Ausdrill’s Appeal Undermined By Risk Profile

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-Exploration subdued, margins tight
-Production exposure key to FY15
-Risk overwhelms value for many brokers
-Questions over value of investments
 

By Eva Brocklehurst

Brokers feared mining service provider Ausdrill's ((ASL)) interim result, posted late on the last day of reporting season, might have some more negative news. As it turned out, the results were broadly in line with expectations, but then brokers had been warned. The company signalled back in November that FY14 would be substantially weaker than FY13, with profit likely to be down 60%. The outlook remains subdued and the company now expects FY14 revenue to be at the bottom end of the prior guidance range. Any improvement in FY15 is predicated on some recent contract wins and increasing volumes on existing mining contracts.

Many contracts have finished in the production related businesses, which has created excess capacity within the group. The company has been tendering for work in both Africa and Australia which, assuming success, should replace a substantial portion of the work that has ceased. On the exploration side, activity is showing no signs of recovery in the near term and margin pressure is evident. Ausdrill expects an increase in capex spending in 2014 will be limited to the major miners. Equipment is in significant surplus and this impacts the rental market. The company expects these conditions to persist in the near term.

Deutsche Bank has a Buy rating on Ausdrill. Taking on board the subdued outlook and downgrade to medium-term earnings forecasts, the broker still thinks the company is relatively well placed. The broker's positive assessment is based on the fact that Ausdrill's production stage exposure, the mature point in the resources cycle, is around 66% of revenue. The company also has diversity in its favour, in terms of geography, commodity type and service provision and this underscores its potential upside, in Deutsche Bank's opinion.

This may be well and good but JP Morgan is not convinced, downgrading the stock to Underweight from Neutral. The broker has become more concerned about the outlook and is not prepared to concede the near-term operational headwinds and high gearing. As the stock is trading above the broker's average valuation of 79c a share, JP Morgan does not believe investors are being compensated appropriately for the risks. The broker notes the weakness in discretionary mining spending will keep hurting the company and excess levels of equipment industry-wide are likely to lead to greater pressure on margins. The broker believes it will take some time to improve profitability. Moreover, JP Morgan believes Ausdrill has lost the strong links to mine production volumes in Western Australian iron ore and the gold sector. The broker espoused this theme in November at the time of the profit warning and downgraded then to Neutral from Overweight.

One positive aspect, according to JP Morgan is that growth for CMS Africa has been encouraging, reflecting a greater proportion of head contract mining services being delivered by the group. However, this will require greater inventory investment, in order to have the right equipment in the right places and, with the fall in the gold price over the past 18 months, miners are still re-evaluating plans and this could mean further changes to Ausdrill's contracts. 

JP Morgan also questions the company's decision to make investment in companies such as Azumah Resources ((AZM)) and Mutiny Gold ((MYG)), in order to secure a preferred contractor position. The total investments are relatively small but the broker thinks investments of this nature are not necessarily the best use of capital at a time when the balance sheet is highly leveraged. If these investments perform poorly, or the company is unable to convert the preferred positions into contracted work, then there's little value in JP Morgan's view. The broker also thinks the acquisition of Best Tractor Parts was poorly timed, as end market conditions began deteriorating.

Macquarie has a Neutral rating. The broker thinks the company may be well managed but is now trading at a steep discount to net tangible assets, and then there's high gearing levels and the ongoing gold price volatility. CIMB found the margin decline painful and the outlook cloudy. The fact that Africa was not as weak as was expected put a brighter tinge on the result but, in Australia, the broker thinks the amount of available contract mining work continues to diminish.

The risk profile is overwhelming the valuation appeal for CIMB, for now. On the positive side, there is potential for the company to outperform if the market is confident that conditions have bottomed. Still, the broker notes gold companies are the most cost conscious in the current environment and this makes it hard to be more positive. This broker also thinks debt reduction will remain elusive, hampered by structural working capital constraints, given the location of work, and adverse currency movements. It adds up to a Hold call for CIMB.

There are two Buy ratings, two Hold and two Sell on FNArena's database. The consensus target is $1.12, signalling 22.8% upside to the last share price. Dividend yield is at 6.8% on FY14 forecasts and 7.7% on FY15.
 

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