Why you should stick with major resources stocks

True believers in mining services stocks are having their faith tested. Falling commodity prices, forecasts that Australia’s mining investment boom will end within two years and reports that $200 billion of planned resources projects are in doubt, should have investors ducking for cover.

The terrible sentiment might also create a long-term buying opportunity in higher-quality mining services companies such as Monadelphous Group and Boart Longyear. The smaller stocks, Bradken, Forge Group and Maca, also look OK value, although I would stick with larger players given market uncertainty.

Never forget that mining services stocks have higher risk. If commodity prices keep falling, more planned investments will become uneconomic and will be abandoned or shelved. Junior explorers, in particular, will find it harder to raise capital and many will wind back exploration budgets to preserve cash. It means less earnings certainty for many mining services companies beyond 2013.

Such companies often promote a huge “pipeline” of work and their involvement in billion-dollar projects. In reality, their earnings visibility can deteriorate quickly and they can be left with expensive, depreciating equipment when work dries up. Higher fixed costs and the cyclic nature of mining services make it an industry for experienced investors.

Then there is the issue of what price- earnings (P/E) multiple to use when valuing such stocks. Mining services companies in the S&P/ASX 300 Index trade on an average one-year forecast P/E multiple of about 10 times, according to BRW analysis of consensus analyst forecasts for 22 such stocks. That looks high given the big risk of earnings downgrades if more projects are shelved.

If commodity prices fall further, it is hard to know what P/E multiple to apply. My guess is smaller ones that trade a forecast P/E of eight to 10 times will be significantly derated if it more resources projects are to be canned, and the market no longer prices these stocks on peak-cycle earnings. A lower P/E multiple and lower earnings per share forecasts would smash many share prices in the sector.

That may not happen if the global economy stabilises and iron ore and coal prices improve next year in anticipation of stronger Chinese demand. Dire forecasts about the near-term death of the mining investment boom look overstated but I would not rush into mining services companies heavily exposed to small- and mid-cap explorers, or those with high fixed-capital costs.

Stick to the best-quality ones exposed to the best resources groups, such as BHP Billiton, Rio Tinto, Woodside Petroleum and Santos. The lowest-cost producers have greater scope to maintain projects as commodity prices fall but BHP and Rio Tinto’s cautious outlook for investment beyond 2015 shows that even big players are under pressure.

Look for mining services companies exposed to producing mines, or projects well into construction, rather than exploration projects in which there is little certainty. Focus on the best-run companies; this is no time to chase new offerings or small- or mid-cap stocks with low earnings visibility.

Take the $75 million offer of Calibre Group, which had a disappointing debut on the ASX this month. It is among the higher-quality offerings in recent years and was reasonably priced on a forecast P/E multiple of eight times earnings, which mostly comes from trophy clients such as BHP Billiton, Rio Tinto and Fortescue Metals Group.

With about 60 per cent of its forecast 2012-13 earnings locked in through an existing and pending $426 million order book and via its engineering and rail services, the well-run Calibre offers a more diversified, integrated offering than many similar-sized mining services stocks. And as it is based mostly on consulting it is less capital intensive.

However, its high exposure to iron ore prices, which have been hammered this year, is concerning. Its earnings visibility beyond 2013 will become clouded if iron ore prices fall more and it can’t diversify quickly enough. There may be heavier selling in Calibre shares later next year as its largest shareholder, a US private equity firm, is free to sell its holding.

Still, it’s a stock to watch over the next six to 12 months if iron ore prices stabilise. Expect some small-cap fund managers to buy the stock if it achieves or beats its maiden full-year earnings forecast later next year.

It’s exactly the type of thinly traded stock that can get too cheap in this sort of market, when sentiment turns and small and mid-cap stocks in out-of-favour sectors are belted.

My favoured mining services stocks are still Monadelphous Group and Boart Longyear. Neither screams value at current prices; Boart looks slightly undervalued and Monadelphous may be a touch overvalued, although it deserves a valuation premium. But both should be among the first mining services stocks to buy if gloom about the resources investment boom becomes overstated and the sector is oversold.

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