Australia | Apr 19 2013
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-Outlook for contractors is bleak
-Multi-year downturn in exploration seen
-Infrastructure exposed are best placed
-Larger contractors feeling the pinch
By Eva Brocklehurst
The outlook remains bleak for Australian engineers and contractors now resources capital expenditure is reaching a peak. Sure, there are some projects in oil & gas that are continuing but in many areas companies are cutting back and this has ramifications for mining and energy services providers as well as civil contractors on infrastructure projects.
Citi describes it thus: CEOs are turning away from empire building to focus on cost and returns. That view may not be so new but the analysts at Citi expect the downside is likely to be greater than estimated, particularly for 2014. Modelling points to a sharp drop in mining capex in 2014 – globally. Mining capex is expected to decline 8% in 2013 and 19% in 2014. The model also points to a 12% decline in 2015. Pricing of mining equipment has deteriorated notably and prices are expected to be up just 2%, year-on-year, over the next 12 months. This compares with an average increase of 6% over the past 10 surveys Citi has undertaken on this measure. The result suggest that prolonged slower growth could drive consolidation amongst mining equipment providers.
Goldman Sachs recalls the recent termination of Leighton Holdings' ((LEI)) pre-strip contract with the BHP Billiton ((BHP)) Mitsubishi Alliance (BMA). The contract was terminated two years early and appears to be driven by BMA's decision to re-tender the contract and award it to a private contractor. For Goldman this underscores the coal industry rhetoric about placing pressure on supplier input prices that's becoming a reality. A positive development from all of this pressure, Goldman's view, is that Leighton is now walking away from loss-making contracts.
While accepting Australian coal producers are facing significant profitability pressures, there are instances of mine closures the analysts think are costing more than operating these mines at small losses. In this environment there is a preference, mainly among global producers with operational expertise, to increase the instances of owner operation over outsourced mining. Witness, Xstrata cancelled Leighton's Collinsville contract and Peabody has brought coal washing operations in house from contractor Sedgman ((SDM)). Risks abound for contractors in this environment.
Goldman Sachs expects a multi-year downturn in exploration activity and those companies heavily exposed to exploration are downgraded as result. This includes ALS ((ALQ)), Boart Longyear ((BLY)) and Imdex ((IMD)). The broker has a Sell rating on ALS, seeing an adverse combination of downside in minerals testing volumes, earnings risk and a demanding FY14 earnings multiple of 16 times. The other two have Hold ratings as they are moving into oversold territory. Increased resources investment has run its course following a strong run in commodity prices. Goldman forecasts that reinvestment rates in the resources sector will now trend back towards historical averages around 54% and companies will take a more selective view. This means a rebound in exploration and growth capex is unlikely in the short term.
JP Morgan's Contractor Expectations Index (CEI) is negative. Profit margins are seen sliding as major projects are delayed or cancelled. A peak in Australian engineering construction is expected within 6-12 months and the volume of work is coming under pressure. Many projects may be progressing but capex cost inflation and growing alternative sources of supply are weighing on new projects. The analysts note the value of new projects coming on line is less than the volume of current projects reaching completion and those that have been delayed or cancelled. It's not only resources, the private sector is also being cautious about major investments in economic infrastructure until there is greater policy certainty and a better balance of risk in private-public partnerships.
Is there any positives in the outlook? The CEI at 34.5 is up 18% from six months ago but down 18% from 12 months ago. The rebound is driven by smaller contractors becoming less bearish. The large CEI was up 1% from six months ago at 43.3. Large contractors may be more positive as far as order books go but profit margin expectations have deteriorated sharply. The small CEI was up 27% from six months ago to 31.2, driven by less pessimism on margins and order books. It appears smaller projects are continuing at a better rate.
For JP Morgan some contractors can find mitigating circumstances in the spread of their work such as Downer EDI ((DOW)) or Lend Lease ((LLC)), as the have a limited exposure to resource and energy. For others such as Monadelphous ((MND)) and Leighton there are difficulties in maintaining revenue growth and margins. Monadelphous has short work duration and a strong level of growth which is likely to come under pressure and Leighton is distracted by other problems such as gearing and the Middle East. Transfield Services ((TSE)) and UGL ((UGL)) have worked through a number of problems in operations and their operations and maintenance exposures may be a help as the installed base of assets grows.
While oil & gas companies are joining others in the resources sector in the downturn segment of the construction cycle, JP Morgan finds the economic construction sector is a bit further ahead, in the stabilising segment of the cycle. Growth expectations have improved and respondents are increasingly positive about the road, water, electricity and rail sectors. Expectations have stayed constant for the telecommunications sector despite the NBN roll-out. There have been some new infrastructure projects announced in the last six months but JP Morgan has not observed any significant increase in total project values. The analysts believe this reflects a reliance on the modest recovery in economic infrastructure to make up for the pull-back in mining and oil & gas.
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