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Focus on the Mining Sector

Mining services companies offer indirect exposure to the buoyant resource and energy grow th cycle. But the sector remains a diverse industry, w ith varying levels of business, customer, commodity and geographical diversification and risk.

Significant growth in resources activity

The emergence of China and India as economic pow erhouses has driven robust demand and strong grow th across the Australian mining and resource sector. Australia is now the w orlds leading producer of bauxite, alumina, rutile and tantalum and the largest exporter of coal, iron ore, alumina, lead, and zinc. Mining services companies are obvious beneficiaries of this grow ing production. More than $80 billion of new mining and LNG projects w ere announced this year, up more than 50% on 2010. The past few months have seen large projects announced. Chevron announced the immediate start of construction w ork on the $29 billion Wheatstone Project offshore north-w est Australia. BHP Billiton (BHP) also announced US$1.2 billion in pre-commitment expenditure for the first phase of the Olympic Dam Project in South Australia. ExxonMobil and BHP disclosed $4.5 billion in approved capital expenditure for gas developments in Bass Strait. In its April 2011 listing of major minerals and energy development projects, the Australian Bureau of Agricultural and Resource Economics and Sciences (ABARES) highlighted $430 billion in advanced and less advanced project capital expenditure. Over $200 billion of this is in petroleum projects, particularly liquefied natural gas. This w ill benefit companies that service this sector such as WorleyParsons (WOR) and Mermaid Marine (MRM). WOR is expected to report strong earnings grow th in FY12 due to buoyant activity levels in the global oil and gas sector. Despite the extent of exploration activity, production expansion and new LNG projects, the share prices of many mining services companies, particularly the smaller ones, have been particularly hard hit. The share prices of these companies are pricing in significant delays and deferments for mining and resource projects, due to European recession fears and faltering US economic conditions. The market is assuming similar circumstances to the w orst days of the GFC, w ith major projects delays and cancellations coupled w ith underutlised equipment, rapidly falling profits and financial distress. While the extent of any project delays or deferments is difficult to predict until the economic situation in Europe and the US becomes more apparent, it is highly unlikely to spiral into the depths seen during the GFC. Asian demand for our minerals and resources is expected to remain strong for many years. Chevron, BHP, Rio Tinto (RIO), New crest (NCM) and other major resource companies continue to undertake long-term resource development, ignoring short-term macroeconomic conditions and commodity price fluctuations, ensuring continued demand for contract mining services. Chevrons Wheatstone Project w ill take five years to build, but has already signed up tw o large Asian pow er companies to 20-year agreements to buy a combined 4 million tonnes of LNG per annum. BHP is completing studies to create one of the w orlds largest open pit mines at the Olympic Dam site, w ith the potential to increase copper production from around 180,000 tonnes per annum to 750,000 tonnes per annum. The Wheatstone and Olympic Dam Projects w ill provide many years and billions of dollars of mining construction and specialist mining services w ork.

Mining services companies better positioned

The mining services sector learnt the very hard lessons from the GFC and undertook steps to maintain margins and low er debt levels. In general, mining services companies no longer use cheap debt to chase higher earnings. Disciplined grow th, w hile maintaining low levels of net debt, is the new w ay forw ard for the mining services industry. Monadelphous (MND), w hich provides engineering, construction management, maintenance and industrial services to the resources and energy sectors, recently announced its tenth consecutive year of revenue and earnings grow th. In FY11, operating revenue rose 13% to $1.4bn and NPAT rose 14% to $95m. MND began FY12 w ith a large net cash balance of $130m and only $30m in current operating lease commitments. Global contract drilling services provider and drilling equipment supplier, BLY also reported very strong first-half results, w ith revenue up 40% to US$959m and NPAT up 126% to US$74m. BLY expects further margin grow th and started the December half-year w ith only US$267m in net debt and net debt to equity of just 23%. NWH is benefiting from significant expansion of activity in the Western Australian iron ore sector and also its ow n initiatives to grow into new commodities and regions such as Queensland coal. It also maintains a healthy balance sheet and ended FY12 w ith net debt to equity of 19.8%. We forecast strong earnings grow th in FY12.

Utilisation rates and forward work levels remain high

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Most mining service companies still see high utilisation rates as development and production activity continues to ramp up, particularly in the iron ore and coal sectors. BLY currently averages 75% rig utilisation, but expects 80% by early 2012. Earthmoving equipment provider EHL reported an average utilisation rate of 85% for FY11 and this is expected to remain high through FY12 given strong levels of demand. MND started FY12 w ith $650m in new contracts and contract extensions. After only four months into the new financial year, the company has w on a further $730m in mining services and construction w ork, including construction and commissioning coal conveyors for Xstrata Coals Ulan West Project. LEI started FY12 w ith a record $46 billion w ork-in-hand, and $20 billion in domestic and international contract mining w ork. In September, LEI w as aw arded a further $100m contract by Fortescue Metals Group (FMG) for the Solomon iron ore mine.

International growth opportunities

High standards of safety and innovation, combined w ith efficiency and dependability, help Australian mining services companies successfully export their services internationally, particularly to emerging regions. LEI operates a contract mining company in Indonesia, PT Thiess Contractors Indonesia, w hich undertakes a combined US$7.7bn of contract mining w ork at various coal mines in Kalimantan. LEI is also undertaking US$352m in contract mining w ork (drill, blast and w aste removal) at the Jw aneng Diamond mine in Botsw ana for the Debsw ana Diamond Company. Diversified mining services company ASL has undertaken contract gold mining in Africa for the past nine years. In June 2009, ASL w as aw arded a five-year drill and blast contract by AngloGold Ashanti for the Geita mine in Tanzania. In April 2011, ASL kicked off a 12-month exploration drilling service contract for BHP in West Zambia. The continuing strength of the Australian dollar limits many other mining services companies from international expansion.

Labour issues present some risks

Apart from the project delays, increased industrial action and a return to ow ner-operator mining are the biggest threats to the sector and ultimately stem from the success achieved by many mining service operators in the past decade. Increased employee claims and threats of industrial action are on the rise in the mining services sector and potentially may become a major issue in 2012, particularly in Western Australia. In-sourcing remains a grow ing risk to the industry after BHPs $705m acquisition of LEIs HWE iron ore business, w hich included 2600 highly skilled staff and a considerable amount of specialised mining equipment. The move by other major resources companies to an ow ner-operator model could considerably restrict grow th for contract miners. Mining project timing, commodity prices, skilled labour shortages and industrial action are all difficult to predict in the short term, how ever Asian customers w ill still require minerals and energy for many years to come in order to maintain economic grow th. The outlook for continuing volume expansion allow s many mining service companies to forecast strong medium-term grow th. Mining consumables manufacturer BKN, w hich recently reported improved profit margins due to a group cost reduction, forecasts 2530% FY12 EBITDA grow th and 3540% NPAT grow th continuing robustly in FY13. We currently have positive recommendations on Ausdrill (ASL), Boart Longyear (BLY), Bradken (BKN), and NRW Holdings (NWH), but caution that the sector only suits investors w illing to accept above-average risk.

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