Mining services slump is not a passing storm

mining servicesEarlier this year the mining services stocks took a collective bath as large mining companies such as BHP, RIO, Xstrata and Peabody made it clear that  they were winding back spending on exploration and development. It was clear that service providers needed to rethink their business plans. The larger names which include Monadelphous, United Group and Downer have already fallen from their peaks this year by 43%, 40% and 33% respectively.

Mining services are an intriguing stock subgroup that have revelled in the recent mining boom. The frenetic rate of development this decade saw expanding workbooks and solid margins for contractors and therefore rising investor interest. Investors, particularly small cap fund managers, have flocked to these stocks that make up a significant percentage of the small cap universe. Amidst the excitement, the cyclical nature of this industry was forgotten.

Quest have had many mining services investments over the years. Our team saw our first bust back in the late eighties, another in the mid nineties, another at the beginning of this century and a practice run post GFC before the latest episode. Our valuation methodology allows for cyclicality which has led us to sell too early on many occasions in a booming environment. At the end of the day, however, all contracts regardless of profitability expire and need to be replaced by new ones. Occasionally the contract goes wrong and the profit margin vanishes. Some guys are better at managing risk than others. This is not a sector that should attract high multiples but it happens in the excitement of every boom.

We do not own any of these companies at this time and we see worse to come for the sector. In our view a number of stocks are in a  very dire predicament with too much debt and not enough work and will not survive to see the next boom. The assurances this week from some broking analysts that the cycle is now at a trough (presumably because stocks have fallen a lot) and the worst is over is nonsense. The boom went for years and so will the slump.

While there will be trading bounces aplenty over the year, this sector is doing it tough. If you have doubts just read the recent outlook comments by newly appointed BHP, CEO Andrew McKenzie or Sam Walsh, CEO of RIO, both of which are instigating major cost savings in exploration, development and maintenance. These are the guys that write the cheques. As Churchill once said, “Now this is not the end. It is not the beginning of the end but it is, perhaps, the end of the beginning”.