Australia | May 27 2021
This story features ALS LIMITED. For more info SHARE ANALYSIS: ALQ
Is the commodities division of ALS Ltd steering the business towards a significant upgrade cycle?
-Notable recovery in second half geochemistry sampling volumes
-ALS benefitting from substantial deployment of miner equity raising
-Cost inflation gathering pace and needs to be monitored
By Eva Brocklehurst
With the slump incurred during the pandemic in the rear vision mirror, ALS Ltd ((ALQ)) has gathered momentum over recent months and its commodities division is now at levels not experienced since the last minerals boom.
Earnings (EBIT) were $301m in FY21, flat on the prior year, with an organic revenue decline of -2% because of pandemic impacts. Yet, the final dividend of 14.6c was well ahead of expectations, underpinned by strong cash conversion and debt reduction.
Morgans suggests some of this may have been simply catching up after a more prudent first half dividend that was at the lower end of the pay-out range. The company provided no specific guidance for FY22 it but expects volume growth in both commodities and life sciences.
UBS found the recovery through the second half notable, with organic revenue growth of 5% compared to the -9% decline in the first half. The recovery was driven by commodities, with geochemistry sample volume increasing 13% and 27% in the third and fourth quarters, respectively.
This has resulted in significant operating leverage, the broker points out, with the EBIT margin in the second half lifting to 30%. The company expects to be able to at least maintain this level of operating leverage throughout FY22.
ALS expects to increase its global geochemistry laboratory testing capacity by 15% while prices are not expected to rise materially at this point. As macro factors are supporting increased mineral exploration the geochemistry testing outlook is particularly robust.
Global exploration was heavily affected during the pandemic because of mobility restrictions but a recent improvement in prices, particularly gold and copper, has provided many junior and intermediate miners with access to equity capital. Hence, the availability of finance combined with an improved outlook for mineral exploration should underpin geochemistry sales in FY22-23.
Management has noted the junior miners are yet to deploy the funds they have raised over the last 6-9 months to meaningful exploration activities. Accordingly, Credit Suisse suspects there could be further upside to already heightened levels of exploration that occurred in April. April financing for junior and intermediate miners was well above historical levels.
Historically, peak margins have been as high as 40%. Assuming a 40% margin in commodities in perpetuity, which was the case in FY09, Ord Minnett calculates its valuation estimate would increase to $13.60 a share yet, conversely, assuming 25%, which is slightly above the average margins since FY15, there is around -17% downside to the latest close.
On the balance of risks, and not yet ready to accept a sustained multi-year commodity up-cycle, Ord Minnett maintains a Hold rating.
Even though the share price reacted strongly, Macquarie believes there is still relative value and the main risk to an Outperform rating is a retracing of gold or copper prices that would mean a loss of momentum in terms of capital raisings.
The broker also notes the company is managing labour and supply chain constraints relatively well through its global diversification and latent available capacity. Global testing and inspection certificate markets are expected to grow 19% to US$244m by 2025. This is driven by a trend to outsourcing services to third-party providers.
On the soft side, coal is underperforming but this is only a small business within commodities. The company's organic revenue derived from coal declined -9.5% largely because of trade tensions with China and a falling coal price. Another softer area is industrial, where Macquarie notes asset care clients continue to delay and reduce the scope of projects.
Morgans suspects the pace at which junior miners will deploy equity funds will be slower than in previous cycles while price improvement is not quite yet in the mix, although the signs are improving. The broker downgrades to Hold, after lifting FY22-24 forecasts for earnings per share by 4-11% as commodities margins move closer to 30%.
Morgans also notes the life sciences division is showing its resilience with improving margins amid a quick realignment of costs. Even Latin America is showing some improvement in volumes. Ongoing lockdowns could interrupt flows but Morgans believes the market should be increasingly comfortable with base earnings in this division.
In life sciences, ALS continues to envisage an annualised improvement to margins of around 30-40 basis points over the next two years, to 17%, noting recent acquisitions have performed well.
UBS expects achieving the company's targets will be driven by growth in commodities and retains a Neutral rating, believing the stock is adequately factoring in improvement in both geochemistry testing and a normalisation of life sciences demand.
Credit Suisse on the other hand believes the outlook bodes well for an upgrade and re-rating cycle. The broker does not consider the valuation stretched given the company's market position and more expensively priced offshore peers.
There is also ample balance sheet capacity and while industrial markets are mixed they are not worsening. The stock may appear to be trading on demanding multiples but Credit Suisse notes cyclical exposure without the extent of labour risks inherent in other comparable names.
Morgan Stanley downgrades to Equal-weight from Overweight, noting the stock is up nearly 50% since mid-2020. The broker was still impressed with the momentum in commodities and expects pricing increases should lead to higher margins, but notes the risk with cost inflation.
Investors need to be careful about valuing cyclical businesses on the back of peak margins as cost inflation is a theme gathering pace globally, Morgan Stanley warns. The broker notes leverage is approaching five-year lows, which offers the potential for further M&A or share buybacks, although the acquisition strategy is likely to remain focused on small deals.
No franking credits exist so earnings accretion is likely to be a less material driver of the share price, as the broker explains an additional $200m buyback would only provide 2-3% valuation uplift. Morgan Stanley acknowledges the potential for further upside but considers this likely to be limited and awaits more compelling entry points to the stock.
FNArena's database has four Hold ratings and two Buy. The consensus target is $12.51, signalling 2.3% upside to the last share price. This compares with $10.28 ahead of the results.
See also, Lift In Exploration Augurs Well For ALS on March 11, 2021.
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