Mining services isn't a disaster zone

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.

Click to enlarge

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.

Click to enlarge

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.

Click to enlarge

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%.

Click to enlarge

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”.