Is it time to buy mining services stocks?

Financial Journalist
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The old share market saying “buy stocks when everybody else is selling” is hard to put into practice. Mining services companies are a good example. After being smashed this year, a few look like good value; most are value traps that could still crunch portfolios.

Investors could not get enough of mining services stocks in 2010 and 2011 as Australia’s staggering resource investment boom peaked. Then commodity prices fell; several large mining projects were deferred or cancelled; and big resource companies sought cost savings from service providers.

The carnage

The result was a sea of earnings downgrades from mining services stocks in 2012-13, and tumbling share prices. Former market darling Monadelphous Group slumped from a 52-week high of $28.48 to $17.54, and Forge Group fell from almost $7 to $4.18.

Then there were disasters such as Boart Longyear, down from a 52-week high of $2.38 to 40 cents. Several smaller mining services stocks are also down 70 to 80% from their price highs, and the carnage continued this month with Ausdrill announcing a profit downgrade and Forge expected to follow (it was in a trading halt as this newsletter published).

The Forge news was particularly troubling, given problems from two of its key projects – and their possible effect on FY14 earnings – were not flagged at the annual general meeting, only weeks earlier.

The potential for nasty profit surprises – and highly dilutive capital raisings – reinforces the dangers of investing in the troubled mining services sector, and questions whether governance, generally, in the sector is keeping pace with the magnitude of earnings risks.

The Forge trading halt was also a brutal, timely reminder that the unwinding of the resource investment boom has a long way to run, and that mining services stocks, which look cheap on average, can get a lot cheaper yet.

Buyer beware

But every stock has its price. Forge, for example, now trades on forecast Price Earnings (PE) of about 5.7 times, according to consensus analyst forecasts, although earnings risk is high. Resource project accommodation company Decmil Group is on 7.6 times. Ausdrill has a forecast PE of 4.8 times 2013-14 earnings.

Cheap? Maybe. A buy? No. For one thing, the E (earnings) in the PE equation has high uncertainty for most mining services companies, given the risks of further resource project cut-backs. In fact, it’s hard to think of any share market cohort with lower earnings visibility right now than mining services.

Moreover, mining services stocks are not great long-term investments at the best of times. These companies typically have high fixed costs, high working-capital requirements, and are prone to having expensive equipment sitting idle and depreciating rapidly when demand slows. They are not set-and-forget investments for long-term investors, such as self-managed superannuation funds, and need to be traded through the mining investment cycle.

Caveats aside, the best opportunities usually emerge when investors give up on sectors. For all the gloom, there have been a few stellar mining services stocks: Clough surprised the market with earnings upgrades and should be fully acquired this year. A new player, accommodation provider Titan Energy Services, turned heads with stronger-than-expected profits and a soaring share price.

Moreover, after being pummelled in 2011 and 2012, the S&P/ASX 300 Metal and Mining Index is up almost 4% so far this quarter – off a dreadfully low base. Optimists hope signs of stabilisation in Chinese economic growth and a higher-than-expected iron-ore price will be a turning point for resource stocks, which, in turn, will eventually flow through to mining services companies.

The golden rules

Value seekers wanting to buy mining services stocks should focus on four broad rules. First, stick to the best-quality companies with a long-term record of high return on equity (ROE). The past is even more important when earnings visibility is low, and forecasting error high.

Second, choose mining services stocks with a blue-chip client base, preferably BHP Billiton, Rio Tinto and Fortescue Metals Group, and exposure to projects in production. Lowest-cost producers have a much better chance of coping with further commodity price falls and maintaining more projects. Avoid service providers with high exposure to smaller resource companies and exploration projects, for they are usually the first to be pulled when capital-raising is problematic and cash flow wanes.

Third, focus on balance-sheet strength. Low net debt relative to equity is vital. Mining services companies with sound balance sheets have a much better chance of surviving the sector fallout and acquiring weakened competitors. Expect more sector consolidation in the next 12-18 months.

Finally, seek a high margin of safety when buying mining services stocks. Or, put another way, a bigger share-price discount to the company’s intrinsic or true value, to compensate for extra risk. Whatever your estimate of fair value, make sure to buy the mining services stock at least 10-20% below it.

The pick of the bunch

Two mining services stocks stand out at current prices – the first, Monadelphous Group is an investment-grade company for portfolio investors. The second, Calibre Group, is a contrarian idea for speculators at this stage.

Monadelphous (ASX Code MND) meets most requirements of the framework set out above. It has an exceptional long-term record, with an ROE consistently near or above 50% over eight years, and is arguably Australia’s best-quality, and best-managed pure mining services company.

Monadelphous earns a chunk of its revenue from blue-chip clients such as BHP Billiton and Rio Tinto and is involved in large engineering construction projects, maintenance and industrial services, and infrastructure. Its balance sheet is strong, with reasonably low net debt relative to equity.

Monadelphous looks okay on the valuation front – though is not a screaming buy. The consensus mean of analysts estimates compiled by Thomson Reuters is a 12-month share-price target of $19.30 at June 2014, versus the current price of $17.60. That implies Monadelphous is trading at a 9% discount to fair value, which should be just enough for long-term value investors, who hold the stock for at least three years and tolerate bouts of share-price volatility.

It would be prudent to wait until Monadelphous has its annual general meeting tomorrow, in case it follows other mining services companies and downgrades its earnings guidance. The stock might get cheaper yet if earnings expectations fall, and give more ammunition to the many short-sellers, who are betting on that happening.

The other mining services idea, Calibre Group (ASX Code CGH), is a higher-risk play. Calibre raised $75 million through an Initial Public Offering and listed in August 2012 with a $1.62 issue price – just as the iron-ore price tumbled. Its $477 million valuation at listing has sunk to $100 million, after savage earnings downgrades in its first year as a listed company. It was one of the worst-performed floats in years.

I always keep an eye on floats that attracted strong institutional support at listing, but were smashed in the first year as listed companies, for the market usually gives up on them, overlooking an emerging stabilisation and then recovery. Calibre, for example, traded as low as 26 cents in the past 52 weeks – and has spiked a few cents higher this month.

Calibre has exposure to iron-ore projects, and the iron price has held up better than many expected when the company listed. It won a few decent contracts in August and September, and several key management changes have been made in the past few months, with it yet to appoint a managing director after former boss Rod Baxter resigned in June.

Calibre had $50 million in cash and short-term investments at the end of FY13, which compares with the current $100 million market capitalisation. The net debt to equity ratio of around 20% is better than a lot of small mining services companies.

Calibre’s trailing PE is 4.2 times. Valuation service StocksInValue estimates Calibre’s current intrinsic value at 53 cents a share, rising to 57 cents in 2014 and staying there in FY15, which compares with a 31 cent share price. If StocksInValue is right, Calibre trades at a decent discount to fair value, provided it can stabilise earnings. The valuation, appropriately, has factored in a lot of bad news – but possibly too much at current prices.

Calibre is not a stock for conservative portfolio investors. But experienced contrarian investors, who are comfortable with higher-risk turnaround situations, could do worse than follow the stock for any signs of operational improvement.

Some big-name fund managers were happy with a $477-million valuation for Calibre just 15 months ago. Now that it’s worth a quarter of that, few seem to be looking at it. Any recovery, however, could take years to play out, with plenty of volatility likely along the way.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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