quo vadis, mining srvices sector?

It seems that just about every other day some or other major mining company is declaring a change of tack in terms of organic expansion, and is cancelling projects (a la BHP) or shaving back expansion plans currently underway (per FMG’s announcement this morning)

Consequently, there appears to be, not just among HC members, but within the financial media and the financial services community, a lot of rumination about the investment merits presented by the mining services sector - now that their share prices have fallen so dramatically in recent day/weeks/months.

I read someone the other day on HotCopper making the ambit claim is that this is the sort of entry level in the mining services sector that Warren Buffet would relish.
Sadly, I strongly doubt it; I think Buffet’s Coefficient of Smartness extends beyond merely “stock prices have fallen 60%, so as a value investor I’ll wade in”.

The trouble, I think, is that the mining services sector presents the classic situation of a “Value Mirage”. i.e., it looks cheap on a prospective P/E basis, but I think the prospective “E” is grossly incorrect.

Here’s why:

I get very nervous when I see pretty rudimentary businesses with no particular competitive advantages have their earnings doubling every year for four or five years, which is what I think has happened to a lot of mining service companies who found themselves basking in the sunshine of the much-vaunted “Commodities Super Cycle”. .

There’s simply something too counterintuitive about it, so as a sanity test let’s put this “growth” into some sort of quantitative context:

The following schedule shows, for a list of prominent mining service companies, changes in EBITDA between 2006 and, importantly, the consensus EBITDA forecasts for FY13.

CHANGES IN EBITDA OVER THE RESOURCES SUPER CYCLE [from FY06 (unless otherwise stated) to FY139(e)]
AAX: FY06 = $8m; FY13(e) = $70m ; >8 times increase
ALQ: $68m -> $440m; 6.5x increase
ASL: $51m ->$364m; >7x
BKN: $77m -> $260m; 3.4x
BLY: $78m -> $460m; ~6x
EHL: $139m -> $300m; 2.2x
IDL: $12m->$143m; ~12x increase [Start year = FY07]
IMD: $12m ->$86m; >7x
MAH: $72m->$198m; ~3x
MIN: $35m->$398m; >11x [Start year = FY07]
MND: $92m ->$200m; >2x
NWH: $28m->$234m; >8x [Start year = FY07]
ORI: $635m->$1,300m; 2x
SDM: $26m->$75m; ~3x [Start year = FY07]
SWK: $10m->$32m, >3x [Start year = FY07]

Now, enthusiastic supporters of this group of companies might argue: “Yes, but what you’re missing is that the size of the activity pie has structurally increased quite dramatically over that time, and this EBITDA uplift merely represents the favourable operating leverage inherent in these businesses.”

Even if I did buy that line of argument – and I don’t on the basis that few of these businesses are scalable, and a lot of the “growth” had had to be acquired, either by buying other entities or by aggressive capex – then what negates it are the EBITDA margin assumptions implicit in analyst forecasts.

The schedule below places some context around the actual margin experience during the commodity boom, compared to consensus expectations of what margins are likely to do now that the boom appears (increasingly by the day) to be over.

The schedule looks at what has happened to margins, from pre-peak conditions corresponding around 2005/6, to the absolute peak (currently, i.e., FY12), and what margins will do –according to analysts – in FY13 and FY14 (i.e., the post-cycle peak period):

EBITDA MARGINS ACROSS THE CYCLE FOR MINING SERVICES SECTOR...EXPANDING INTO THE DOWNTURN (?!?):

AAX: FY06 = 10.4%; FY12 =10.7%....FY13(e) = 10.9%, FY14(e) = 11.5%
ALQ: FY06 = 19.8%; FY12 =26.2%....FY13(e) = 27.2%, FY14(e) = 26.3%
ASL: FY06 = 15.9%; FY12 =24.2%....FY13(e) = 25.1%, FY14(e) = 26.4%
BKN: FY06 = 12.1%; FY12 =14.9%....FY13(e) = 16.7%, FY14(e) = 17.3%
BLY: FY06 = 6.9%; FY12 =18.6%....FY13(e) = 16.3%, FY14(e) = 16.9%
EHL: FY06 = 36.6%; FY12 =45.7%....FY13(e) = 46.3%, FY14(e) = 46.7%
IDL: FY07 = 19.4%; FY12 =31.0%....FY13(e) = 33.9%, FY14(e) = 34.2%
IMD: FY06 = 18.8%; FY12 =30.8%....FY13(e) = 31.3%, FY14(e) = 30.6%
MAH: FY06 = 10.4%; FY12 =10.7%....FY13(e) = 10.9%, FY14(e) = 11.5%
MIN: FY07 = 18.7%; FY12 =30.8%....FY13(e) = 31.3%, FY14(e) = 30.6%
MND: FY06 = 8.6%; FY12 =10.3%....FY13(e) = 10.5%, FY14(e) = 10.6%
NWH: FY07 = 11.1%; FY12 =13.9%....FY13(e) = 14.6%, FY14(e) = 14.7%
ORI: FY06 = 15.7%; FY12 =17.6%....FY13(e) = 19.5%, FY14(e) = 21.4%
SDM: FY07 = 12.1%; FY12 =11.5%....FY13(e) = 12.6%, FY14(e) = 12.8%
SWK: FY07 = 16.9%; FY12 =20.9%....FY13(e) = 21.4%, FY14(e) = 21.9%

(The reason FY13 and FY14 have been chosen as the terminal points for the exercise is not a random one; it serves to highlight how out of touch with reality broking analysts appear increasingly to be.)


Out of this exercise, the following warrants emphasising, I believe:
1. Current margins at the height of the boom (i.e., corresponding to FY12) are an order of magnitude higher than the start of the cycle upswing in the mid-2000s.
2. Not shown in the data above, is the fact that the FY12 margin is – in almost every single case – a record level of margin for each company
3. Despite this, and despite business conditions becoming far less favourable, forecast margins are going to INCREASE somehow going forward.
4. Not only will margins continue increasing, but they will continue to BREAK ALL-TIME HIGH LEVELS
5. The only case where some sensibleness is represented in forecast margins is BLY, which was the subject of the mother of all expectation-deflating exercises at the release of their FY12 profit result. Analysts have – in their usual herd-like manner – reduced forecasts margins (but they are still at a level that is above the average margin achieved by the group over the past 5 years, bar the record FY12 year)


Conclusions:
1. The sector is cum-downgrade, probably at the revenue line as work-in-hand slows, but if not at the revenue level, then almost certainly at the margin level, where consensus expectations are in need of some significant recalibration.
2. Given that many of these of overwhelmingly fixed-cost businesses, with operating leverage, any margin compression will have a highly deleterious impact on operating profits (just like the leverage boosts profitability on the way up, it does so in the opposite direction too.
3. I hear a lot a talk about “such-and-such a stock being on a P/E of 5x and a DY of 7%, so I’m buying it”. My nagging concerns is that the “E” is cum-downgrade. Significant downgrade, potentially.
4. I will therefore not be buying any mining services sector businesses, simply because they have underperformed so chronically. When I invest, the starting point for me is always "How Much Can I Potentially Lose?", and not "How Much Can I Potentially Gain?". And I’m bracing for more pain in coming months.

NB.
1. This exercise is not mean to be prescriptive; rather, it was something I conducted for my own edification, and that I thought might be of assistance to investors in mining services stocks by providing them with an historical framework in which to couch their investment decisions.

2. By its nature, it is somewhat generic and broad-brushed in nature, so there might be individual, stock-specific situations which render my negative position irrelevant.



Prudence Always

Cam