The mining services sector remains risky but Monadelphous Group and Clough show good value prospects.
Photo: Peter Braig
After being mauled this year, value is returning to a small group of mining services stocks. None yet warrant aggressive buying, such is the risk of a peaking resources investment boom and awful sentiment towards service providers. But there is enough emerging value to watch the sector closely.
Caution is needed. Mining service stocks are hard work at the best of times given they are mostly capital intensive and leveraged to resource projects beyond their control. The odds favour more projects being cancelled and the mining investment boom peaking earlier than expected.
The key question, as always, is value. Earlier this month, I argued investors should add resource exchange-traded products, or BHP Billiton and Rio Tinto, to portfolios in the next eight weeks.
The theme was to “buy the sector” rather than punt on single commodity recoveries, choose producers over explorers and avoid small or speculative stocks.There seems little need to chase mining service stocks when sector leader BHP Billiton and Rio Tinto offer solid, long-term value after price falls.
However, a handful of mining service stocks have strong balance sheets, relatively reliable project pipelines and visible earnings. A few have surprised the market with earnings upgrades as their peers slash profit forecasts.
Take Monadelphous Group. It is the market’s highest quality mining service stock, with a stunning average annual total shareholder return (assuming dividend reinvestment) of 44 per cent over 10 years.
Monadelphous has slumped from a 52-week high of $28.48 to $20.76. Although it reported a strong half-year result, the market expects slower revenue growth and contracting profit margins. The main risk is iron ore and gas projects being delayed or cancelled.
In its half-year report, Monadelphous expected 2013-14 to consolidate extraordinary growth during the resource investment boom, and said a “slowdown in near-term major projects is likely to reduce the pipeline of opportunities in the medium term”.
The market is pricing in a sharper slowdown. Consensus analyst forecasts complied by Morningstar have Monadelphous on a forecast price earnings (PE) multiple of 12.1 times 2013-14 earnings. Two analysts rate it a strong sell, four say hold, and only one rates it a strong buy.
Monadelphous could easily drift lower in this market, but it has the best record in the sector, one of the strongest balance sheets, an undemanding valuation, and a forecast 7 per cent yield, fully franked.
Monadelphous is also exposed to the best commodities (iron ore and gas) and the best companies (BHP and Rio). Look for mining service companies that are leveraged to committed resource projects and have a client base of low-cost producers that will still be standing if commodity prices sink further.
Lincoln values Monadelphous at $22.74 a share. Add the 7 per cent yield and a double-digit total return over one year is plausible – provided investors can tolerate volatility and bouts of share price weakness as resource projects are cancelled.Monadelphous will look even more attractive below $20.
Never been stronger
Gas industry service provider Clough also stands out. Two earnings upgrades in the past 12 months have driven Clough sharply higher. Management says its outlook has never been stronger thanks to a record order book and strong tender pipeline.
Clough sold its 35.9 per cent stake in Forge Group in March, which created more confidence that its 62 per cent shareholder, Murray & Roberts, is not looking to sell its stake.
Clough looks slightly undervalued, despite rallying from a 52-week low of 60¢ to $1.40, before easing to $1.18. Better value exists in Forge, which Clough arguably sold too cheaply, although it has higher risk given exposure to the mining sectors and Africa projects.
With no debt, Forge has plenty of capacity to mop up weakened competitors. A strong balance sheet is mandatory when choosing mining service providers in an uncertain market. Also, it’s amazing how smaller firms, such as Forge, often find new growth when owners set them free.
Among smaller stocks, Mastermyne Group looks a touch undervalued and micro-cap Titan Energy Services has impressed with earnings upgrades. Lincoln values Titan at $1.84 a share, compared with the $1.63 share price.
Titan doubled to $2 earlier this year. After recent price falls, Titan is back in value territory, but like all micro-caps has higher risk.