are the knowledge and capability of staff. Instead we turn to measures of profitability for value, specifically, an enterprise value to earnings before interest, tax, depreciation and amortisation (EV/EBITDA) multiple. This measures cash being generated by a business and considers the debt employed. As EBITDA is likely to be cyclically depressed, we won’t subscribe a particular multiple. The paradox of cyclical businesses is that often the best time to buy them is when their valuation multiples are high because earnings are so depressed.

Is it resilient?

There are several determinants of resilience. First, debt must be comfortably covered by operating cash flow. We demand interest cover (operating cash flow divided by cash interest payments) of at least five times; revenue stability from long term contracts earns points as does exposure to bulk commodities such as iron ore and coal. These commodities tend to display stickier volumes because transport contributes to enormous fixed costs. Cutting output is therefore expensive. Activity devoted to production rather than exploration and development is also a good sign. As commodity prices fall, exploration budgets fall first, followed by development plans. Ongoing production is the last, and most reluctant, casualty of the price cycle.

Does it display quality earnings?

We explained in Part 1 why watching cash flow is crucial. Although there may be reasons for cash flow in a particular year to deviate from profits, in general weak cash generation is hard to forgive. We demand that at least 90% of EBITDA converts to cash, a high burden that will likely knock out several candidates.

Are management acting prudently?

The final filter is the most difficult because it must be applied manually. We’re looking for signals that management has recognised a turning cycle and are adapting to leaner times. We want to see dividends cut, capital expenditure or employee counts reduced, growth plans amended and balance sheets repaired. The downturn could be an extended one. Only businesses quick to adapt will survive.

Running our filters produces the results that are summarised in Table 1.

Ausdrill and MACA earn perfect scores and go straight to the next round. Ausenco and Austin Engineering fail at the first hurdle. Neither is obviously cheap. Austin pays unaffordable dividends – turning last year’s cash flow surplus into a deficit – and it is hunting for acquisitions. The company is trying to do too much with too little. Ausenco is similarly flawed, with weak cash generation and a diversification strategy that is looking for the next boom rather than acknowledging the bust.

Boart Longyear looks to be in its death throes; with crippling debt and poor cash flow, it is effectively for sale and is unlikely to survive in its current state. Even at 30% of NTA, we aren’t tempted. Decmil appears to be navigating the downturn successfully but deteriorating cash flow strikes it from our list.

With a strong position in a global niche, Imdex is tempting. Drilling fluids and downhole instrumentation are, however, largely exploration activities where demand has collapsed. Costs are already low; expenditures minimal. There are few options other than to wait for a turnaround in the industry. At a large discount to NTA we would look again but it’s currently not cheap enough.

Trading at a healthy premium to book value and a generous (for this company) EV/EBITDA multiple, Bradken isn’t obviously cheap. Yet with 85% of revenues coming from consumable products (that is, recurring purchases), the company has fared better than most. It has also responded aggressively to the downturn, cutting capacity and replacing expensive output from Australia with Chinese manufacturing. As demand cools, cash flow could improve as capital expenditures are cut. Today’s valuation could look cheaper as cash flow improves. Bradken goes through.  

Emeco’s average utilisation rates have collapsed but the downturn is worst in its Indonesian business, where utilisation rates have fallen from 70% to under 2%. Outside of that business, conditions are poor but not dire and the company may close its Indonesian operations. Cash flow is improving as capital expenditures fall and debt is attractively structured. Best of all, it is among the cheapest of the group. It makes the cut.

MacMahon has been savaged since shedding its construction arm to become a pure mining contractor. Cash flow concerns appear to be one-offs and should improve and the business has large contracts on some of the best projects around. At just 30% of NTA, it’s cheap enough to slip though.

Matrix looks awful from almost every metric. Cash flow is abysmal; profits nil. Yet it is a leader in the manufacture of riser buoyancy, an industry that has been cyclically impaired. As normal conditions return (or the currency falls), Matrix can potentially make plenty of money. We’re sceptical, however, of claims that there is a genuine competitive advantage in the business. At lower prices we would consider it, but today it narrowly misses the cut.

NRW is largely a civil construction business for miners. It has enjoyed great success as industry capacity has expanded but we suspect future revenue will be hard to replace. Yet the company has already prepared for a harder future, cutting costs and debt and winning work on the giant Roy Hill development. Trading on an EV/EBITDA multiple of under three, the bad news already appears priced in. That valuation sneaks NRW over the line.

We have culled our watch list down to six; Ausdrill, Bradken, Emeco, MACA, MacMahon and NRW. In part 3 of this series, we’ll dig through the survivors to emerge with our mini portfolio.