No End In Sight For Engineer & Contractor Pain

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-More miner cost cutting to come
-Spending on parts, service to decline
-Diversity is key to weathering the storm
-No V-shaped recovery in sight

By Eva Brocklehurst

The engineering services sector is in for some acutely painful months, or even years. As mining sector demand unwinds there is little that appears to be taking up the slack. Civil infrastructure building is being hamstrung by governments with no cash in their pockets and Australia's new federal government's infrastructure budget is considered just a drop in the ocean.

Citi has tracked the 12-month outlook for global capex and services spending in mining. The survey shows that participants still expect mining capex to fall by 14% year-on-year over the next 12 months with a greater risk of projects being deferred to 2016 and 2017. Around 78% are still expecting to lower future capex budgets and, of this, 40% is related to equipment spending. Even the most optimistic participants still expect a flatlining recovery rather than anything U or V shaped.

The broker has, for the first time, introduced after-market related questions into the survey. Participants expect spending on spare parts, consumables and service to decline by 4% in 2013 and 5% in 2014. Citi observes that after-market sales/orders in the second quarter declined for both Sandvik and Metso, and this compares with over 10% average growth over the past five years. Even adjusting for FX, the growth is no longer in double digits.

In terms of the highest risk for price declines it is in mining trucks, tractors/dozers and loading equipment. In addition, a majority (78%) of participants are planning to resist prices on mining services. This is particularly the case for drilling equipment, tractors/dozers, mining trucks and to a lesser extent for crushing equipment, pyro processing and pumps. The recent survey of Caterpillar dealers in China pointed to a relatively stable outlook in terms of near-term demand but it's not going gangbusters. Increased infrastructure spending and roadway investment were cited as positives, while mining weakness and tighter credit were the negatives. Higher incentives do appear to be helping reduce dealer inventories, as Citi notes a smaller percentage of dealers are saying inventory levels are too high.

JP Morgan has also surveyed Australian civil contractors and, again, the news is bleak. Expectations for profit margins for the large contracts are firmly in negative. The broker prefers those that have limited exposure to mine production. Overweight ratings are ascribed to Lend Lease ((LLC)) and Downer EDI ((DOW)) with these two having advantages of diversity, relatively lower resources exposure, stronger order books and, in the case of Lend Lease, development businesses. Monadelphous ((MND)) and Transfield Services ((TSE)) are rated Underweight as revenue and margins come under pressure. The large contractor expectations index has recorded three consecutive readings below 50 now. The broker also thinks the peak in Australian engineering construction spending has either passed or is nigh. This is beginning to have a material impact on order book expectations. Competitive market conditions are emerging as project sizes shrink and more interstate or offshore players enter the market.

A corollary to this is that the frequent complaint of skilled labour shortages and wage pressures has also dissipated. Input cost inflation is subsiding, although JP Morgan notes there are certain areas where prices are likely to rise such as in quarry-based, oil price-linked segments. Access to credit for contractors has continued to tighten, with cash flow problems and tougher end market conditions likely to increase the pressure.

BA-Merrill Lynch notes the recent strength in share prices across the engineering and contractors sector is going against the grain of continuing declines in capital and operating expenditure by the global miners. The market could still be underestimating the extent of the downsizing and impact on mining service. The broker estimates that, at this stage, significant changes are still to be made on spending targets and miners are about one third along a US$13.1 billion targeted cost reduction program. An analysis of cost cutting initiatives from the major miners concluded there was still a further US$8.3bn in pre-tax savings to be delivered, representing significant cost pressure globally. Industry-wide cost curves are expected to move lower and service providers will bear the brunt. Merrills suspects, for those exposed to bulk markets, a recovery is unlikely until 2016.

Which stocks are the most exposed to this? On Merrills' list is Leighton, Monadelphous and Bradken ((BKN)), which represent the "build" or capex stage of the mining cycle. Then there's ALS ((ALQ)), Ausdrill ((ASL)), Leighton, Bradken and Monadelphous at the operate and maintain stage. Furthermore, Australia's non-mining infrastructure investment has likely peaked and the broker forecasts declines of 9% and 8% in 2014 and 2015 respectively. The federal government's $4.6 billion increase in road spending will not change this state of affairs. States have traditionally funded most of the road spending and, as they are tightening purse strings, it's likely the amount allocated will decline over FY14-17.

Merrills is most bearish on Leighton. Best choices, with a Buy rating, are Downer, WorleyParsons ((WOR)) and Seven ((SVW)). Downer has a compelling valuation and a leadership position in diverse end markets, WorleyParsons is more protected by its leadership in hydrocarbons and Seven has a good portfolio of brands.
 

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