A cyclical sector well positioned for the year ahead
There are parts of the market that should benefit from supportive monetary policy, stimulus in China and buoyant commodity prices, and we believe the mining services sector is high on this list. In saying that, investors should also be selective in what is typically a volatile segment of the market.
Supportive macro environment
The backdrop for global trade and commodities markets heading into 2020 appears supportive, with positive measures including the signing of the Phase One trade deal between China and the US, a Brexit resolution, and perhaps most importantly, potential for China stimulus. This year is the last of China’s 13th five-year plan and targets need to be met relating to GDP growth. Local government areas are expected to issue a large amount of bonds and use the proceeds to stimulate infrastructure investment, which in turn will be positive for construction materials demand, and therefore commodities such as iron ore and copper.
Here in Australia we are seeing the iron ore majors (BHP Group, RIO Tinto and Fortescue Metals Group) embark on large capex programs to build new iron ore mines after a long spending hiatus. These new mines are adding very little in the way of incremental tonnes to the market and are largely replacement mines for old ones approaching the end of their reserves. This is likely to be an ongoing feature for the iron ore majors over the coming decade, with RIO Tinto recently flagging an increase in iron ore capex guidance for the next three years:
Source: RIO announcement to the ASX on 31/10/2019
Investment is happening in other commodities too. With the gold price hovering around record levels in AUD terms, gold producers are focused on expansion plans to produce as many ounces as possible. The forecast demand for battery materials has seen the restart of the Ravensthorpe and Savannah nickel mines, in addition to the planned restart of Odysseus by Western Areas and Cassini by Mincor. There is also the potential for gas investment to restart in WA in a few years’ time as new discoveries in the North West Shelf and the Perth Basin are attracting considerable interest.
Miners are now more rational and it’s extremely unlikely we will return to the boom times at the start of the previous decade. However, with higher commodity prices the focus inevitably turns more to production levels than costs and this should be good for mining service providers’ margins. This is particularly the case in an environment of tightening labour and equipment availability – we are hearing the consistent message from mining companies that they are struggling to attract skilled labour, and a recent chart from Emeco shows the mining fleet in Australia hasn’t increased in five years despite a rapid rise in production of bulk commodities.
Source: Emeco investor presentation released to the ASX on 19/09/2019
The mining services investment landscape
There has been somewhat of a shakeout in the ASX listed mining services space over recent years as M&A activity (Broadspectrum, UGL, Sedgman, Pacific Energy) and bankruptcies (RCR Tomlinson, Briety) along with few new IPOs have contributed to a smaller pool of stocks than previously, especially at the larger and more liquid end of the small cap market.
Despite this, the available stocks mostly offer investors exposure to the desired commodities at the current point in time, as shown below:
Source: AMP Capital estimates and FY19 results disclosure
After a tough few years at the bottom of the cycle in FY15-17 revenue and earnings for the seven small cap pure play mining services stocks listed above have bounced back strongly. Aggregate revenue and EBITDA have doubled in the past few years, and NPAT is up more than five times. There are a number of other stocks exposed to the sector (including Seven Group, Mineral Resources and Codan), however these businesses have other divisions so we have chosen to focus on the pure play mining services stocks in this article.
Source: AMP Capital, Factset , January 2020
Consensus forecasts for FY20 and FY21 have earnings growth of 11% and 14% respectively, a level which appears reasonable in aggregate, but our forecasts do vary at the stock level. We believe the upcoming reporting season will be challenging for companies exposed to the construction cycle, as contract awards have been delayed and a number of these stocks will require a stronger second half of FY20 to meet consensus numbers. Our earnings focused investment process has us interested in stocks that are likely to at least meet, or even beat, consensus earnings estimates.
Valuations look reasonable
When analysing valuations of this group of stocks on an EV/EBITDA basis using forecast earnings, it becomes apparent that there have been significant fluctuations in valuation on a stock by stock basis, but on average the group has remained relatively flat in the 5-6x EBITDA range over the past two years.
Source: AMP Capital, Factset , January 2020 - *Past performance is not a reliable indicator of future performance
Mining services stocks deserve to trade at a discount to the broader market, given their inherent cyclical nature, earnings volatility, high capital intensity and competitive industry structure. This discount will expand and contract over time depending on industry conditions, from 25% at the peak of the boom to over 70% at the bottom of the bust. It’s currently sitting at around 40%, a level that is close to the average over the past 10 years and offers some upside given industry conditions are becoming more favourable. Individual stocks trade in a wide range around this discount and this range has increased in recent years, allowing opportunities for active managers.
Source: AMP Capital, Factset, January 2020 - *Past performance is not a reliable indicator of future performance
Macmahon Holdings (MAH): Well Positioned
Macmahon is a company that we have held in the fund for a number of years that fits our investment process. The company has had a challenging few years; with a failed takeover bid by CIMIC, a class action, board changes and a problem contract all resulting in the stock consistently trading at the lowest EV/EBITDA multiple relative to peers. While issues such as these are an ever present risk in the sector and may recur at some point in the future, in our view they have all been resolved for now. These issues have also masked the good progress that we believe CEO Mick Finnegan has made over the past 3 years in building a culture around safety and engagement, winning work with tier 1 clients to underwrite a solid order book, and expanding the company’s offering through bolt on acquisitions. We have visited mine sites where Macmahon does work and the feedback from clients has been universally positive to date.
The market will be able to view Macmahon with a clean slate at the upcoming results, and we see FY20 earnings guidance as achievable which may cause investors to question the discount in valuation relative to peers including NRW Holdings, Perenti Group and MACA. There is potential for 3 contract extensions and expansions in 2020 from existing jobs at Tropicana, Batu Hijau and Byerwen, which would materially grow the order book and provide the market with 5 years of forward revenue visibility.
A word of caution
Mining services stocks are very volatile. We’ve come to expect that, each year, a few of these stocks will run into problems. This can come down to a lack of work, a problem contract, or a stressed balance sheet. In our view, investors should diversify their exposure in this sector and keep a close eye on order books, cashflow and any contracts which may cause an issue.
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Matt is Co-Portfolio Manager for the AMP Capital Australian Emerging Companies Fund. He has 11 years investment experience in the Australian small and micro cap space, previously working for IFM Investors and Macquarie Group.