Tony Featherstone Columnist

Tony is a former managing editor of BRW, Shares, Personal Investor, Asset and CFO magazines. He writes a weekly column for BRW and The Australian Financial Review, specialising in small listed companies,IPOs, entrepreneurship and innovation.

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Major value in miner service stocks

Published 27 February 2013 22:19, Updated 27 February 2013 22:51

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Major value in miner service stocks

Improving fortunes for big diversified miners like BHP should have a flow on effect for mining services companies such as Monadelphous, NRW and Calibre. Photo: Mario Borg

Finding undervalued stocks to buy gets harder by the day. A stellar 28 per cent total return over 12 months has the sharemarket in fair-value territory. Even so, expect it to drift higher this year, with occasional pull-backs, as better investor sentiment and the sheer weight of money lift stocks.

Investors putting new money to work will need patience and discipline. They could easily chase stocks to silly levels, such is the sudden euphoria about this “new bull market”. It’s better to ignore market noise, focus on stock valuations, and buy when the market dips.

Another strategy is to scour the market for pockets of value that have lagged the broader rally. I recently ran filters through several sharemarket databases using a range of metrics to spot groups of undervalued stocks. One industry stood out: mining services.

As always, care is needed when relying on databases for stock ideas. Always treat them as a starting point for further research, not a concrete list of stocks to buy. A big issue for mining-service stocks is what happens in 2014 when more work starts to run out, given long project lead times.

Panic about the resource sector last year threw up some terrific investment opportunities in select mining services stocks. Six months ago, newspaper headlines prematurely called the end of the resource investment boom amid a tumbling iron ore price. Key mining projects were being cancelled or deferred. Sentiment was abysmal.

Yes, the outlook for parts of the mining sector, such as coal, has deteriorated badly. Still, I doubt it is quite as bad as the share prices of several mining service stocks suggest. Compared with many other small-cap stocks that have soared lately, a handful of mining service stocks offer value.

A word of caution: they are not for the risk averse. Smaller mining service companies usually have high fixed costs, lumpy revenue and can be battered by the loss of a few key contracts. They are terrible stocks to own when industry conditions turn and expensive equipment sits idle. Consider the mining service sector as a deeper, riskier, contrarian idea in this market.

But leverage works both ways. I expect diversified miners BHP Billiton and Rio Tinto to lead the next leg of the sharemarket rally as the global economy slowly improves, commodity prices firm and, importantly, the Australian dollar finally eases. I wrote earlier this year that high-quality resource companies would be among the year’s standout contrarian ideas.

I expect diversified miners BHP Billiton and Rio Tinto to lead the next leg of the sharemarket rally as the global economy slowly improves.

Improving sentiment towards the resource sector will rub off on select mining service companies by year’s end. The likely change of government at the federal election in September will get wheels spinning faster in the sector as resource companies get more regulatory certainty. However, long project lead times will still make this year and next problematic for many mining service companies.

I rate Monadelphous as the sector’s best and included it in my list of the 10 best small and mid-cap stocks for 2012-13. Monadelphous has leapt from $21.28 when the list was published in July to $26.93. It posted another strong half-year result and flagged a challenging medium-term outlook. Fully valued now, Monadelphous is still a top stock for watch lists, in anticipation of improving value during the next market pullback.

NRW Holdings is another high-quality stock. It fell from a 52-week high of $4.36 in March last year to as low as $1.25 in December as investors panicked about resource projects and NRW’s leverage to Fortescue Metals Group, which cut project spending as iron-ore prices tumbled. NRW this month announced a $140 million contract to provide drilling services to Fortescue and has recovered to $1.92.

Among other small mining services stocks, Calibre Group is improving after being hammered last year on listing. It also has heavy exposure to iron ore projects and Fortescue. After raising $75 million at $1.63 a share through a float in July, Calibre soon tumbled to below $1. It has since rallied to $1.50.

Calibre was among the better-quality small floats in recent years. Its offer was well structured and the valuation less aggressive than many floats, given a forward price-earnings (P/E) multiple of eight times at listing. Calibre’s big flaw was timing and sentiment: nobody wanted to know about companies with high exposure to iron ore projects, let alone an initial public offering.

In its recent half-year report, Calibre said it expected continued strong growth for the full-year result and that its forward order book stood at $1.3 billion. It ticks plenty of boxes: a strong balance sheet, low capital expenditure requirements, high profit margins, good management and exposure to blue-chip companies. Importantly, it is less exposed to exploration projects by junior miners.

Calibre looked badly oversold below $1 and still appeals at $1.50 for long-term investors comfortable with small-cap stocks.

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