Don’t Let Panic And Noise Be Your Investment Guide

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By Rudi Filapek-Vandyck, Editor FNArena

The past nine months have been both unusually kind and unusually harsh for companies that provide talent, equipment and services to miners and energy projects. In the first six months it appeared these "pick and shovel service providers", as I like to call them, could do nothing wrong and every investor and his dog wanted to own a piece in each of them. From March onwards the tide has turned and many stocks in the sector have seen share price falls of 20% and more.

At face value, it seems like reality finally caught up with investors who once again had become too excited about a short-term growth story – and there are some good arguments in favour of such view. After all, share prices of some smaller players in the sector doubled in only a few weeks and Price Earnings ratios (PEs) for some of the higher quality names surged well beyond 20x.

When looked upon from the sidelines through the lens of a longer-term value investor, these were not the type of stocks that still looked attractive other than that share prices in the short to medium term could potentially have surged higher on continued technical trading and share price momentum. Alas, it was not to be and -as happens with every bubble big or small- from the moment the underlying momentum turned, so did the fast money. Share prices went through some heavy falls as a result.

There are still genuine and tangible risks hanging in front of the sector. Analysts at Citi recently analysed miners' capex intentions on a global scale and they concluded that on a worst case outcome, spending by miners may well drop up to 18% from 2011 levels in 2012 and 2013 combined. This would mean the peak in global capex is already behind us. It would also translate into some heavy profit downgrades for companies whose growth outlook depends on the millions spent by miners and energy companies (up to an estimated 98% in some cases).

Citi's analysis also brought home one other important characteristic behind the unprecedented spending spree by global miners: the top three spenders -Brazil's Vale and Anglo-Australians BHP Billiton ((BHP)) and Rio Tinto ((RIO))- represent 50% of total capex scheduled for the years ahead. All three have indicated actual spending is likely to be lower than previously communicated intentions. In Australia, the realisation that BHP's gigantic Olympic Dam project is far from a certainty (to put it mildly) has changed the national psyche on future prospects for the country overall.

Australia is an expensive place to operate and other surveys have already shown that if miners have the choice, they'd rather spend millions on new projects in other locations, such as in Africa, which might translate into a lot less in benefits from the resources boom for Australia in the years ahead, but that's a story for another time. Uncertainty about Olympic Dam is simply reiterating that message.

What does all this mean for companies such as Monadelphous ((MND)), NRW Holdings ((NWH)) and Ausenco ((AAX))? Has the unprecedented boom now ended well before anyone thought it would?

The answer to that question is likely negative as illustrated by economists at UBS in early March. The chart below shows that falling commodity prices combined with increased uncertainty about the eurozone and its banks have forced miners to put future spending on hold for the time being, but -and this is key- only for those projects where no firm commitment is in place as yet. So yes, a project such as Olympic Dam, which is still in a conceptual stage, may not make it into start-up, but projects that have already started or where budgets have already been allocated for this year and next remain firmly on the cards.

Observe how, on the chart below, committed projects (dark green at the bottom) have remained stable while projects already under construction (black, rising above the pack) will be growing strongly into 2013, while the major casualties are "projects under consideration" (light green and falling next to the downward pointing arrow).

Making this distinction is important for investors to understand the true state and prospects for companies that live off money spent by miners and energy producers. It means that growth prospects for the higher quality names in the sector remain well above market average for this year and next, unless the eurozone implodes and the world as we know it today does go to hell in a handbasket. If the latter is not a scenario you think is likely going to unfold in the months or years ahead, then maybe "pick and shovel service providers" should be on your radar from now onwards?

Investors should note both Citi and UBS expect that, under more subdued scenarios for the years ahead, spending by miners should fall more heavily in the years 2014 and beyond from what will be elevated spending levels in 2013. This will have major ramifications for companies in the sector for the years ahead, such as:

1. share prices are unlikely to see a return to the bubble valuations from earlier this year as investors now have a defined, shorter horizon
2. management teams at the higher quality companies are now facing the task to diversify and they have two years to implement strategies
3. for investors, "high quality" and "fundamental research" return as key components for investment strategies and that's not necessarily a bad thing (unless you like to play bubbles)

Against the background of all of the above stands the observation that valuations for the stocks concerned have come down to earth since March and many stocks such as Monadelphous and Fleetwood ((FWD)) -two of my long standing personal favourites in the sector- are now offering healthy dividends in combination with much cheaper valuations, healthy balance sheets and plenty of cash flows to safeguard those dividends.

In addition, it is my personal observation that share market strategists at leading stockbrokerages in Australia have been adding "pick and shovel service providers" to their Buy-with-Conviction Lists in recent updates. Note that paying subscribers can check any of these names against consensus forecasts, ratings and price targets from eight leading stockbrokers via Stock Analysis on the FNArena website.

On Monday, market strategists at Macquarie updated their Conviction List ("Marquee Ideas") by adding QR National ((QRN)). Also, the list already included RCR Tomlinson ((RCR)), Seven Group ((SVW)) and Mermaid Marine ((MRM)). The inclusion of the latter is important since big question marks have now appeared for capex intentions by miners, but no such question marks have become apparent for investments in large energy projects. At the time of including Mermaid Marine, Macquarie makes a special effort to point out this difference, implying any perceived risks for the sector are much lower for the likes of Mermaid Marine who provide marine services to gas projects off the coasts of Australia and in Africa.

Macquarie quant analysts have selected Campbell Brothers ((CPB)) as one of their Top 5 Alpha stocks (implying the stock is a major candidate to see its share price rise in the short term) while quant peers at Citi have selected WorleyParsons ((WOR)) and Lend Lease ((LLC)) as stocks poised to outperform from the beginning of June.

Over at RBS, where strategists define Conviction Calls as opposing pair trades inside a given sector, the view is that Downer EDI ((DOW)) will prove a much better buy than Leighton Holdings ((LEI)).

Credit Suisse's Small Caps Focus List contain quite a few names from the services sector (in no particular order): Qube Logistics ((QUB)), Royal Wolf ((RWH)), Bradken ((BKN)), Industrea ((IDL)) and the earlier mentioned Mermaid Marine and NRW Holdings.

Goldman Sachs' Structural Leaders' Focus List, which has a long term orientation, includes WorleyParsons ((WOR)) and Bradken ((BKN)). Goldman Sachs' Emerging Companies' Focus List contains the following names: Bradken, Emeco Holdings ((EHL)), Imdex ((IMD)) and Sedgman ((SDM)). Norfolk Group ((NFK)) was recently removed from the list but the strategists explained they remain positive on the stock, it's just that Emeco is seen as a better opportunity.

Goldman Sachs' recently introduced Conviction List for Australia and New Zealand includes Asciano ((AIO)), Orica ((ORI)), WorleyParsons and Emeco.

Other stocks that recently received positive reviews and recommendations from stockbrokers and other investment experts include Boart Longyear ((BLY)), Forge Group ((FGE)) and Decmil ((DCG)).

The most elaborate effort, thus far, has come from analysts at Morgan Stanley who issued an industry update this week, stating they had grown "cautiously optimistic" on the sector, as "Activity should increase through 2013, driven by work to complete already sanctioned projects." The analysts see growth in FY13-14 accelerating for "stocks focused on the later phases of the construction cycle", including Downer EDI and Monadelphous.

Morgan Stanley would agree with the chart above as the analysts argue throughout the recent sell-down investors have overlooked the sizeable commitments that make up the industry's pipeline and the fact those commitments will secure growth for the quality names in the sector. The analysts observe that all stocks in the sector now appear cheap, but they believe structural drivers make some stocks more attractive than others. The stockbroker's two favourites are WorleyParsons and Downer EDI.

Most importantly, I couldn't help but noticing the following statement in this week's sector report: "we think the industry's underlying earnings outlook remains unchanged".

To back up that last claim, Morgan Stanley analysts produced the chart below which suggests that, even with capex projected to peak in 2013, the total backlog in jobs at hand for the industry won't peak until one year later and will only fall significantly from 2016 onwards. Seems to me too many people simply got scared while they didn't have the full picture in front of them, wouldn't you agree?

(This story was originally written on Tuesday, 05th June 2012. It was sent out to paying subscribers in the form of an email on that day).

Readers should note all names are mentioned for educational and informational purposes only. Investors should always consult with a licensed professional before making investment decisions.

P.S. I It has been my personal view that superior equity investment strategies in the post-2008 era are built around three key characteristics: 1. sustainable dividends, 2. All-Weather Performers and 3. "pick and shovel service providers". This view remains unchanged to date.

P.S. II All paying subscribers now receive two e-booklets with their FNArena subscription. The team is currently working on an update on "All-Weather Performers". This e-booklet is estimated to be completed before the end of June and will also be made exclusively available to paying subscribers. If you are a subscriber and you have not yet received your copies, send an email to info@fnarena.com

P.S. III Last year's e-booklet "The Big De-Rating contains a list of 50 companies leveraged to investments made by miners and energy producers

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