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Why BHP & Rio will outperform mining services

I’m not wanting to sound like a broken record but while diversified, low-cost miners BHP Billiton (ASX: BHP) and Rio Tinto (ASX: RIO) release solid production numbers and upbeat outlooks, the mining services sector continues to get clobbered.

The broad thesis I am working on is that commodity prices over the next few years will be lower than the
last few. This will affect different miners in different ways. Large, low-cost producers like BHP and Rio will reign in costs to help protect profit margins by squeezing contractors to lower their prices. They will also expand output to maintain revenues.

Meanwhile, many small, high-cost miners and projects at the exploration and feasibility stage will shut down or be put on hold. This in turn will put a number of contractors out of a job, increasing supply at the same time as demand is decreasing and leave mining service contractors fighting for a diminished pie of work. This will force contractors to cut their margins back to razor thin – which is where they have historically been.

Case in point

After reaffirming guidance back in February of “at least matching the reported net profit after tax for the year ended 30 June 2012 of $112 million”, drilling contractor Ausdrill (ASX: ASL) has come back to the market in April revising expected profit down to around $90 million. The stated reason for the revision in guidance is that management had expected the mining sector slowdown to recover… so far, it hasn’t. The market didn’t take kindly to the downgrade, knocking 9% off the share price.

Mining vehicle supplier Emeco (ASX: EHL) also updated the market this week, stating that it continued to expect a decline in second half earnings compared with the first half. Global vehicle fleet utilisation was weak at 55%, down from 67% just 2 months earlier. The market must have thought this was baked in to the multi-year low share price though, as it briefly sent the stock up 12% before closing flat.

Foolish takeaway

If you were a hedge fund and agreed with the above analysis you would buy (“go long”) the lowest-cost miners and short sell (“go short”) the weakest mining service stocks. This would allow you to potentially profit from both sides of the thesis. There are a number of risks involved with shorting and I for one have never and I expect never will short a stock, in any case, I would currently demand an extra-large margin of safety before purchasing any mining service stocks given the current headwinds.

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More reading

The Motley Fool’s purpose is to help the world invest, better. Click here now for your free subscription to Take Stock, The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead.  This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson. Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.

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