- Slowdown impacting on resource capex spend
- Mining services companies under threat
- Analysts discuss preferences
By Greg Peel
The main reason the RBA held off for so long before finally unleashing rapid rate cuts these past couple of months was based on the potential inflationary pressure provided by the Australian resource sector's great capex binge, both underway and planned. Spending on mining and energy project development and expansion had never before seen such numbers. Up until May, capex was enough to force the central bank to stand fast despite the obvious slowing of the ex-resource sector economy.
Evidence of this binge has been provided by some very substantial gains in the share prices of those companies servicing the mining and energy industries, being the providers of construction, engineering, equipment hire and other general services to the resource sector, known mostly as the “mining services” sector. Such gains have been booked at a time when the actual resource sector producers have seen their share prices sliding through a combination of (a) spending or planning to spend so much on capex in the first place, (b) exponentially rising costs of development of which mining service fees are one part, and (c), commodity prices falling due to evidence of a global slowdown, with China's slowing of greater concern than the troubles in Europe (although not unrelated).
It didn't take long before the big miners in particular started reeling in their grandiose capex plans, delaying projects in the face of weaker commodity prices and higher costs. Every miner/driller in the country has been hit with such issues. There is evidence now salaries are no longer soaring to the moon for anyone prepared to relocate to some distant outpost, or to take up important professional level positions in resource companies. It would only be a matter of time, one could only assume, that this slowdown (or deflating of the bubble) would impact on mining service company earnings.
Credit Suisse stock analysts have recently reviewed the resource sector capex pipeline using a bottom-up approach for each project and arrived at a “mid-case” scenario. The scenario suggests 2012 levels of capex will be sustained out to 2015. Credit Suisse's small cap analysts agree with this outlook, which is important given a lot of the mining services companies fall into the small cap bracket.
Under a mid-case scenario, decisions by the large cap iron ore miners are deferred to an extent, resulting in a delayed start to major iron ore projects. Thermal coal projects will more ominously suffer multi-year delays given current thermal coal price weakness. On the flipside, capex will be supported by a strong pipeline of LNG development through to 2015-16.
Note that recent thermal coal price weakness has been argued by some as reflecting a longer term downtrend as the world eschews dirty coal power for ever cheaper gas power. The seemingly come-from-nowhere explosion of the US shale industry has driven US natgas prices to record lows against the oil price and the US is preparing to export LNG down the track. Before that happens, the first of the new wave of Australian LNG projects will be hitting first production. Gas is set to become abundant.
Unfortunately the Credit Suisse equity strategists do not agree with the Credit Suisse stock analysts. This is not uncommon, and the two groups are often spotted staring each other down across the bar. Analysts are bottom-up in their valuation approach while strategists are top-down. The CS strategists believe 2012 will be the peak in capex and no further final investment decisions (FID) will be made on yet to be committed projects. The only projects to proceed will be those underway or those already committed to.
Weighing up both arguments, the CS small cap analysts suggests capex is likely looking at negative growth after 3.5 years and on that basis they prefer to invest in stocks with a greater weighting to recurring production/maintenance-style earnings. To that end, Mermaid Marine ((MRM)), Alliance Aviation ((AQZ)) and Bradken ((BKN)) are the preferred choices. Mermaid's particular appeal stems from its exposure to long-dated North West Shelf construction.
The RBS small cap analysts also like Bradken, but otherwise highlight Ausdrill ((ASL)) and Emeco ((EHL)).
RBS has also been having a look at the capex pipeline given the current environment of heightened risk aversion. The strategy team conducted a similar assessment of capex activity and noted a total of US$420bn of capex plans between 2012-20 (of which US$160bn is for bulk commodities) which would peak in FY13 but remain elevated through to end FY16. The spend would result in 95% growth in iron ore production and 82% growth in coal production. But given the aforementioned risk aversion, the small cap analysts are keen to play it safe.
On that basis they prefer production-focused names – those companies servicing actual production while skills shortages threaten to delay other projects. Ausdrill creates 85% of its revenues from gold, copper and iron ore production work, mostly commissioned by the major mining houses. The company is also exposed to the lower cost, less constrained African market. Bradken provides the most balanced exposure to the sector and RBS believes balance sheet issues for Bradken have been overplayed by the market. The analysts also believe the market is overlooking the benefits of the changes to Emeco's business model post-GFC, which have the company now 90% exposed to actual production.
If it's all sounding a bit depressing, take note that Rio Tinto ((RIO)) has just approved a further US$4.2bn in iron capex having reached FID on the expansion of its WA assets (US$3.7bn) and for its Simandou project in New Guinea (US$500m). In the opinion of the UBS analysts, the two companies they cover which are best positioned to benefit from these approvals are Ausdrill and NRW Holdings ((NWH)).
Meanwhile, BA-Merrill Lynch believes there are still good opportunities in the coal sector despite negative market sentiment. Having spoken to various players in Queensland, BA-ML concludes that the bad news is supply has improved but demand has weakened for both metallurgical and thermal coal and that a margin squeeze for upstream producers will mean less urgency for new capacity. The good news, however, is that expansion activities have not stopped. Dalrymple Bay Coal Terminal noted a fall in throughput to well below system capacity, but on the other hand had noticed a rebound in shipments of met coal over the past two months, mainly to India and Japan, but “couldn't explain why”.
Sedgman ((SDM)) noted that the “heat had come out” of the market for new capex and the industry was now focused on brownfield rather than greenfield developments and, understandably, on reducing costs. However several big projects are underway and likely to continue.
Downstream providers in logistics, construction and services continue to benefit from opportunities delivering production and maintenance, UBS suggests, but face risks from a changing market structure. A review of property portfolios and outsourcing currently underway creates opportunities for service providers such as United Group ((UGL)) and Transfield ((TSE)) but at the same time the business has sufficient rail capacity and is looking to lower costs which may mean lower revenue and margins for UGL, Downer-EDI ((DOW)) and Bradken, the analysts add, somewhat confusingly.
UBS nevertheless has a preference for Monadelphous ((MND)) and Mastermyne ((MYE)) in the mining services space.
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