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All eyes on Monadelphous

Monadelphous Group’s (ASX: MND) share price reached a high of $21 this week but opened this morning at $17.41. The question that is on everyone’s mind is why.

In its most recent half year report, Monadelphous broke records in NPAT, sales revenue, EPS and EBITDA, which sent its price up to a high of $28.48 in February. The thought of the mining boom ending was doubtful and the company was hopeful of new contracts becoming available in the future. Now, less than six months later, the environment has changed. Analysts are saying mining services companies will be the first to fall from the downturn in mining investment — investors are following suit.

I’m not disagreeing with the profound effect that the slowdown will have on mining services, and we’ve already seen the spin off in companies like ALS (ASX: ALQ) and Ausdrill (ASX: ASL), down 20.6% and 58.6% respectively. Leighton Holdings (ASX: LEI) occupies a similar position to Monadelphous, which has had a recent rally, only to be brought down 30% since its high. It also has other issues in addition to poor investor sentiment, such as management and foreign shareholder concerns.

In an ASX announcement on 19 February, Monadelphous attributed much of its performance to contracts secured in the previous financial year. This year the company secured $1 billion in contracts across its three divisions before it won an additional $260 million contract for Rio Tinto’s (AASX: RIO) Western Turner Brockman Project. The combined contract base should provide the company with similar revenues as that of current period in 2014.

However, looking ahead a few more years, many investors’ expectation is that the company will suffer from a slowdown in mining investment and cost-cutting from our largest resource stocks. We’ve already been given evidence to support this contention. BHP Billiton (ASX: BHP) and Rio have cut and sold projects that total into the billions of dollars. This may not have an effect on Monadelphous in the short term, but in the medium to long term this could have a large effect on the company’s ability to secure contracts, create revenue and turn a profit.

The company said that of its three divisions the Engineering Construction (EC) division was responsible for the massive surge in its most recent results. It was driven up 71% from the previous period because of growth in construction projects around the country. This division accounts for approximately 55% of the company, but it says “uncertainty remains in respect of the rate of new project approvals in the resources and energy sectors as customers reassess their capital expenditure plans and focus their attention on high-return options along with improvements in project delivery productivity”.

Uncertainty in the mining industry can be very rewarding for those willing to accept a higher amount of risk. The company realises that “whilst the opportunities for construction beyond this financial year remain solid based on the volume of approved projects, project delays and a slowdown in near-term new major project approvals are likely to reduce the pipeline of opportunities in the medium-term.”

Foolish takeaway

This month has been the hangover after a big couple of months in gains. As investors got drunk off the records set throughout this year, some appear to have forgotten why and are beginning to realise the potential downside. However, I expect that the bigger mining services companies will not be affected as badly as the smaller, more vulnerable services stocks. Investors must be cautious before taking the plunge into this company, although if it can continue to secure both contract extensions and new contracts in the 2014 calendar year, it will put it on firmer grounds to maintain sales revenue and profit.

This week’s drop in share price is not representative of the company but of the industry. At a P/E of around 10, the market has already adjusted its expectations of the company and it wouldn’t surprise me if this stock price rebounded slightly in the very short term. Investors considering purchasing this stock for the long term should expect a drop in revenue in future years, which will reduce the value of the stock and watch for any new contract approvals.

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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 Owen Raszkiewicz owns shares in Rio Tinto.

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