Spotlight on mining services

Levi Strauss has a lot to answer for. At the time of the California gold rush the inventor of jeans homogenised men's fashion and cemented the idea that supplying miners, rather than digging up minerals, was the way to benefit from a resources boom.

Every boom is now accompanied by whispers about 'picks and shovels', which is just one reason why the mining services sector is so loved. The boom in their share prices is another. Recent falls may make the sector look more attractive but investors seeking shelter from volatile commodity prices won't find it here.

The problem is twofold. First, revenues are dependent on volume growth, which is spurred by high commodity prices – making mining services just as cyclical as the miners themselves. Second, the sector is fiercely competitive. Engineering groups pop up easily and without much capital. But at what looks like the tail end of the boom, the apparent pessimism might offer an opportunity.

Mining services can be separated, although not always neatly, into those that offer engineering services and those that provide equipment. The distinction is important.

A services business tends to carry few assets on its balance sheet and typically boasts high returns on assets (ROA) and equity (ROE) and low levels of depreciation and maintenance capital expenditure. With little chance of reinvesting profits at high rates of return, dividends should also be high whilst debt should be low. Remember, though, such businesses face high competition for contracts and staff.

The equipment companies are quite different. With balance sheets laden with assets, ROA and ROE will be lower. Debt is usually higher, as is capital expenditure, which will impact cash flow. Such businesses will, however, offer a greater chance of reinvesting profits and will benefit from lags as equipment supply struggles to meet demand. Let's take a look at what's on offer (see Table 1).

ALS

First up is the company formally known as Campbell Brothers, ALS. This is a large testing lab and an unlikely beneficiary of the boom. Earnings per share have grown from 6 cents in 2002 to 66 cents last year. That growth has largely been fuelled by the minerals business which has more than doubled profits since 2009.

ALS has poured cash into expanding assets, which rose from $805m in 2009 to $1,635m last year. Almost half of those assets are tied up in minerals testing. Returns are sensational, but there is no doubt the business is boom-fuelled. High commodity prices encourage exploration and expansion, which provides ALS with samples to test and mine sites to inspect. As mining activity stalls, profits could fall. Trading on a price-earnings ratio (PER) of 17, that possibility doesn't appear to be sufficiently reflected in the share price. AVOID.

Mineral Resources

Listed in 2006 at a price of $1.15, Mineral Resources now trades at over $10. Time machine anyone? A constructor of pipelines, a processor of minerals and a miner in its own right, higher prices and higher volumes have been a boon for this business.

Naturally, the metrics are sensational: revenue up tenfold since 2006; profit margins up from 10% in 2006 to 26% last year; earnings per share up from 20 cents in 2006 to 132 cents last year; and dividends are generous.

But you can almost smell the cyclicality. Mineral Resources is particularly exposed to iron ore through its large crushing contract with Fortescue Metals and its own production of almost 4m tonnes of ore last year. The embedded relationships with big miners offer some protection but it's hard to see such enormous margins staying high against the backdrop of falling iron ore demand. For now, AVOID.

Ausdrill

Drilling, blasting and contract miner Ausdrill is far less attractive. Iron ore accounts for a third of company revenue, which may be a problem given the company's significant debt. The balance sheet shows just $200m in debt but there's another $160m in hire purchase liabilities. The effective debt-to-equity ratio is therefore 48% – way too high. During the global financial crisis, for example, operating cash flow fell below $50m before swinging back to $123m after China began stimulating its economy. Ausdrill remains vulnerable to a downturn. AVOID.

Austin Engineering

Austin Engineering manufactures dump-truck bodies, excavators, buckets and water tanks. It's heavily exposed to bulk commodities where colossal levels of earth need to be moved. With our decidedly negative view on coal and iron ore prices, casting a verdict on Austin is easy. AVOID.

Ausenco

Engineering group Ausenco generates 84% of its revenue outside Australia and carries both debt and high expectations. Trading on a PER of 14, the good times are baked into today's valuation and earnings are more likely to fall over the coming years, perhaps substantially. AVOID.

Miclyn Express

Miclyn Express owns a fleet of 115 ships that it leases out. We're just going to say it: it's impossible for Miclyn to earn better than average rates of return over time. Once customers see Miclyn's returns they'll switch from leasing to owning ships themselves or, more likely, competitors will build more ships and lease rates will fall. This is exactly what happened to large bulk carriers during the height of the iron ore boom. It's hard to justify paying more than asset value for this business. With the price at around twice net tangible assets (NTA), we therefore say AVOID.

Emeco Holdings

Emeco, which leases heavy equipment to miners, is in a similar position but trades at a discount to book value with $382m in net debt and $640m in equity. Remove $175m in intangibles, and NTA comes to $465m, still a small discount to the market capitalisation. But with a heavy debt load it's another one to AVOID.

NRW Holdings

Also making the case for cheapness is engineering group NRW Holdings. With over 85% of last year's profit coming from civil work and mining services, the business boasts few defensive qualities. A PER of just six does, however, appear cheap. In a downturn, both revenues and margins should sink. But if we assume revenue falls to a third of last year's level and margins halve, that still leaves a profit of $25m that might be earned in a downturn, or a bottom of the cycle PER of 22. This is no quality business, but it's cheap enough to HOLD.

Mermaid Marine

Mermaid Marine, like Miclyn, leases vessels, but also operates three supply bases conveniently located off the Western Australian coast. Offshore project operators get significant value from using the bases for maintenance and logistics. To send ships further away would mean more downtime and, ultimately, higher costs. So geography grants Mermaid an advantage, although vessel leases still account for 57% of profit. Mermaid is more interesting than its peers but, trading at more than twice book value, it appears expensive. AVOID.

Forge Group

Engineering and construction business Forge Group has grown revenue tenfold since 2007. During that time, net profit has grown more than 20 times (time machine again please, Mr Wells). Such growth suggests Forge has benefited from the cyclical boom but net profit margins have actually fallen with growing volume compensating. That's surely unsustainable.

Forge is, however, well run. It carries plenty of net cash, generates high free cash flow and pays handsome dividends. A PER of 10 doesn't appear high but revenue could conceivably fall a long way, taking profits with it. Today's earnings are a function of yesterday's boom. Forge joins Monadelphous as one of the best in the industry but at this point of the cycle it is one to AVOID.

Decmil

Like Forge, Decmil is conservatively run. It holds plenty of cash – more than $100m last year compared to a market capitalisation of $417m – and pays regular dividends. Yet construction and civil work for the mining industry has been greatly aided by soaring mining investment. We'd need a cheaper price to get interested. AVOID.

Imdex

Unlike other engineers, Imdex owns some of its own technology so it's no mere commoditised business, supplying drilling fluids, down-hole instrumentation and other niche services. Its customers are drilling and contractors rather than giant miners themselves, which is one small comfort.

But the company is vulnerable to drilling activity. With 70% of revenues from gold and copper, those two metals have a strong impact on its future. While the boom has helped results, Imdex's success will depend on whether the industry accepts its products as much as volume growth.

Imdex is already a world leader in drilling fluids and a solid waste removal unit that saves drillers water is also being rolled out. There's plenty of scope to expand into supplying the coal seam gas and shale gas sectors, too. Boasting a PER of 9, it's an ideal candidate for further research. We aim to become more familiar with the business over time. For now, HOLD.

Sedgman

Perhaps best known for building coal handling preparation plants, Sedgman also designs processing plants for minerals and iron ore production. The company recently agreed to acquire South African-based MDM Engineering for $104m, a big sum for a company with a market cap of just over $200m. Sedgman will now have a larger presence in Africa. It's hard not to see the move as a defensive one; coal and iron ore markets could be severely impaired in future and the takeover diversifies the company's earnings. AVOID.

MacMahon Holdings

After selling its construction arm to Leighton for $16m, MacMahon Holdings is now a fully-fledged mining contractor. The company's contract wins have been high profile: it won the $1.8bn contract to mine at Fortescue's Christmas Creek project and at giant Tavan Tolgoi coal field in Mongolia. It's also been mining at Olympic Dam for many years. But a series of profit warnings has seen the share price plunge to the point where it now trades at around half NTA.

There are still reasons for caution. Almost 80% of the company's order book comes from Western Australia and the bulk of that from iron ore. MacMahon's return on assets is half that generated by its peers. Yet with Singaporean group Sembawang threatening a takeover and plenty of room for operational improvement, there are reasons for interest. A closer inspection beckons. For now, HOLD.

Matrix Composites & Engineering

Finally Matrix Composites & Engineering, which manufactures buoyancy modules for the offshore oil and gas industry. Low-depth buoyancy modules are a commodity, but Matrix has a technological edge in making such modules withstand deep-sea pressures.

Unfortunately the company is in awful financial shape. New orders have been slow, affected by the high Australian dollar. There's been a downturn in industry procurement and teething problems at a new production facility, too. Working capital is tight and a capital raising might be needed. No wonder Matrix trades at a healthy discount to book value. The case to buy requires more work but it's cheap enough to HOLD for the time being.

That's not a great haul for this sector sweep, but the handful of companies worthy of further research might produce something a little more exciting. We'll keep you posted.