Ausdrill Cheap, But Risks Remain

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The company is included in ALL-ORDS

-Significant contract losses
-Debt covenants still OK
-Sentiment to improve over time
 

By Eva Brocklehurst

The reduction in mining activity has scalped specialist service provider Ausdrill ((ASL)). The company returned from a trading halt decrying a sharp downturn in business in Australia and Africa, reducing FY14 profit guidance to $35-45m, down 60% on FY13. Earnings are under significant pressure and it will be some time before that pressure is alleviated.

There may be longer term value but currently there's enough risk for Citi to stick with a Neutral rating. Return on equity for FY14 is forecast to be at its lowest for the past 10 years and the current cycle looks like its nearing a base. This presents both a risk and an opportunity. The risk is with the carrying value of the assets. Here, Citi thinks the auditors will be taking a close look in FY14 at the carrying value of all assets. Whilst the stock trades at attractive multiples, given the volatility in the gold sector, Citi's confidence in FY14 remains diminished.

The opportunity exists for the medium-term leverage the stock offers for returns when the cycle starts to improve, given Ausdrill's significant fixed-cost business model. Ausdrill is exposed to strong long-term demand drivers, with a multi-commodity exposure to mine production in Australia and Africa. The strategy of seeding new divisions internally and looking for new business opportunities up the value chain should support longer-term returns for shareholders, in Citi's opinion.

Citi assumes a 50% cut to dividends to maintain historical pay-out ratios. Macquarie's dividend forecasts continue to assume a 35-40% pay-out of estimated FY14 earnings. This is a similar level to what the company has paid out in recent years and places the stock on Macquarie's calculations at a yield of 5%.

On the FNArena database there are currently two Buy ratings, four Hold and one Sell (BA-Merrill Lynch). Not all database brokers have updated their forecasts, hence a consensus target price of $1.30 is no doubt doomed to be further reduced. This target compares with $1.66 ahead of the update.

Debt levels are improving slowly and the company plans to lower capex in FY14. Despite the downgrades there is room in the debt covenants, with Citi calculating that earnings would need to halve again to breach current covenants. Macquarie also observes that Ausdrill remains comfortably within covenants, expecting debt to reduce to $355m. This would put net debt/earnings at 1.7 times and earnings/interest cover at over 5.5 times. Based on Macquarie's capex and earnings forecasts, Ausdrill should survive the next two years without tapping equity markets. Macquarie estimates Ausdrill has over $200m in surplus debt capacity following its US$300m note offering last year. Morgan Stanley is also comfortable about the debt covenants and estimates a slight rise in net debt/earnings, to 1.75 times, estimating current net debt at around $450m.

Ausdrill provides a range of specialist services to the mining sector such as drill and blast services, contract mining, equipment hire, assaying, procurement, logistics and manufacturing. The whole spectrum has been affected by both miner cut-backs and lower commodity prices. Macquarie notes Africa was the prime cause of the profit warnings with revenue that was lost in FY13 not replaced. The broker has examined the cost position of key Ausdrill gold mines (65% of FY13 revenue) and found that many are under pressure at current gold prices around $1,300/oz. The company's iron ore book fares better, concentrated on BHP Billiton and Rio Tinto (30% revenue). Together iron ore and gold account for near 95% of the core contracted revenue.

JP Morgan has downgraded the stock to Neutral from Overweight, believing the changes to the earnings outlook are too great. The broker is niggled by the contrast in the company's loss of contracts to growth in underlying mine production volumes. This raises concerns about the ease with which mining customers can reduce demand for Ausdrill's services. The resultant break to the previously strong links to mine production volumes in Western Australia iron ore and gold and West African gold mean it will take some time to rebuild profitability and, hence, confidence. It also raises questions for JP Morgan regarding the timing of recent investments that increased Ausdrill's exposure to more cyclical business, such as equipment hire and mineral exploration. Having said that, the broker still thinks the company has capacity to improve working capital and curtail expenditure.

Morgan Stanley considers there's valuation support at current levels and retains an Overweight rating. Ausdrill will require a stable period of earnings and improving sentiment. The broker observes, beyond the known areas of weakness and previously disclosed cessation of contracts in Africa, the most telling impact from the company's update came from changes to the mine plans at two of the company's largest contracts – Perseus Mining's Edikan and Resolute Mining's Syama. Morgan Stanley expects the share price will take time to recover, with substantial improvement unlikely before the results are reported in February.
 

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