There are just three “mining service” companies I consider to be...

There are just three “mining service” companies I consider to be of investment grade: ALQ, MND and ORI

One of the reasons a distinction is made between these three companies and the rest of the cottage industry of mining service companies that have sprung up over the past five years is that ALQ, MND and ORI have been around for many boom-and-bust resource cycles.

There is therefore some precedent available for investors to make an informed view of prospective performance of these respective business as we go beyond the peak of the commodity cycle, especially in terms of factors such as:

• Revenue-at-risk,
• Likely margin experience and,
• Most importantly, the likelihood – or not – of whether fresh equity capital will need to be issued, to the dilutive detriment to the value of the business, in order to protect the balance sheet

(Yes, DOW and LEI, too have seen a few cycles in their day but, unlike ALQ, MND and ORI who cope admirably with down-cycles, DOW and LEI have the distinct tendency to have the guts ripped out of their margins at the slightest hint of tough project conditions, they fail to make investment grade status.)

Focussing on ALQ, following the halving in its share price from the peak four months ago, and the plus-20% fall in just the past few days since the BLY result which provided some sobering outlook commentary.

In order to derive a valuation for ALQ, I believe financial forecasts for FY13 are not that relevant given the company has already guided to September-half (remember this is a March year-end company) NPAT of $130m to $140m (representing growth of 27% to 37% on the $102m achieved in the previous corresponding period), with the caveat that the “rate of growth in the second half of this year will not match the growth rate achieved in the first half”.

So we can roughly figure out what FY13 NPAT will look like:

1H13: $135m (mid-point, say, of guidance)
2H13: Say, 20% growth (which is less than 1H’s 27% to 37% growth) on pcp which was $119m, so $142m

This gives full-year FY13 NPAT of $278m. This compares to consensus NPAT forecasts for FY13 of $260m, which is 7% conservative compared to guidance (for once, rightly so; given the pace of unravelling in the mining services space – I think a healthy dose of conservatism is warranted).

I therefore don’t have much issue with FY13 forecasts; I think they are in the bag from a likelihood-of-delivery point of view.

The problem I have with ALQ relates to FY14 consensus expectations which, as they currently stand, are ludicrously overstated, and will need to be revised downwards to quite a degree.

Here’s my thinking:

For starters, even novice investors in ALQ should be aware that the division that matters most is the Minerals business, given it constituted 57% of total group EBIT in FY11, 66% in FY12 and probably 69% in F13.

[Despite ALQ’s significant efforts – and they’ve done an excellent job at it, don’t get me wrong – to deploy the super-normal returns derived from the minerals boom into diversifying the company into other areas of analytical testing, it is still largely a “minerals testing” P&L...with the attendant volatility to goes with that. I hear a lot of commentators waxing on about how much ALQ has diversified away from Minerals earnings. In fact, they haven’t really, but in a way they have been punished for hitting a good shot, as in “we’re running hard to move away from Minerals, but Minerals is doing so well, that however fast we grow non-Minerals, it still remains dwarfed by Minerals’ super-normal earnings.]

Anyway, dissecting the FY12 and FY13 P&Ls in more detail, so that the inherent variability of this largest division, Minerals, can be assessed:

FY12
EBIT:
Minerals = $215m
Life Sciences = $78m
Energy = $24m
Industrial = $25m
Chemicals = $8m
Reward = $4m
Corporate = -$25m
GROUP EBIT = $328M
Less: Net Interest = -$16m
PRETAX RPOFIT = $312m
Less: Tax = $-$87m
NET PROFIT = $225m -->

For FY13, my modelling yields the following:

FY13
EBIT:
Minerals = $267m [includes 4 months’ incremental contribution from Stewart acquisition]
Life Sciences = $90m [includes full-year contribution from Eclipse/AMS, and 7 m contributions from CAS and Milina/Artek]
Energy = $25m
Industrial = $28m [7m contribution from Austpower acquisition]
Chemicals = $3m [sold in Aug, 2012]
Reward = $3m
Corporate = -$26m
GROUP EBIT = $390M
Less: Net Interest = -$28m [comment: higher NIBD following almost $300m in acquisitions FY12 and FY13]
PRETAX RPOFIT = $362m
Less: Tax = $-101m
NET PROFIT = $260m --> [comment: this is roughly in line with consensus]

But for FY14 my modelling is significantly at odds (i.e., lower) than current consensus expectations:

FY14
EBIT:
Minerals = $179m
Life Sciences = $98m [includes 5m incremental contribution from Milina/Artek]
Energy = $26m
Industrial = $30m
Chemicals = $0m [sold in FY13]
Reward = $3m
Corporate = -$28m
GROUP EBIT = $307M
Less: Net Interest = -$25m
PRETAX RPOFIT = $282m
Less: Tax = $-79m
NET PROFIT = $204m --> [comment: consensus is still at $260m...I THINK THE STOCK IS CUM ~20% DOWNGRADE FOR FY14)

It should be clear for all to see that determinant of the big variance in profitability between FY14 on FY13 is the Minerals Division, where I expect EBIT to go $185m in FY13, from $267m in FY13.
The other businesses are relatively stable (which is why the board/management have been so hard at work in seeking to acquire these sorts of businesses as offsets to the volatile – but high-returning – Minerals business).

Cleary, the expectation of such a fall in Minerals’ EBIT in FY14 warrants some explanation.

The beauty of following a company like ALS is that one has some form of precedent upon which to draw when making forecasts, namely the last slowdown in exploration spending during the GFC, which hit ALQ’s P&L in the FY10 year.

During that period Minerals Revenue fell by a whopping 34%, from $311m in FY09, to $205m in FY10, and the EBIT margin dropped from 36% in FY09 to 26% in FY10.
As a result, EBIT more than halved, from $112m in FY09, to $53m in FY10.

(This, I think, goes to show just how vulnerable a company like ALQ is, and why it is not as robust a company over the entire cycle as most analysts believe. Fact is, this was a largely unknown stock 5 years ago, and today all the bulge bracket investment banks have analysts following it, none of them having really closely studied the company’s history. It had become a market darling without any real understanding of the downside operating leverage risks, in my view.)

By comparison with the GFC, my modelling for FY14 has Minerals revenue falling by 20% on FY13, and the EBIT margin falling from 36% in FY13, to around 30% in FY14.

The reason I don’t believe things will become as severe beyond the peak of the current boom, compared to the GFC-related slump is as follows:

1. Revenue: The GFC occurred with speed and severity that caused the world of global commerce and industry to essentially come to a near-halt; what’s happening now is a slowdown, for sure, but it is observable, and therefore more manageable. Activity isn’t stopping dead in the global mining exploration industry as it did during the GFC; activity is merely slowing. WHICH WHY I DON’T THINK A CATCLYSMIC 35% FALL IN REVENUE WILL BE REPEATED.
2. EBIT Margin: Because of the speed at which the activity stalled during and after the GFC, ALQ was caught somewhat off guard (I had the good fortune of meeting the CEO soon after the GFC and he conceded as much). The “Hub-and –Spoke” nature of the Minerals’ business model means that the company has the distinct ability to “variable-ise” its fixed costs, which it was slow to do during the GFC. I suspect management will be far more proactive this time around, given that the slowdown now is not as dramatic and unprecedented. I think the GFC presented a really extreme set of conditions. It warrants mentioning that, once management galvanised itself into action following the GFC, the margin in SH10 rebounded strongly, up to 34.6%, from the SH09’s low of 25.5%. WHICH IS WHY I DON’T SEE MARGINS FALLING BELOW 30% THIS TIME AROUND


VALUATON

On my modelling, ALQ is trading on the following valuation metrics:

On FY13 Forecasts:
P/E = 9.5x
EV/EBITDA = 6.4x
DY = 6.2%
FCF (on Market Cap) =7.9%
FCF (on EV) = 7%

On FY14 Forecasts:
P/E = 12.1x
EV/EBITDA = 7.6x
DY = 6.2%
FCF (on Market Cap) = 9.4%
FCF (on EV) = 8.6%

So, on FY13 numbers – which I believe is what most market participants have been using to value the company – the stock looks truly undervalued.

However, I think this valuation point is misleading: the market’s glare will increasing (actually, it probably has already) be directed to FY14.

On the valuation metrics for that year, I think the stock looks to me like being merely fairly valued for this stage of the earnings revision cycle.

In other words, while I think that the pending earnings downgrades are largely factored into the stock price, and that the downside from here might be limited from a hard, fundamental value point of view, history has shown that stocks do not perform very well in the face of downgrades.

And the problem for ALQ, I fear, is that the pending downgrades will still take many more months to permeate into the market, given the usual tardiness among broking analysts.

The way I am approaching ALQ is as follows:
I will only buy the stock at the current price level, once consensus forecasts have been downgraded to what I believe to be a more realistic level.
I will, however, buy the stock (even if it is still cum-downgrade) if the FCF yield on the EV exceeds 10%. That occurs at a share price of $6.50.

It’s a tough one, this, because I think it is being discarded by investors along with the entire mining services sector, yet it is a significantly better business than most of the companies in that space.
But the time to buy it, I believe will only be once analysts have taken their medicine in terms of forecasts, and I think that will only be after their interim result, in late November (at the earliest).

There’s a semblance of value emerging, but not enough to provide a buffer against the negative earnings momentum with which the stock –and the sector – is pregnant.

In short, I think its a 7.50 out of 10 business being valued like a 7.25 out of 10 business (if I may presume to be so precise!)


Hope this helps

Prudent Investing

Cam