Boart Longyear Downgrades, As Expected

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This story features DOWNER EDI LIMITED, and other companies.
For more info SHARE ANALYSIS: DOW
The company is included in ASX100, ASX200, ASX300 and ALL-ORDS

-Downgrade to FY13 earnings
-Gearing may present a problem
-Threat to dividends
-Broad footprint a mitigating factor
 

By Eva Brocklehurst

Another week, another downgrade in the mining services sector. At its AGM, drilling services and products supplier Boart Longyear ((BLY)) notified the market that FY13 earnings are likely to be at the lower end of consensus range of US$199-271 million. This compares with the guidance the company gave back in February of US$260m. Management expects a recovery at some stage, but the bets are off regarding just when that will happen.

The stock has been sold off since the beginning of April by about 35% so a lot of the bad news is factored in. It didn't stop brokers ratcheting down their price targets further. The guidance assumes conditions do not deteriorate further and management stated rig utilisation rates have steadied to around 60%. Macquarie has decided, with the stock trading at 4-year lows and the downgrade not as bad as feared, that a Buy rating can remain in place, joining two others on the FNArena database.

UBS is the most negative of those brokers covering the stock and believes there is worse to come. On the basis of commentary from peers, a lack of exploration funding for junior miners and delays in decision making by major customers, UBS has forecast a nil dividend pay-out in FY13 and a heightened risk to debt covenants, rating the stock a Sell. BA-Merrill Lynch's Hold recommendation is driven by the valuation. Nevertheless, the broker is starting to think this looks interesting as the market factors in a lasting downturn. JP Morgan is also expecting the near term environment to place pressures on the share price, and there are no catalysts that could narrow the discount to the broker's valuation.

On the FNArena database there are three Buy ratings, four Hold and one Sell. The consensus target price has been reduced post guidance downgrade to $1.21 from $1.60, suggesting 70.6% upside to the last share price.

Debt has moved higher in May but this is a seasonal build-up and Macquarie is not unduly worried. Macquarie estimates earnings would need to fall to US$140-150m before there was a potential breach of covenants. Moreover, the broker does not expect earnings to revisit the GFC lows of US$111m. This is because gold and copper prices are still generally above the cash cost of production and Boart Longyear has less exposure to the junior miners than it did back in 2008/09. Activity levels were also affected by a credit freeze back then, which is not the case in the current circumstances. Another reason to be cheerful is that the company has modernised its fleet and revenue per rig is considerably higher than it was four years ago. 

Deutsche Bank remains concerned about the room to manoeuvre on the debt front and has opted for a Hold rating. The broker notes the company is responding to the market conditions by reducing costs and the revised guidance allows it to maintain debt covenants. JP Morgan, mindful too of the lack of room in the debt covenants, does highlight some improvements to debt structure which could help the company better manage weaker earnings.

Protecting the equity value is vital, in BA-Merrill Lynch's view, and longer-term strategic options are off the table. They will resurface eventually because, as the broker notes, the returns for equity in the current structure have been poor. Gearing is the largest problem. This will end FY13 at 31%. Management did indicate there may be a reduction in the dividend to conserve capital and improve gearing.

Moves to cut dividends, reduce working capital and cut capital expenditure are all warranted but a spin-off of the products business is not, in Merrills' opinion. JP Morgan found commentary around greater integration and collaboration between services and products, which could add cost savings, also signalled management preferred to keep these businesses together. While capex maybe pulled back, production rates across bulk, base and precious metals continue to hold up and this is supportive of those operators that are directly linked to the volume market.

JP Morgan continues to view subdued equity raising activity among junior miners as the key problem for the mineral exploration sector. Equity is a major source of funds for junior miners as they are normally unable to secure debt, or rely on operating cash flow to finance exploration. As these miners represent a meaningful portion of exploration activity this leads to a slowing of drilling demand. Where Boart Longyear can counter this is in the provision of production related services and products.

Management did indicate at the AGM that some areas of drilling services were proving more resilient, such as underground coring, mine de-watering and production related drilling. These segments accounted for 40% of drilling services revenue in FY12. For FY13, pricing for drilling services is expected to decline by around 10% and products pricing should be flat to slightly lower. The backlog of products business has declined to US$35 million in mid May from US$51m in mid February. Management does not expect material impairment of the inventory balance.

Boart Longyear is trading at a 21% premium to domestic peers on a FY13 price earnings basis. Historically, this has been a discount because peers such as Leighton Holdings ((LEI)), Downer EDI ((DOW)) and Orica ((ORI)) are more exposed to mining production than exploration. Mining production is considered more stable than exploration. In terms of drilling services, Major Drilling is the closer global peer and Boart Longyear is trading at a premium to Major. This could be justified, in Macquarie's view, as Boart Longyear has a products business as well as a broader geographic footprint. In terms of drilling products, the company is seen trading at a discount to Atlas Copco and Sandvik, which are much larger global businesses across a range of construction and resources machinery.  

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