Is it time to look at mining services?

Is it time to look at mining services?

Among the biggest casualties of falling resources capex have been the various engineering, contracting and construction firms that provide services to the resources sector. Monadelphous (ASX: MND) is a case in point: With strong demand to fuel its growth, the Mondaelphous share price rose 50-fold in the decade leading up to 2012. Over the last few years however, a decline in earnings has seen the share price fall by around 70 per cent – a painful drop in any language.

Investors have been similarly harsh with a host of other services companies, and in a market where value is not easy to find, it is natural to ask whether some of these beaten-down companies may now offer unusually good value. In many cases businesses that previously were seen as good examples of the genre can be had for low single digit multiples of FY15 forecast Net Profit After Tax (NPAT).

The answer to this question may well be ‘yes’. Companies that are able to survive the difficult times could fetch significantly higher prices down the track. We note the example of Maca Limited (ASX: MLD), which has no net debt, a solid order book, has guided the market to expect record revenue for FY15, and trades on about 3.5x forecast FY15 NPAT.

For us, however, the answer is ‘no thank you’. The issue is that while Maca’s own financials may present a picture of rude health, many of its customers are under serious pressure. Included in these are iron ore miners like Atlas Iron, Arrium and Sinosteel Midwest, which will struggle to make acceptable returns in the current environment.

It is hard for a business in one part of the value chain to prosper where other parts of the value chain are struggling. If iron ore prices stay where they are, a number of smaller and mid-tier producers will close mines or fail. The pool of available work for mining contractors will shrink, but the pool of mining contractors competing for that work may not. For those mines that do remain in operation, costs will be a priority and contractors will need to be sharp on price.

Over time, this must translate into difficulties for Maca. We don’t know how severe the difficulties may get, but for risk averse investors this is a big red flag, and it’s our preference to keep a respectful distance from red flags when we see them.

There is of course, more to the Maca story than this. Part of Maca’s customer base is in the gold industry, where prices have recently improved. This part of the business may enjoy relative stability, and potentially even growth. In this context, 3.5x FY15 NPAT may seem like a pretty reasonable balance of risk and reward.

For us, however, it’s all about the red flags. We’re happy to sit on the sidelines until we can find opportunities that meet all our criteria of: value, quality and prospects. Two out of three won’t do.

Tim Kelley is Montgomery’s Head of Research and the Portfolio Manager of The Montgomery Fund. To learn more about our funds please click here.

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Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.

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