The fate of the contractor

24 Mar 2016

By Shadforth Financial Group

The mining services and contract services sector experienced positive gains during reporting season, however, it appears to be more of a relief rally rather than fundamentally driven. This sector will deliver very mixed returns and stock selection is paramount.

The sector continues to face a cyclical downturn and won’t recover until we see mining companies grow capital expenditure and increase investment. Given that mining companies are still trying to conserve cash, cut capital expenditure budgets and delay investments, it is more likely the sector continues to have further downside risk.

The contractors were highly leveraged to the upside of the mining cycle, but equally leveraged to the downside. Margins will continue to fall as fixed costs remain high and fewer contracts are awarded.

The potential growth areas for these companies lie in increased domestic infrastructure opportunities and potential maintenance contracts, however the completion of a number of large energy projects, combined with the negative sentiment around Chinese growth, outweighs new infrastructure opportunities.

Relatively few companies will benefit from the infrastructure projects up for tender in New South Wales and Victoria. These projects are government-based, complex and therefore most likely to remain in the planning phase for an extended period. Earnings or revenue recognition is potentially only going to become evident in 2017.

The contractors have been in survival mode for a number of years and the easy wins from a cost-saving perspective are most likely complete. They will need to peddle very hard to survive the cycle.

With debt levels rising, capital expenditure cuts and fewer income opportunities, there are not many companies one can have confidence in. However, there are a few companies that will be able to protect earnings to a degree, or may survive the down cycle owing to balance sheet strength, good management, the provision of needed services and consumables combined with being dominant operators in a particular area.

A number of companies will not survive the cycle while a few will benefit from a takeover bid – but it is a risk/return dynamic that is weighted well to the downside and depends more on luck than skill. This sector is to be avoided for the medium term.

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