ALS Has Upside Potential, But When?

This story features ALS LIMITED. For more info SHARE ANALYSIS: ALQ

-Pressure on margins and earnings
-Leverage to cyclical improvement
-Less volatility, upside from diversity
-Question of when turnaround happens
 

By Eva Brocklehurst

Analytical laboratory service provider, ALS ((ALQ)), is feeling the pinch from all quarters. Earnings and margins are being affected, by reduced sample flows, increased costs, competitive pressures, delays and cancellations and the general downturn in the resources business. Brokers are subdued in their expectations for the company, mainly because the future is so uncertain with regard to any turnaround in the resources industry.

Citi is a little more buoyant than many others on the FNArena database, retaining a Neutral rating in the wake of the first half results. The company proffered no guidance for FY14 because of the lack of visibility. New businesses have yet to show their worth and, therefore, there's no immediate offset to the core minerals business. The one positive item that Citi snatched at was that geochemical sample volumes, while down 30% on the prior corresponding half, are showing signs of stabilising. Nevertheless, competition is expected to continue pressuring margins, although Citi does not see material falls in either volume or margin from current levels. The stock offers significantly more leverage to any cyclical improvement compared with its peers and at some point Citi believes this will justify a smaller discount.

Operationally, the contribution from oil and gas was strong but overshadowed by minerals and coal weakness. Credit Suisse is of the view the company is managing the downturn effectively and making progress in diversifying away from minerals exploration. Management did signal the market was challenging in minerals exploration and there was a slowdown in environmental services activity in the northern hemisphere. Oil and gas may be operating at peak season in the fourth quarter in North America but Credit Suisse suspects it will be overshadowed by the headwind in the mining-exposed business in the short term.

UBS is attracted to the company's position and scale in the industry but can't move from a Sell recommendation until there's visibility around the timing of a turnaround in minerals. The Reservoir coring business, which accounts for almost half Reservoir's revenues, has been quiet. This has mainly been from postponements and cancellations. This niggles at UBS, although management does not believe the trend is entrenched. UBS expects the current trends will continue through the remainder of FY14 on the back of cut-backs to minerals exploration and greenfield projects by the major miners while juniors are struggling to access capital and fund exploration.

Morgan Stanley takes a different tack. The broker believes ALS is on the verge of a period of significant earnings growth. The drivers of this will be the presence in oil and gas, expansion of life sciences – particularly food – as well as potential growth in asset care. The broker thinks the profile of the company is changing and neither minerals nor coal is contributing to this new outlook. Furthermore, the discount to global peers – around 20-25% – should narrow as investors appreciate the more defensive and diversified nature of forecast growth rates. The diversification strategy has become more noticeable to Morgan Stanley as geochemistry revenues went through a rapid change of fortune from cyclical peak to trough in just over 12 months. As a result, the second element of the company's FY17 strategic revenue target – one third minerals, one third life sciences and one third other divisions – is already in place, in the broker's view.

It's not happening quickly enough for JP Morgan. A lack of organic revenue growth, increased competition and restrictions in life sciences and weakness in minerals exploration means Underperform in the broker's opinion. The new Reservoir business in coring fell short of expectations because of weak demand in coal mining. The broker thinks the decision to not provide FY14 guidance emphasises the challenges facing the group. JP Morgan prefers the production exposed mining services companies. Deutsche Bank continues to rate the stock as Sell, given the high level of uncertainty and the belief that margins are unlikely to expand until activity levels improve.The fourth quarter is the off season for minerals exploration and there is reduced environmental activity in the northern hemisphere but it is the peak for North American oil an gas drilling. The lack of guidance suggests to Deutsche Bank that management is unsure about whether oil and gas activity will offset weakness in minerals and environmental services.

The life sciences testing and inspection service margin was squeezed as South American earnings underperformed because, as Macquarie points out, integration and cultural changes took longer than expected. The broker expects margins will stay soft in the second half, given the seasonality of the business. The energy segment was the only one where there was no decline in overall margins. In this case, the coal business suffered from lower volume and price pressure. Macquarie expects the energy segment will have steady margins over the next few years as the oil business ramps up and coal stabilises. Power generation work – higher margin – is expected to get a lift in the second half and gradually pick up in FY15 as these deferred projects are re-started.

Macquarie is waiting for the turnaround, as well as monitoring the Reservoir acquisition. The stock looks fully priced in a domestic context but cheap relative to global peers. Still, the recommendation is Underperform until the extent of the pick up in oil and gas is more quantifiable. BA-Merrill Lynch retains an Underperform rating too but expects the portfolio should become more balanced as energy and life sciences acquisitions are absorbed. This diversification should produce lower cyclicality in earnings but it's not enough for the broker to throw caution to the winds just yet. 

Merrills questions just whether the seasonal strength in oil and gas is enough. The broker emphasises that the minerals division will still represent 40% of earnings in FY14 and this is heavily weighted towards exploration, particularly gold. If gold prices of US$1,200/oz were to be sustained this unpleasant scenario signals to the commodities team that 37% of operating mines would be uneconomic. Moreover, if, as the commodities team suggests, further downside risk exists for oil, coal and copper in the event of a US Fed tapering, then the company's earnings in the minerals and energy sector are likely to be pressured beyond FY14.

The FNArena database tells the story. There is one Hold and six Sell ratings. The consensus target is $8.15, suggesting 7.5% downside to the last share price. The targets range from $7.00 (UBS) to $9.75 (Citi). The dividend yield on consensus earnings for FY14 and FY15 is 4.2% and 4.7% respectively.
 

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