Mining Services Sector Still Attractive

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 – Mining service companies delivered strong results in 2H11
 – Further growth expected given strong investment expectations
 – Valuation question offset by earnings growth momentum
 – Stockbrokers update preferred exposures

By Chris Shaw

The second half of 2011 was a period of strength for Australian mining services companies, as the sector on average delivered earnings per share (EPS) growth of 20% in year-on-year terms. Driving this growth, observes UBS, was 25% growth in average revenues, while earnings margins were broadly flat relative to the previous corresponding period.

This meant most stocks in the sector either beat or met market estimates. BA-ML suggests the best results during the period in terms of margins and positive operating leverage were delivered by Imdex ((IMD)), Ausdrill ((ASL)) and Sedgeman ((SDM)), while Industrea ((IDL)), Bradken ((BKN)) and Emeco Holdings ((EHL)) were poorer performers on this basis.

The growth in average revenues achieved in the December half of last year was possible as UBS notes in 2011 over $62.6 billion was invested in the Australian resource sector, including a record in the December quarter of $18.8 billion. Capex intentions surveys by the Australian Bureau of Statistics suggest investment in the sector should grow by more than 75% in FY12 and more than 60% in FY13.

This offers a positive investment scenario for companies operating in the mining services sector, as evidenced by shares prices in the sector rising by 19% year-to-date. UBS notes this compares favourably to the 9% year-to-date gain in the Small Ords Index.

Macquarie is also positive on the earnings outlook for the sector, expecting it will strengthen further. The broker's estimates imply 5% average EPS growth in FY12, rising to 13.6% in FY13. Stronger top-line growth will be the major driver of the increases, as Macquarie expects margins will weaken somewhat.

Not all sector observers share this view of margin pressure, as UBS continues to expect a general improvement in margins in coming months as contracts recently started begin to mature. Margin improvement is unlikely to be universal, as UBS expects the likes of Emeco Holdings and Boom Logistics ((BOL)) will show the largest rate of improvement, while margins are forecast to decline at both Industrea and Mermaid Marine ((MRM)).

Valuation is becoming something of an issue for BA Merrill Lynch, as most of the mining contractors have re-rated substantially in recent months. UBS agrees, noting the average sector multiple has increases to 10.5 times from a low of 9.0 times. 

Earnings growth momentum should continue to prove supportive according to BA-ML, especially in terms of value relative to other sectors of the market. Again UBS agrees, the latter pointing out compound EPS growth for the sector could be as much as 63% over the next three years.

In terms of how best to play the strong earnings growth outlook for the mining services sector, brokers have a range of views. UBS prefers NRW Holdings ((NWH)) and Ausenco ((AAX)) in the sector, the former given a superior return profile and growth prospects and the latter a reflection of a transformation of the business.

Elsewhere, UBS rates Boom Logistics, Bradken, Emeco, Macmahon Holdings ((MAH)) and Mermaid Marine as Buy, while Fleetwood Corporation ((FWD)) and Industrea are rated as Hold. Adding in small cap engineering services companies, UBS rates Ausenco, Cardno ((CDD) and Coffey International ((COF)) as Buy, while WorleyParsons ((WOR)) is rated as Neutral. 

For Macquarie the contracting sector standout is Boart Longyear ((BLY)), reflecting strong operating leverage and margin improvement. Macquarie prefers front end exposed stocks given stronger earnings growth in this group when compared to companies focussed on later stage activities such as Transfield ((TSE)) and UGL ((UGL)).

Overall Macquarie rates Boart Longyear, WorleyParsons, Leighton Holdings ((LEI)) and Transfield as Outperform, while United Group and DownerEDI ((DOW)) are both ascribed Neutral ratings.

BA-ML covers a number of companies in the sector and has split its preferred plays according to market cap. Among the large cap exposures the broker's top pick is Boart Longyear, while Leighton Holdings is also rated as a Buy and Campbell Brothers ((CPB)) is rated as Neutral.

Among the small-cap plays BA-ML prefers Bradken, while also rating Imdex and Sedgeman as Buy. Both Ausdrill and Emeco are rated as Neutral, while Industrea scores an Underperform rating from by BA-ML.

At the micro-cap end of the sector BA-ML rates both Mastermyne Group ((MYE)) and Swick Mining ((SWK)) as Buy, with the former being preferred given a strong industry position, good growth prospects and management capability.

Goldman Sachs has also split its list between the large cap and small cap exposures, offering its key selections in both categories. The broker's large cap top picks are Boart Longyear, WorleyParsons and UGL, while least preferred of the large cap plays are Transfield Services and Monadelphous ((MND)). Both are rated as Sell.

While Monadelphous is highly regarded by Goldman Sachs for its market leading position in the structural, mechanical and piping market, the issue is valuation given limited scope for additional margin expansion in the business. Transfield is similarly not regarded as attractive given a limited earnings growth outlook, especially when compared to others in the sector.

Among the other large cap exposures covered, Goldman Sachs applies Neutral ratings to Leighton Holdings, Campbell Brothers and DownerEDI.

At the smaller end of the sector, Goldman Sachs prefers Norfolk Group ((NFK)), Bradken, Sedgeman and Imdex. All are rated as Buy, while Ausenco, Emeco, Seven Group Holdings ((SVW)) and WDS ((WDS)) are rated as Neutral.

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