Material Matters: Zircon, Mining Services And Oil & Gas Stocks

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-Zircon prices stabilise
-Mining services perhaps oversold
-Woodside's depreciation dilemma
 

By Eva Brocklehurst

It appears zircon prices have stabilised in China. Credit Suisse has found that producers are, reportedly, unwilling to cut prices further and stocks are low. This doesn't mean that prices will go up necessarily but a modest price rise should stimulate demand by convincing customers that the downward price cycle has ended. Tighter supply in China represents a re-imposition of market discipline by producers in the analyst's view.

The world's biggest producer, Iluka Resources ((ILU)), has observed demand in the ceramics sector had picked up and told Credit Suisse, subsequent to the quarterly report, that it had sold out of zircon at one of the Chinese warehouses and was shipping more sand. The company's warehouse in Fujian has, according to a recent article, only 10,000 tonnes in stock, down from 120,000t a year ago. Credit Suisse notes this tightness is regional rather than global and, unlike the base metals market, there are no traders in mineral sands to arbitrage away a regional premium by shipping product. Zircon producers sell directly to customers. The second biggest producer, Rio Tinto ((RIO)), has no stocks in China.

Sentiment towards mining services companies remains negative, as major resource companies delay final investment decisions on significant greenfield projects. This has caused UBS to revise estimates for the companies under coverage. The broker finds valuations are attractive at current levels, with much of the negative sentiment already priced in. Furthermore, the multiples fail to recognise the relatively low levels of gearing across the sector and instances of strong return metrics. Based on the broker's revised estimates the sector is trading on an average FY14 enterprise value/earnings multiple of 3.4 times and a price/earnings multiple of 6.0 times.

The earnings estimates for FY13 are revised down by 2-3%, on average, and for FY14 by 9%, on average. Estimate revisions are led by Boom Logistics ((BOL)), Bradken ((BKN)) and Macmahon Holdings ((MAH)). The broker finds NRW Holdings ((NWH)) the most perplexing stock. The company has the highest expected return on capital employed (ROCE) over the next three years at 32.5%, versus an average of 14.8%, but has well below average gearing, at 0.3 times versus average of 1.0 times. Of interest is the fact that, should estimates be reduced on average by a further 20%, the sector would trade on an average FY14 price/earnings multiple of 7.5 times, with only Ausenco ((AAX)) and Bradken trading over 10 times.

At this point in the cycle UBS favours those companies that are either heavily focused on production, have strong contract visibility or are trading at a significant discount to intrinsic valuations. This elevates to the broker's top three picks Ausenco and Bradken, which are well positioned to deal with cycles, and NRW, because that stock's current valuation fails to recognise the quality of the business model.

Yield may be king at the moment but CIMB is concerned about the sustainability of that yield, particularly in the oil & gas sector, where it is always more expensive to return to investing in mothballed or new projects. Witness the reaction to Woodside Petroleum ((WPL)) increasing the pay-out ratio. It doesn't appear to be worrying investors at the moment. CIMB thinks investors buying the stock in 12 months time may not be so carefree. This is particularly likely, given the absolute dollar yield will be starting to fall then and, in the case of Woodside, the company will start to deploy more capital.

The importance of the continued under-depreciation of a mature oil & gas business is key to explaining why other mature oil & gas businesses trade at a meaningful discount to local benchmarks, in CIMB's view. The broker believes this is why, following virtual admission of no growth in the business from Woodside, there should be a material de-rating of Woodside.

For Woodside, and to a lesser extent Santos ((STO)), CIMB expects earnings will decline materially if production is sustained through new, and more expensive, projects. This is the earnings manifestation of the rising capital costs in order to just stand still. This makes it a cash issue. An industrial business in steady state indicates depreciation should equal the stay-in-business capex but, on CIMB's reckoning, incremental projects in oil & gas are increasingly expensive and depreciation is just 50% of stand-still capex for Woodside and 75% for Santos.

To rebuff the counter argument that this is not a cash issue so why does it matter, CIMB states that a perpetually increasing depreciation charge is the earnings manifestation of the significant stand-still capital costs. Assuming flat peak production, by 2025 Woodside's depreciation will be US$2.5 billion, against the current US$1.3bn and Santos' depreciation will rise to US$1.9bn (there is no steady-state comparison there).

In summary, in a steady-state environment of oil price and cost inflation, earnings for Woodside will continue to decline as depreciation rises. Woodside will rise from 16 times price/earnings today to more than 23 times in 2022. CIMB notes FY13 will be year five of a progressive dividend for Woodside. Even sustaining an 80% pay-out, with earnings in terminal decline, CIMB expects the absolute dividend will soon be falling.
 

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