No End In Sight To ALS’ Pain

This story features ALS LIMITED. For more info SHARE ANALYSIS: ALQ

-Recovery unlikely inside 12 months
-Life sciences, industrial growth modest
-Price wars keep margins in check
-Structural and internal "issues" to fore
 

By Eva Brocklehurst

Testing and inspection services provider ALS ((ALQ)) has downgraded its first half earnings outlook in the face of soft trends in mineral services revenue. Volatile commodity prices, and economic and political disturbances, continue to affect mining industry volumes coming to the laboratories. Indeed, Macquarie observes global expenditure on exploration has continued to fall in every geography. ALS fears the trend will last into FY16 and is undertaking strategic reviews on operating locations to determine efficiencies.

The company has revised estimates for first half profits to $64m against guidance of $74m provided at the AGM back in July. Such a result would be 36% below the prior corresponding half. The disappointing guidance is driven by persistent weakness in minerals exploration, which reflects continued reductions in spending by miners. The company's oil & gas segment will sustain lower earnings too, on a combination of low volumes and reduced prices for coal.

Since the AGM, all divisions have experienced a weakening of conditions. The usual seasonal improvement has been less than expected. The balance sheet remains strong and the company is unlikely to resort to raising equity but, in Deutsche Bank's view, its ability to make value-accretive acquisitions has diminished. ALS may have significant leverage to a recovery in minerals exploration spending but the broker suspects it is unlikely to happen inside 12 months. Moreover, Deutsche Bank considers the stock is expensive and, with revenue volatile in the oil & gas sector, ALS could disappoint investors further.

Deutsche Bank retains a Sell rating, as do the other four FNArena database brokers covering the stock. The consensus target price is $6.04, suggesting 3.6% upside to the last share price (which was trounced yesterday). This compares with $6.57 ahead of the downgrade announcement. The dividend yield on FY15 and FY16 forecasts is 5.1% and 5.8% respectively.

ALS is experiencing some growth in the life sciences business and there is a recovery in industrial segments, but JP Morgan observes these are just not growing fast enough to offset resources weakness. Moreover, industry commentary suggests life sciences markets are highly price competitive and this will keep the company's margins in check. Goldman Sachs downgrades earnings forecasts by 18% and 22% for FY15 and FY16 respectively and reduces its target to $5.12 from $6.55. The broker continues to view a 10% discount to the market valuation is appropriate, given earnings are now late cycle and amid forecasts of declining capital returns.

The extent of the downgrade surprised Morgan Stanley. The broker takes some heart in signs that ALS is shifting its business away from minerals exploration and that some of the issues the company is contending with – and why earnings forecasts have been downgraded across the board – reside with execution problems, particularly in oil & gas. The broker believes a component of ALS' oil & gas business must be loss making, which could challenge the $453m in goodwill held against Reservoir Group, acquired in 2013.

The issues in oil & gas were cited as structural changes, which UBS suspects relate to the shift to production from exploration among customers in North America. This has a substantial impact as Reservoir Group derives 60-70% of its revenue from exploration. The company's reference to internal issues in the oil & gas business is assumed to relate to restructuring costs. UBS observes Reservoir Group is a private equity roll-up story and only partial integration was concluded at the point at which ALS acquired the business. UBS remains attracted to the company's industry position as well as its scale and track record, but is also concerned about the lack of visibility surrounding the timing of a turnaround. Moreover, Reservoir Group is principally a coring rather than a traditional laboratory based business and has more risks on that front.

Given the minerals cycle is stabilising, if execution issues are resolved, ALS could be capable of delivering strong growth in FY16. That said Morgan Stanley is mindful that the strength of any rebound will depend on correcting the problems in oil & gas. On the downside, the broker notes there is little visibility on this count and management appears to have been blindsided by the emergence of these issues. There is, therefore, a risk that FY16 earnings could still disappoint.

Macquarie suspects the primary cause of the downgrade to guidance is weaker margins in oil & gas and life sciences. The Reservoir business not only sustained softness from lower expenditure in oil & gas but there were internal cost control problems and inadequate pricing strategies, in Macquarie's view. This resulted in a loss of market share. Competitors in life sciences are also engaged in price wars and ALS has to defend its market share in that realm too. The broker believes ALS has a lot on its plate to get the Reservoir business into shape and there is a tough second half on the way.
 

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