Going Still Tough For Contractors

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-Some relief offered in maintenance work
-Margins still under pressure
-Focus on debt reduction
 

by Eva Brocklehurst

Mining service contractor shares have been subdued for some time and this means expectations are low. Even so, there's still some further risk of downgrades because several of the stocks in the sector have earnings expectations skewed heavily to the second half. Those significantly impacted are UGL ((UGL)), Transfield Services ((TSE)) and WorleyParsons ((WOR)), Macquarie notes. JP Morgan adds Ausdrill ((ASL)) to that list. FY14 is expected to offer some relief to a depressed sector in the flow of work from oil and gas projects and recovery in the maintenance market, as that cannot be deferred indefinitely. The environment is still tough and increased competition for what work is available is expected to pinch margins.

Deutsche Bank is cautious on the outlook but does not expect 2014 to be as negative as 2013, suspecting that most of the marginal and low return projects have now been re-scoped or cancelled. Nevertheless, a better outlook is predicated on cash being generated and expectations for commodity prices being realised. Contract mining was hit in 2013 as work was taken in-house and scope was reduced. While there is potential for further scope reduction and re-tendering, Deutsche Bank does not think this is as significant as in 2013.

Citi has surveyed miner sentiment and found participants still expect a decline in capex over the next 12 months. This has reduced to around 5% and the levels of decline appear to be stabilising. Still, there's no uptrend yet. In fact, 57% of respondents are considering lowering future capex budgets. Added to this is the possibility of a negative pricing environment, with participants expecting equipment prices to be down 2% over the next 12 months. The highest risk here is with mining trucks, haulage systems and tractors/dozers. Pricing risk is also increasing in services, with 86% planning to push back prices in that area. The after-market may grow but at a very low rate, according to the survey.

Coal production could provide the positive surprise in 2014, according to Deutsche Bank. Coal companies have cut back significantly and re-priced contracts. With fewer contract disruptions miners may focus on maximising production volumes to cover fixed costs. This in turn could feed a recovery in maintenance spending. Deutsche Bank expects maintenance contracts for gas projects QCLNG and GLNG to be awarded this year with APLNG following in 2015. There could be some surprises in this area as deferred expenditure resumes and greenfield projects award the work contracts. Conditions for Downer EDI ((DOW)) are tough in terms of locomotive sales but Macquarie is confident this can be offset with accelerated cost cutting and lower interest rates as well as a solid performance from mining and in New Zealand. Macquarie has an Outperform rating on the stock, Deutsche Bank a Buy and JP Morgan is Overweight.

Leighton Holdings ((LEI)) has featured less in news in the last month which, to Macquarie, means near-term write-downs are less likely. Still, gearing is likely to be at the upper end of prior 25-35% guidance and the receivables target is unlikely to be met, as bribery issues have delayed collection. The broker's focus is also on WorleyParsons' ability to achieve full year guidance, given the extent of what's required in the second half split. Macquarie will also be watching Monadelphous' ((MND)) margin decline.

Deutsche Bank expects a lot of attention on debt levels this year, as most companies found they were over-geared when contracts were cancelled and work scope reduced. 2014 will be the year of re-paying debt to better match revenue. Those most at risk for large write-offs for cost variations include Leighton and Monadelphous in the broker's opinion. Macquarie's focus will be on UGL's relatively high gearing and debt as well as any update on the de-merger plans. Attention will also be on Transfield's potential asset sales and the progress of debt reduction. On Deutsche Bank's list of those under pressure to reduce gearing are Ausdrill, Boart Longyear ((BLY)), Leighton, Transfield and UGL.

Deutsche Bank is becoming more positive about the outlook for Australian infrastructure given a large number of projects in the tender phase. Leighton, of those in the contractor sector, has the greatest exposure to this market. Also, the level of resources work still be done remains at elevated levels and investment in the LNG sector should counter some of the decline, although it's not enough to be an offset. Here, Deutsche Bank notes Monadelphous has the largest exposure to the resources capex market. JP Morgan is Underweight Monadelphous and does not expect there will be enough activity in economic infrastructure to offset weak resources and energy capex. In contrast, JP Morgan is Overweight Lend Lease ((LLC)), as the company's strong revenue backlog and development pipeline, with lower exposure to resources, leaves it best placed to manage the current market.
 

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