No V-Shaped Recovery
Those of you who are boat owners would know all about the V-Sheet – distress signal. A ‘V’ is also one of the shapes a recovery can take. But while the ‘V sheet’ is an apt alphabetical metaphor for the state that mining services is now confirmed to be in, it isn’t the right shape anyone should be expecting recovery to take.
You know, we’ve held the view that a tsunami was going to hit the mining services space for more than a year and that tsunami is now washing over the sector. The question however is, when is it – if ever – safe to go in for a swim?
Listening to Boart Longyear’s annual results presentation today it’s hard to be enthusiastic about mining services just yet. The company noted that conditions were as bad as in 2009. Back in 2009 however, the weak conditions were finance-related but that this time the weakness is demand-led. That should tell you that a “V” shaped recovery is not something to be betting on.
The company noted,“Operating conditions and key performance indicators have continued to deteriorate early in the second half of the year and are similar to levels experienced during the previous market downturn in 2009. As a consequence, the Company expects its second-half 2013 result to be lower than the adjusted result for the first half despite the benefit of restructuring initiatives. The Company believes market expectations may not adequately reflect the risk of price erosion in the second half and may assume larger benefits in 2013 from the Company’s cost reduction efforts than are likely to be achieved… Our operating performance and the restructuring and impairment charges we took during the first half reflect the very challenging conditions in our markets since the beginning of 2013. The magnitude and velocity of the market’s contraction during the year has surprised many people in the industry.”
In describing contract drilling conditions the company observed industry-wide utilization rates of just 40-45% (note for those investors, like us, keen to avoid business with high operating leverage) and were hopeful that the rate of deceleration was slowing. Having suggested a bottom may be in view the company did note that an “immediate bounce back up” was unlikely.
In particular management observed something we have talked about previously; that the large mining companies were being pressured by their shareholders to return cash. As a result many projects were being pushed out and spending is being lowered to afford their shareholders better cash flows.
Pricing pressure would also be a feature and you might recall we have explained on many occasions that the combination of 800 mining services companies and fewer projects being commenced would mean pressure on tender pricing. While the company was brave in its suggestion that they would be able to push back on pricing because of a good safety record and incumbency, I reckon they should see how far such ‘features & benefits’ got Qantas when competition became irrational in air travel. More importantly, it is likely that the benefits from any purported pricing power will be insufficient to offset the negative impact from significant operating leverage.
Pricing pressure, miners return cash to shareholders and a still too-high number of suppliers means that the old art of ‘bottom picking’ in this sector is not for the serious value investor. Indeed anyone calling a bottom at this point cannot call themselves value investors. Rather we should call them value speculators. And perhaps any hopes of a V should be replaced with thoughts of an ‘L’.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Jenny
:
Obviously companies with a high level of debt, heavy investment in capital equipment and exposure to the exploration sector are to be avoided. But it does seem that while companies like BLY are imploding, others are doing OK. They’re getting production contracts renewed at reasonable prices and don’t seem to be especially worried at the idea of someone like BLY (or Transpacific or Macmahon) invading their territory. Is it possible that they’re just better at what they’re doing? This is an area where an incompetent operator can cost you more than it’s worth to employ them.
Roger Montgomery
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You are right Jenny. There’ll be some diamonds in the rough.
Paul Middleton
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I’m just wondering if all mining service companies should be assigned a place in the same boat…
No doubt we have seen the large miners tighten the purse strings on capital expenditure, but will they stop mining altogether is the question I pose because some mining service companies are required just to get the ore out of the ground and crushed.
Whether mines close depends on commodity prices and the marginal cost of production. But to my way of thinking, a company like MLD is well positioned even though it is a mining services company facing an industry downturn. Will Atlas Iron stop mining iron ore and cancel MLD’s contract? This would take a substantial and sustained fall in the iron ore price, and while it can never be discounted, it is a big call.
Yes there is some pricing pressure for a company like MLD, but NPAT margin shows only minimal. Where are the competitors / or where are they going to come from, who has the tens of millions and the inclination to take on a new division in times such as these.
So I just wonder if all the mining services companies truly are facing the same difficulties as Boart.
Roger Montgomery
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I agree with you Paul. I don’t think they are the same at all. Ultimately there will be fewer, more profitable and larger companies remaining. Sentiment however might offer better prices one suspects.
james medica
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Understand the backdrop to your message, but its important to distinguish between mining service companies with high operating leverage and those with significant net cash on the balance sheet. In one case with the business having an an Enterprise Value at 50% of its Market Capitalization and significant franking credits, talk of a special dividend is not out of the question. Important because it (1) demonstrates an empathy for shareholders and (2) allows the company to bide its time. In the case of a business running with high operating leverage you are afforded no such luxury.
Roger Montgomery
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I agree James. As I mentioned to Paul, I don’t think they are all the same at all. Ultimately there will be fewer, more profitable and larger companies remaining. Sentiment however might offer better prices one suspects.
Greg McLennan
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That’s all fine, James. However, would you prefer a company that has net cash on the balance sheet and a wad of franking credits that is in a sector that is tightening its belt and has lots of other similar companies that can dig holes just as well, or a company that has attractive metrics and a competitive advantage that is in a sector with a big tailwind?
Some companies will still be quite profitable but things will be no where near as easy as they were a few years ago. If one needs to go bottom fishing in this pond, it might be better to wait until companies are falling over left, right and centre and then go for the best of what remains. Poor sentiment might then give you a reasonable entry point.