Australia | Jun 17 2021
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Just when commodity prices are enjoying boom times, along come labour shortages to frustrate the contractor services sector
-Labour shortages in WA coinciding with strong commodity prices
-JPMorgan, Credit Suisse assess Seven Group best placed
-Downer EDI most exposed to labour inflation outside WA
By Eva Brocklehurst
Restricted movements of personnel related to the pandemic and wage inflation stemming from labour shortages represent heightened risks for contractor services in terms of operating performance and margins. At the same time, order books for both mining services and infrastructure construction are at record levels.
While the sector appears cheap, Credit Suisse notes investors are not trusting the earnings base being capitalised even if the issues are probably transient. The broker assesses the average price/earnings ratio sector is at 13.3x on a 12-month forward basis, at a material -35-40% discount to the market.
Perenti Global ((PRN)) was the main driver of negative sentiment in May as a combination of the impacts of the pandemic on productivity, higher Australian labour costs and FX drove downgrades to forecasts.
Investors quickly de-rated the sector, with Monadelphous ((MND)), NRW Holdings ((NWH)) and Maca ((MLD)) bearing the brunt. In contrast, and annoyingly, this is at a time when commodity prices are strong and capital expenditure on mining is recovering.
The main exceptions to subdued mining contractor performances were ALS ((ALQ)), as its geochemistry sampling and life sciences segments experienced strong flows. Cimic Group ((CIM)) was also a better performer, given its exposure to Australian east coast infrastructure, Credit Suisse notes, having been awarded the M6 project that provides more visibility from 2022.
Macquarie finds the commodity outlook is encouraging the development and expansion of mining projects and has initiated coverage on NRW Holdings, Perenti Global and Macmahon Holdings ((MAH)) with Outperform ratings.
Macmahon Holdings is preferred as it has a material order book in the vicinity of $4.2bn and a large tender pipeline, while underground developments should improve group margins.
Perenti Global is moving its business into "safer" geographies, from other parts of Africa to Botswana and to North America. It has a large tender pipeline of $9.2bn of which 25% is in North American growth regions. NRW Holdings, too, offers a full suite of services with key exposure to iron ore and infrastructure.
Credit Suisse's preferred contractor is Seven Group ((SVW)) and JPMorgan agrees, as the company's WesTrac business is a beneficiary of the present commodity boom with iron ore exports tracking at record levels.
Coates Hire, another subsidiary, is an east coast infrastructure play and therefore lower risk in terms of contracts and labour, providing a higher leveraged way to gain increased exposure to the heightened expenditure on Australian infrastructure.
JPMorgan believes Seven Group's focus on cost efficiencies in its core businesses has created a firm platform for a multi-new growth trajectory. While presently delayed, projects on the east coast could ultimately come into play and lead to a period of "near-perfect" operating conditions for the company.
JPMorgan finds the extent of the impact of labour inflation is hard to assess accurately but it would appear Downer EDI ((DOW)) is most exposed to labour inflation outside of the Western Australian, market where it is currently acute, and Downer has the narrowest margins.
The broker downgrades to Underweight, concerned that the planned divestment of higher-margin businesses could exacerbate the current labour dynamics. Still, JPMorgan recognises the upside that could come from successful execution of the urban services strategy.
On the broker's assessment, Downer EDI trades at a -10% discount on FY23 estimates which is justified by lower relative margins and growth, while the current news flow regarding ongoing divestments of mining and hospitality businesses may have negative implications for valuation.
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