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This article appeared in the April 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Several listed companies that service Australia's booming resources industry have delivered solid share-price gains in recent years, as tens of billions of dollars are invested in mining projects. In this simple guide, TREVOR HOEY, shows how to spot the best mining service stocks and understand the risks.

Photo of Trevor Hoey By Trevor Hoey, author

The increase in new ASX-listed resource companies has been accompanied by an influx of providers of mining and energy industry services. Some of these service companies appear to have the attributes required to survive. Others could struggle.

It is arguably harder when industry conditions are at their best to identify companies that will not make it through the tough times. But there are some key indicators for investors looking to gain exposure to the resources boom, by targeting service companies.

As with any investment, gaining an appreciation of the overall picture is important - not easy given that there are more than 50 ASX-listed companies solely focused on providing services for varying stages of mining projects. An understanding of the sector can best be achieved through an overview of just what is involved in a mining project.

Start with some drilling

Drilling, of course, is an important part of exploration, and companies such as Ausdrill, Boart Longyear, Imdex and Swick Mining are active players. If a project gets the go-ahead, these companies are also involved in the minerals extraction stage.

Companies such as Cardno and Lycopodium are actively involved in the engineering and consultancy stages of project preparation. Skilled Group and Programmed are prominent players in putting workforce teams together.

Analysis of drilling results is a key to establishing whether a project is financially viable, and Campbell Brothers is a global player in this.

Companies involved in early-stage preparation that involves heavy equipment include Leighton Holdings, Macmahon Holdings and NRW Holdings. Another is Austin Engineering, which manufactures and distributes specialised heavy-duty equipment on a global scale.

Some mining companies prefer a "build, own and manage" model. Sedgman is heavily involved in the construction and management of coal-processing plants. Decmil Group provides, and in some cases maintains, accommodation villages. Monadelphous is a company that gets involved in most stages, including inspection, repair and maintenance work, much of which is driven by regulatory requirements and this generates a significant proportion of its recurring income.

Environmental workplace safety issues have become an increasingly important focus and Tox Free Solutions and Industrea are two companies in this area.

Logistical companies involved in the transport of materials include QR National and Bradken. Mermaid Marine and Miclyn Express Offshore assist in the transfer of personnel and equipment to offshore rigs.

Management profiles

Quality management has a significant effect on a company's fortunes. Profiles of management can be found in an IPO prospectus, annual reports or on the company's website. Industry experience, particularly with other successful players, provides a degree of confidence.

It is worthwhile identifying niche mining service operators that have substantial barriers to entry. Often they have proprietary technology that cannot be replicated by potential competitors, effectively giving them substantial pricing power that is reflected in the comparatively strong profit margins in the business.

A note of warning: be wary of companies that have such a defined revenue stream that the emergence of a similar competing product at a cheaper price could lead to a substantial decline in income.

Mining service companies that choose to move into complementary markets do so for a number of reasons. It is often a successful way of driving revenue growth by providing exposure to new sectors, or entering new geographic regions. This broadens the company's client base and the opportunities to cross-sell services.

There is a choice of acquiring an entity with relevant expertise or establishing a business from the ground up. Whichever course management decides on, capital investment is required, and the true measure of such an initiative is profit growth rather than merely increasing the top line revenue. Look at a company's history to determine whether it has been successful in the past in integrating new businesses.

Regional expansion, even in domestic markets, involves challenges in doing business at arm's length, and overseas there is the added risk of political, legal, economic and social variances. In acquisitions, maintaining a successful management team can help to alleviate some of these challenges.

Efficient use of assets

Some mining and energy service businesses by their very nature carry more risk than others. The term capital intensive relates to businesses that have to invest heavily in plant and equipment to successfully compete for project work.

These are traditionally low-margin businesses where there is little scope for error from initial tendering through to project execution. The other key risk is a downturn in activity, whether from a cyclical downturn in the resource sector or a lack of success in winning contracts.

A decline in the utilisation of assets such as plant and equipment can be the death-knell for contracting businesses. Those that have taken on substantial debt to invest in equipment are most prone to failure. Consequently, balance sheet strength is important when revenue is dwindling and interest on loans is building.

This underlines the importance of flexibility, and mining and energy service companies that require less capital investment are arguably lower-risk investments. Typically they are consultancy-type businesses that generate income from intellectual property such as highly qualified staff and technical equipment.

They have the capacity to move with cyclical trends, increasing or decreasing staff in keeping with demand. Although they may choose to sell or sublease some office space if industry conditions deteriorate, the resultant financial impact is much less than for a contracting company that has to sell a fleet of bulldozers to meet interest payments.

Earnings visibility

The issue of earnings visibility is always extremely important, but in the highly competitive mining services sector, companies that have this attribute are generally priced at a premium to their peers.

Earnings visibility can take a number of forms, one of them being generation of recurring revenue that is often underwritten by long-term contracts. This type of work usually involves inspection, repair and maintenance services. Providing further surety of income is the fact that these services are a function of regulatory requirements, such as those under the workplace health and safety code.

The extent of secured work is another way of measuring a company's earnings visibility. This is an area renowned for misrepresentation; be wary of companies that base their confidence on the extent of industry activity. The value of work being tendered for is of little significance in a highly competitive environment. Look for companies that can quantify secured contracts.

Forward earnings important

Beware of cliches such as "pipeline of activity" and do not be drawn in by companies announcing the award of work to be completed at a billion-dollar project. It is the value of the work awarded, not the size of the project, which drives the company's revenues.

Good operators will also provide some guidance as to when revenue from such contracts is likely to be received, in what financial year. An investor should focus on the potential forward earnings impact.

One of the best endorsements of the quality of a company's performance is the award of follow-up contracts. In mining services, it is not unusual for a company to be involved in one or more contracts over many years with one company.

About the author

Trevor Hoey is one of Australia's leading freelance writers on small and mid-cap stocks, and has analysed them for 12 years. He provides editorial consulting services and corporate writing for companies and financial organisations. Contact Trevor

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