Mining services isn't a disaster zone

There is a lot of fear around mining services … but some are still thriving.

Is mining services the most underappreciated sector?

Be afraid, very afraid. That’s seems to be the mantra most investors are adopting when it comes to engineering contractors as the sector appears to be running from one disaster into another.

The rush of bad news for the sector comes at a time when the industry has been accumulating intangible assets at its fastest pace on record. This could have significant implications for earnings, and I’ll explain later.

It’s near impossible to focus on anything but the negatives with Ausenco (AAX), the latest company to request a trading suspension as it prepares to release what is likely to be disappointing news to investors. This development follows shocking earnings updates from industry leaders WorleyParsons (WOR) and Forge Group (FGE). See my update on Forge below.

Ausenco will probably need a capital injection, not unlike Forge, with media reports stating that the latter needs to be bailed out by its bankers due to problems with two large power plant construction projects.

We are likely to see a pick-up in asset write-downs in the current financial year, as demand for engineering services and equipment has not increased quite as quickly as some of these companies had hoped.

The write-downs will likely be focused on their intangible assets (non-physical assets like goodwill), as the value of these assets tend to be much harder to justify in a downturn.

The value of intangibles has ballooned by more than 10 times in just a decade to around $7 billion, which could potentially leave some wallowing in red ink given that intangible asset values are twice the expected pre-tax profit for the sector.

The growth in intangible assets stands in contrast to tangible asset values. The amount of tangible assets, like plant and equipment, has increased at a more modest pace to $35 billion in 2012-13 from $6 billion in 2002-2003.

The high level of intangibles isn’t the only thing that makes the sector vulnerable to profit shocks – the industry’s slim operating margin of 5.7% is another point of contention, as it leaves little buffer if profitability were to deteriorate further. The historical average margin should be closer to 7% and it will be a while before we see any mean reversion.

However, those who have steered clear of the sector shouldn’t be smiling either. It would surprise many, but engineering services and equipment companies have on the whole been outperforming the market.

This group of stocks have generated returns of over 30% since the start of the 2014 financial year – around the time when the market bottomed. This is 15% ahead of the S&P/ASX All Ordinaries. Resource services and equipment providers on the Uncapped 100 have also given investors reason to cheer. Suddenly, our August article A mining services revival doesn’t seem like such a bum steer.

Ignoring Forge, as it is still in a trading halt (although it will likely plunge when it resumes trading), six out of seven contractors in our emerging companies index have seen their share price appreciate over the past five months, with the average price gain of 52%.

It is easy to get lost in the bad news, but the share price movements show the sector is far from being at crisis point despite well-documented company-specific blow-ups.

In fact, companies like RCR Tomlinson (RCR) and WDS (WDS) have issued positive outlook statements recently, and even those that have come out with bad news have said that their tender book is looking pretty full.

“It’s the company’s strategic positioning – the fact that we’ve got businesses that are slightly out of sync with each other that provides a high degree of [earnings] stability,” answered WDS’ chief executive, Terry Chapman, when asked by Eureka Report on how the company is managing to navigate the difficult market.

Chapman also stressed that contractors should have good cash flow, as WDS has, and this has enabled the company to pay a generous dividend on a quarterly basis.

There is certainly an amount of luck thrown into the mix as well for WDS. Its main business had been servicing the coal mining industry, but management made a decision to expand into the energy space. It struggled to gain much traction with its diversification strategy, and the stock suffered as a result.

However, the energy bet is paying off as growth in that division has more than offset the slowdown in coal mining, and Chapman thinks demand from coal miners won’t pick up until 2014-2015.

That mining services stocks are only suitable for those with a stronger stomach for risk is stating the obvious, but I think the risk-reward balance makes the sector an attractive place to look for value buys for those happy to ride out the volatility over the next 12 to 18 months.

WDS may be up 44% at 85 cents since we rated it an “outperform” on August 14, but I think there is further upside to the stock given its robust yield of around 10% once franking credits are included.

NRW Holdings (NWH) was also highlighted as a “buying” opportunity in that same article, and I continue to hold a positive view on the stock.

The civil and mining engineer is one of the most cash generative companies of its peers with a free cash flow yield of around 20% (i.e. the amount of free cash it generates for every dollar shareholders invest) and management has achieved a very impressive three-year average return on equity of over 24%.

This doesn’t mean a profit downgrade can’t be lurking in a dark corner, but I think some of that is already priced into the stock as it is trading on a 2013-14 forecast price-earnings multiple of around 6 times and is on a 11% fully franked yield.

The other good thing about NRW is it has lower write-down risk, with intangible assets worth $32.5 million on its books, which represents less than 4% of total group assets.

NRW will have to take a pretty big profit downgrade before it looks expensive and I encourage risk-tolerant investors to buy the stock at these levels.

LogiCamms (LCM) is the remaining “outperform” call we have in the sector. The stock is almost flat since we wrote about it on August 7 after it retreated 27% over the past month.

The sharp fall in the stock prompted the ASX to issue a “please explain” notice to the company, but management said the stock’s decline is due to negative sentiment surrounding the sector and that nothing has changed operationally.

That is good news as management is predicting “year-on-year earnings growth” thanks to its acquisition of oil and gas engineering group Independent Technology Holdings in May this year, although it didn’t provide a specific forecast.

The company also said it has an opportunity pipeline of around $490 million, and managed to more than double its earnings before interest, tax, depreciation and amortisation (EBITDA) margin to 10.9% over the last two financial years.

These factors, coupled with its expected yield of around 9% once franking credits are included, puts the stock in a good position to ride out the challenging times ,and I reiterate my “outperform” recommendation on the stock.

Investor fear towards the sector is understandable and these stocks are not for the faint hearted, but the overused quote from investment great Warren Buffett comes to mind – “be greedy when others are fearful”.

Think big, go smalls!

Update on Forge Group (FGE)

It’s little wonder Forge Group (FGE) lost sight of two critical projects that cost shareholders dearly. The phone number for its media contact on the press release went through to St John Ambulance.

The engineering contractor can’t get a phone number right even as it tries to reassure investors that it is on top of the crisis-stricken Diamantina and Angelas power station construction projects, which are forcing the group to take a $127 million profit write-down for 2013-14.

Perhaps the telephone number was deliberate. After all, shareholders were left haemorrhaging, with the stock suffering its worst pounding on record as it plunged to its lowest level since the global financial crisis.

The stock was suspended from trade at the start of November and it resumed trading this morning, with an 80%-plus freefall to around 76 cents – its lowest since 2009.

The engineering contractor took nearly a month to hammer out a bailout financing deal with Australia and New Zealand Banking Group (ANZ), which will see shareholders massively diluted through a warrant issue that would give the lender the right to exchange the warrant for shares at just 1 cent a pop.

It’s hard to fathom that just two problem contracts from its very large order book can do this much damage. The group is now expecting to post an earnings before interest, tax, depreciation and amortisation (EBITDA) loss of $85 million to $90 million for 2013-14.

Excluding the power station construction projects, pro-forma EBITDA should range between $45 million to $50 million, according to management.

The pro-forma EBITDA is still about half of consensus estimates forecasts and there are still many unanswered questions that will dog the stock.

Management has yet to return calls, and I recommend existing shareholders to hang on until I can get further clarification to form a view on whether the worst is over (it seldom is when a material project blows up).

In the meantime, I am downgrading the stock to “neutral” from “outperform”.

"Outperform" recommendations on the Uncapped 100

NameCodeDate of recPriceAuthorArticle Name
eBetEBT26-Jun-13$1.130Brendon LauSmall cap with biggest earnings upgrade
Silex SystemsSLX03-Jul-13$2.320Brendon LauWhy a dog can be an investor's best friend
NewsatNWT03-Jul-13$0.400Brendon LauWhy a dog can be an investor's best friend
Tiger ResourcesTGS03-Jul-13$0.190Brendon LauWhy a dog can be an investor's best friend
M2 Telecommunications GroupMTU10-Jul-13$6.020Brendon LauBig expectations for small caps
Starpharma HoldingsSPL17-Jul-13$0.940Brendon LauFive bargains for under a buck
ColorpakCKL17-Jul-13$0.725Brendon LauFive bargains for under a buck
GI DynamicsGID17-Jul-13$0.600Brendon LauFive bargains for under a buck
Horizon OilHZN17-Jul-13$0.355Brendon LauFive bargains for under a buck
Collins FoodsCKF07-Aug-13$1.760Brendon LauThe next dividend dazzelers
LogiCammsLCM07-Aug-13$1.470Brendon LauThe next dividend dazzelers
NRW HoldingsNWH14-Aug-13$1.140Brendon LauA mining services revival?
WDSWDS14-Aug-13$0.590Brendon LauA mining services revival?
ThinksmartTSM21-Aug-13$0.355Brendon LauBiggest smalls earnings surprises
Beadell ResourcesBDR28-Aug-13$0.865Brendon LauShort-selling gold signals
Universal BiosensorsUBI04-Sep-13$0.680Brendon LauSmalls in a sweet spot
Specialty Fashion GroupSFH18-Sep-13$0.930Brendon LauSmall cap surprises for 2014
Mint WirelessMNW02-Oct-13$0.180Brendon LauFour new stocks for the Uncapped 100
YTC ResourcesYTC09-Oct-13$0.260Brendon LauXmas sale starts early for small caps
Ridley CorporationRIC16-Oct-13$0.850Brendon LauAppetisers from the agri stocks field
Wide Bay AustraliaWBB16-Oct-13$5.600Brendon LauAppetisers from the agri stocks field
STW CommunicationsSGN30-Oct-13$1.580Brendon LauSmall consumer stocks at Christmas crossroads
Retail Food GroupRFG30-Oct-13$4.580Brendon LauSmall consumer stocks at Christmas crossroads
NanosonicNAN06-Nov-13$0.830Brendon LauFirst profit, first choice for stock pickers
AMA GroupAMA06-Nov-13$0.365Brendon LauAMA chief's double plan

Uncapped 100 - Australia's most interesting small cap stocks

Small cap stocks covered by the Uncapped team
CodeNameRationaleMarket cap ($)Total return 1-year (%)Sector (GICS)
NHF NIB Holdings /AustraliaOnly listed health insurer. Widely held. Good performer.1,095,315,43030.54Financials
MTU M2 Telecommunications Group Amazing growth story and well run company. High free float and strong insto support.1,056,575,80666.95Telecommunication Services
GEM G8 Education Only listed childcare operator. Acquisition strategy paying off with stock delivering solid gains.981,989,868148.26Consumer Discretionary
MMS McMillan Shakespeare One of the best performers since the GFC, but ongoing risk of change to FBT rules will hang over the company.901,739,990-2.12Industrials
ARP ARB Corp Well covered but good candidate for core holding due to quality management.883,184,69215.34Consumer Discretionary
AAD Ardent Leisure GroupWidely held stock. Earnings more defensive than anticipated. Good yield. Potential core holding.814,161,98753.28Consumer Discretionary
MRM Mermaid Marine Australia Its strategically located facility on WA coast gives it a key advantage over competition in servicing Gorgon & Pluto projects.752,630,0051.85Industrials
BGA Bega Cheese Corporate interest in Australian food companies makes the cheese maker worth following.706,378,662154.66Consumer Staples
AUB Austbrokers Holdings The insurance broker is a strong performer. Widely held and well liked by small cap investors.690,127,99153.33Financials
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.673,862,3668.24Health Care
RFG Retail Food Group Owns a number of well know franchise brands. Widely followed by instos.626,482,72752.17Consumer Discretionary
SGN STW Communications Group One of few companies able to benefit from online shift. Widely held and good insto support.603,723,63347.01Consumer 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.573,277,283-29.61Materials
AMM Amcom Telecommunications Well covered junior telco but good candidate for core holding.511,124,32954.24Telecommunication Services
CWP Cedar Woods Properties Property developer with good ROE and earnings growth track record.491,796,99764.22Financials
TGR Tassal Group Salmon farmer is finally turning a corner with an improved harvest strategy and growing demand for product.468,089,935139.03Consumer Staples
TOX Tox Free Solutions Widely held stock in the waste solutions business. Its unique because it operates in a defensive-growth niche.467,680,66425.11Industrials
SEA Sundance Energy Australia Analysts have a favourable take on the oil & gas explorer, but stock is still under radar of most. Sundance provides exposure to prospective Eagle Ford shale.467,238,09822.42Energy
MYX Mayne Pharma Group Sizeable generic drug maker with interesting board members.436,681,458171.93Health Care
CCP Credit Corp Group Strong price run attracted good investor interest. Leveraged to any rise in loan defaults. Not well covered by press.426,719,91019.74Industrials
MYS MyState Well regarded and could make good alternative to bank stocks. Has good yield and earnings growth over past few years.425,425,93444.37Financials
BRU Buru Energy Substantial size but not often covered by press. Widely held with good insto support.423,679,291-52.67Energy
RCR RCR Tomlinson Good first half FY13 result and outlook, but will its fortunes change this year with the mining capex slowdown?421,025,48268.35Industrials
ACR Acrux One of the most successful Australian biotechs in recent history. Widely held by instos.408,810,791-9.24Health Care
NXT NEXTDC The cloud computing company is an IT sector darling. Fairly widely held and followed.408,680,9395.32Telecommunication Services
HZN Horizon Oil One of better regarded small energy stocks that doesn't receive much media attention.383,838,623-32.04Energy
MOC Mortgage Choice Has a good track record and is leveraged to any housing recovery. The stock is also liquid with good insto support.366,389,95499.83Financials
CCV Cash Converters International Strong performance is attracting investors. It's Australia's only listed pawn shop and pay day lender.363,423,126-1.68Consumer Discretionary
FGE Forge Group Good track record has been marred by a recent shock downgrade and capital raising. How long will it take to redeem itself?360,186,46217.25Industrials
NWH NRW Holdings One of the better regarded mining & civil contractors with good track record in delivering on projects.347,215,576-25.59Industrials
SLX Silex Systems Its uranium enrichment technology could become one of Australia's best innovations given its potential to change the nuclear power industry.344,001,465-38.6Information Technology
IPP iProperty Group Worth watching as it is trying to be the REA Group of Asia.333,773,102111.49Information Technology
TGA Thorn Group One of few retail stocks that is performing well despite its flat outlook for FY14. The Radio Rentals chain owner is also well supported by instos.329,062,71423.57Consumer Discretionary
BNO Bionomics One of the larger cancer treatment developers in this market.325,603,180178.82Health Care
AEU Australian Education TrustWell performing childcare centre property owner. Good yield story and outlook. 309,652,74036.65Financials
UXC UXC Company has turned corner and enjoyed re-rating. What's next?288,588,440-5.66Information Technology
SHV Select Harvests Noteworthy for turbulent past and exposure to soft commodity market.280,984,406259.47Consumer Staples
TFC TFS Corp The sandalwood products company offers exposure to both the agri and cosmetics industry. It will start commercial harvest this year.280,746,613113.15Materials
VOC Vocus Communications Telecom stocks are in favour but Vocus is one of the least covered276,563,629111.42Telecommunication Services
RKN Reckon Fierce competition for cloud base accounting software puts it in firing line.275,422,516-7.02Information Technology
GID GI Dynamics IncLargely forgotten by investors but could attract attention this year as it looks to gain US approval to use its intestinal liner on diabetics.272,984,58912.9Health Care
RIC Ridley Corp High corporate interest in the sector and the shrinking pool of agri listed stocks make Ridley worth following.267,800,842-16.88Consumer Staples
GXL Greencross Acquisitive veterinary group. Good profit growth and share price performance, but gets little press.267,544,556127.86Health Care
IMF IMF Australia Litigation funder is unique stock. Stock not liquid but its outlook appears promising given the number of potential class action lawsuits.267,195,55713.64Financials
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.257,611,11527.88Materials
SPL Starpharma Holdings Noteworthy for its good pipeline of innovations. Well run, widely followed.244,381,866-46.91Health Care
AJA Astro Japan Property GroupStrong leverage to Japanese economy makes this an interesting stock to watch.239,273,83424.11Financials
NWT Newsat Potential large cap if it can launch its own satellite in 2015.233,627,075-25.47Telecommunication Services
NAN Nanosonics A successful medical tech story. Should be close to turning in maiden profit with its disinfection device.218,142,63961.17Health Care
MXI MaxiTRANS Industries Transport equipment maker posted good interim result. Has appealing yield and growth.211,592,39229.88Industrials
SIV Silver Chef Strong jump in the share price of the equipment financing group has attracted a good following.209,148,77349.19Industrials
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.208,371,948-4.33Financials
NEA Nearmap A stellar performer with an Interesting business that offers high quality aerial maps to companies & government.206,858,0471475Information 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 further206,350,64779.51Industrials
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.196,185,97499.8Consumer Discretionary
ACL Alchemia /AustraliaOne of the few biotechs with revenue stream. Good pipeline of oncology treatments.194,646,1339.09Health Care
PFL Patties Foods Illiquid stock but has suite of well recognised consumer brands. Defensive yield.187,844,864-6.69Consumer Staples
HSN Hansen Technologies Operates in a high potential/growth industry but is not covered by press or brokers.181,446,86939.01Information Technology
IFM Infomedia Interesting tech play in the car parts market. Strong share price gain but gets little air play.173,823,30358.79Information Technology
DWS DWS Will be a big beneficiary if governments start spending on IT again.172,733,398-5.95Information Technology
ESV Eservglobal Mobile money transfer company that has been gaining traction. Widely held by instos but low press coverage166,860,825103.03Information Technology
DTL Data#3 Well respected IT company that receives little press coverage.159,364,075-3.96Information Technology
SFH Specialty Fashion Group In early stages of turnaround. Can the women's apparel retailer sustain the momentum?151,866,54732.61Consumer Discretionary
CKF Collins Foods One of the few food franchise listed companies.150,195,00735.56Consumer Discretionary
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.144,751,343-7.53Consumer Discretionary
BGL BigAir Group The wireless small cap has gained strong following over past year or two but is often overlooked by investors and the press.138,446,70144.88Telecommunication Services
MLB Melbourne IT A perennial underperformer could be interesting turnaround story as management is in midst of restructuring the business.136,720,94726.02Information Technology
MNW Mint Wireless Huge market potential if the mobile card payment solutions provider can gain market traction. Management aiming for $1 billion in transaction value a year.135,297,2561870.59Information Technology
GHC Generation Healthcare REITOne of the more interesting REITs. Income is more defensive than typical property stock and its greenfield expansion gives it earnings growth potential.131,955,42932.89Financials
AZZ Antares Energy Liquid with good insto support. Already in production with exploration upside in Texas.131,324,997-2.83Energy
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.127,558,243-13.79Health Care
IMD Imdex Drilling company is well supported by instos and should benefit from any rebound in exploration activity.123,652,992-54.16Materials
WDS WDS Widely held with strong insto support. Engineering contractor diversified across mining, energy and infrastructure.123,029,52688.23Industrials
AMA AMA Group Good turnaround story but under the automotive services group is radar of most.118,659,08816.01Consumer 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.114,588,158-58.15Materials
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.110,693,97720.91Consumer Discretionary
LCM LogiCamms Strong price performance and reasonable valuation attracting interest.108,902,61153.68Industrials
REX Regional Express Holdings Well run airline that is overshadowed by Virgin and Qantas.101,342,026-17.12Industrials
RUL RungePincockMinarco IT company to resource industry. Facing tough operating climate with new CEO trying to restructure and turnaround company.98,941,65055.56Industrials
CAA Capral An aluminium manufacturer that is actually holding up relatively well given that manufacturing is on the nose. 94,651,64925Materials
UBI Universal Biosensors IncWell regarded biotech and one of few that's successfully manufacturing in Australia. Struck deal with a few global medical companies.94,306,084-40.66Health Care
DRM Doray Minerals Widely held by instos. One of the more favoured gold explorers by brokers.89,376,060-24.1Materials
CLV Clover Corp One of the star performers in 2012. Operates in growing but relatively stable niche.81,764,946-5.67Health Care
EML Emerchants Trying to change way corporates and governments disburse cash with its trackable and controllable debit card offering. If company can get $1 billion in loaded value on cards, the stock will surge.81,034,225261.11Financials
LGD Legend Corp Electronic parts supplier to utilities and other industries. Stable earnings with good yield. Often overlooked.80,117,59237.22Information Technology
AOH Altona Mining Noteworthy copper play with Xstrata pull-out of Roseby project in Australia and the good ramp up of its Finnish project.77,174,026-45.28Materials
BOL Boom Logistics Crane hire group is riding out the downturn in construction.  It's widely held by instos and is very liquid.70,043,137-49.14Industrials
TAN  Tandou The only direct equity exposure to cotton prices. Also trades water rights and receives little press.68,002,80015.5Consumer Staples
CKL Colorpak The small cap packaging company has grown via acquisitions over past few years.65,229,72140.89Materials
PEN Peninsula Energy Widely held by instos and large free float. It's the only uranium miner on the list.63,892,681-48.78Energy
OTH Onthehouse Holdings Alternative small cap to online property leader REA Group. It is trying to use more timely housing data as a competitive edge against REA.59,165,9512.86Consumer Discretionary
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.57,737,3431.74Industrials
YTC YTC Resources Next 12-mths will be eventful after YTC secured funding for its projects from Glencore.57,602,776-33.85Materials
CUV Clinuvel Pharmaceuticals Interesting skin disorder treatment developer that has done reasonably well over past year50,255,405-25.28Health Care
EBT eBet Potential alternative to star performer Ainsworth Tech. Has exclusive deal with US poker machine maker WMS.47,504,543222.68Consumer Discretionary
TSM ThinkSmart Potential turnaround story worth keeping eye on.47,069,05756.76Financials
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.42,314,270-86.15Materials
UML Unity Mining Growing Tassie gold producer with high free float. Valuation looks compelling too.35,801,888-59.2Materials
NTC NetComm Wireless Under appreciated small IT hardware maker that is punching above its weight. Hardly covered by press.29,600,97576.92Information Technology
PGC Paragon Care Emerging hospital equipment supplier that has been ignored by market.21,790,348110.83Health Care
Source: Eureka Report, Bloomberg

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