Mining service companies offer good profit outlook - choose wisely

Share |

One of our roles as investors is to critique others research; but an additional role is to add-value to others research without plagiarising it, since we respect their intellectual property, as we would expect them to respect ours. Now, I came across this article by TheBull.com.au describing the financial fundamentals of a number of mining service companies. I have not examined their calculations because its not a sector that I follow; however it is actually good exposure to this next phase of the mining boom. If you recall me saying, this next phase will be about 'volume' or 'capacity' increases; as opposed to strong real price rises. 

China and India will need more ore, but the supply-cost curve will be flatter, as they pay less for those more tonnes, but demand higher volumes. The reason why the supply curve will be flatter is because:

1. There will be many more mines

2. New capacity will be incremental to existing capacity, whether expansion of existing mine capacity or satellite capacity using existing railways, ports, etc. 

3. The spectre of pass-through of cost advantages to buyers resulting from these economies of scale at the tail-end of the supply cost curve, as they attempt to be competitive

4. There will be fewer factors to differentiate between projects

5. Cost savings through consolidation of miners. i.e. In the price spike in the 2000s, there was a rapid rise in the number of miners, particularly in the iron ore sector, which was already highly consolidated. This prompted miners to sponsor new market entrants, to give them more bargaining power looking forward. Now the majors are going to embark on another phase of consolidation. It will anger China of course, and that will probably demand some kickback for a party official. Yes, I know, its against Communist Party policy. Rest assured; it will be all worked out. 

Now, why is this good for mine services companies? Well, the reason why its good is because:

1. Mine service contractors struggled to provide cost-competitive services in the price boom because the spike to exploration caused a shortage of parts & equipment, rigs, as well as labour.

2. Mine services are actually more profitable than exploration services, since mining is continuous, so more easily supported. 

3. A flat supply-cost curve means its easier for mine service companies costs to be absorbed by miners as simply a 'pass through' to the consumer. 

4. The prospect of 'tough times' now means that consolidation in the sector will result in better profit margins moving forward.

5. The cost of capital for debt-financing has never been cheaper

6. We have already mentioned the very favourable growth in 'volumes'. Mine service companies are paid to mine 'volumes' as opposed to the contained metal content.

That is a lot of benefits. Of course some projects are better than others. i.e. You would expect a mine services company to prefer large mining operations, say coal, iron ore, because they have a 20+ year mine life, so easier to leverage their services and debt finance. Remember interest rates are going to be low for a long time yet. Of course these companies still have to be good managers, and you will want to watch their profit margins to ensure they are good analysts of their costs. Leverage is a two-edged sword. 

So this brings us to the research performed by The Bull - see this article. I never liked the accounting; I prefer the strategy and conceptual side rather than the number-crushing. Thanks to The Bull! 

Now, you might wonder which of these companies offers the best exposure; and whether you should invest now. The market is going through a 'correction' at the moment, so you might want to wait for a technical entry into these stocks - or others. These are mostly drilling contractors, however you might want to look at providers of other services to mines like:

1. Recruiting companies that specialise in mining - since recruiters are paid really well - though they have suffered a shake-out of profit margins as well. 

2. Security companies 

3. Catering companies

4. Transport companies, i.e. regional airlines servicing the mines, or bulk ore handling groups (you will need to look internationally). 

5. Regional media groups. i.e. A Western Australian newspaper group.
6. Explosives providers - A company like Orica does not just manufacture explosives, it provides a down the hole delivery service. i.e. This is a value-add service. I have made a special topic of this company

It is hard in most of these areas to get 'specific' exposure to mining. This tends to leave you looking at mining contractors, or regional service providers benefiting from the 'trickle down, like newspapers. Just ask yourself where the greatest upside and growth lies. I would think its with the mining contractors. Recruiting has low barriers to entry, so margins can be undermined. Once you get a good contractor, you won't change for a price reason; you will change by default, unless its a substantial point of disadvantage, and no contract is the same, so its hard to undermine the competitive position of a contractor. Its harder than signing up for a new cell phone contract, but you can see how they bog you down in details. Where do you think they learned how to 'complicate' the process....from dealing with companies. 

So back to what makes a good entry? Well, you will want a company who displays high margins, but you will not want a company who has high debts because they are fully leveraged, so there is no upside in terms of expanding earnings as the market volumes recover. You will want a low PE; but you would not want to compromise on the leverage upside. Cash on hand is not necessarily a good thing because it could be construed as under-utilised resources, or funds for acquisition. They may use these funds for acquisition, and that would be good news at this time. A takeover in uncertain times is always good if its a contrarian investment. 

Lastly, one will want to know what 'work in progress' might change the nature of these financial ratios. Such ratios can be dangerous because they can conceal an important context, which might not be alluded to with ratios, or it might be a conceptual consideration not readily quantified. This is the problem with ratios. Financially, use your technicals to pick entries. 

So when would you expect to sell such investments? Well, that would be:

1. When they are a technical sell

2. When interest rates start rising substantially - a long way off

3. When and if your stock is a takeover target - wait for alternative bids, and seek out the smaller companies which might in fact be the target rather than the predator

4. When global economic activity or equity markets again look peakish

The implication is that these mine service companies will be good long term investments when they bottom. You can happily put them in your super fund. I would not leverage a leveraged enterprise though using contracts for difference unless you have the diversification to do so. The last thing you want is a contractor dispute. It is preferable for this reason to have a stock with a diversity of projects, with no single over-investment in one project. Its actually good to have a regional focus since that is an economy of scale; and miners are price-takers anyway. This would not be the case however if your region of interest is all high-cost mining capacity (i.e, at the tail-end of the mine cost curve), as they will all be priced out of the market at the same time. i.e. Let's say that most iron ore miners are close to the cost, and you buy a mining contractor exposed to a suite of miners 2000kms inland. This is a 'transport cost penalty', so unless they have an offsetting advantage like premium ore grade and economies of scale from thick ore horizons and bulk mining and train freighting advantages, and say a backhaul, then you will find that this is a critically vulnerable stock to failure at times of metal price vulnerability. A likely ghost town scenario. 

When you see a bottom in this vulnerable market, you might consider mine service contractors. Just be weary about the timing as this financial uncertainty is undermining confidence, and therefore spending. But don't wait too late, use technical indicators. Its a long term strategy, so use a 1month 20-day period for an entry, then a relatively long term moving average as an exit signal. Mining contractors only go broke if mining ceases; otherwise their earnings are more sheltered than actual miners.

Asian property markets outperforming Japan Foreclosed Guide Philippines Property Guide

Profit from mining with Global Mining Investing eBook   Global Mining Investing Community.

Author Andrew Sheldon| Applied Critical Thinking | www.SheldonThinks.com