Value emerging in the mining services sector?

Contractors servicing Australia’s resources and energy sector have been hammered in recent times. They are probably starting to find out how it feels like to be a gold miner.

The major miners have been slashing capital expenditure and exploration programs to the bone, renegotiating existing contracts at lower rates and selling off non-core assets, as they focus on improving the productivity of their core assets.

Since the beginning of this year, Emeco Holdings (ASX: EHL) has lost 67% of its market value, while compatriots Monadelphous Group (ASX: MND), Boart Longyear (ASX: BLY) and Forge Group (ASX: FGE) have lost 34%, 84% and 89% respectively.

Monadelphous has greater exposure to the oil and gas sector, hence the reason it hasn’t been punished as severely. Arguably, Forge has been punished mainly for not doing its due diligence on takeover target CTEC properly, with the company’s woes caused by two power station contracts it inherited as part of the CTEC acquisition in 2012.

But when stocks lose as much market value as these four have, brave souls may want to have a closer look. Benjamin Graham would call them “cigar butts”. The theory postulated about these stocks is that they may well have a few puffs left in them, despite being chucked out by the market.

And the value in these companies may not be recognised by the market, because the average investor may only focus on earnings and the income statement, whereas the potential value in these types of stocks often lies in the balance sheet.

In some cases, companies could be trading for less than the cash on their balance sheets, giving the business a value of virtually zero or lower. In the case of Emeco, Forge and Boart Longyear, the current price attributes zero value to their ongoing business, with all three trading at substantial discounts to their net tangible assets. In layman’s terms what that means is if you hypothetically bought the whole company and sold off all its assets and paid its debts, you would be left with a profit.

To give you an example, Forge had net assets of $213 million at the end of June 2013. Excluding intangible assets of $40 million implies that its net tangible assets are worth roughly $163 million. With a market cap of just $49m, that suggests an investor could make a profit of more than $110 million, if they could buy the whole company for its market value, pay off its liabilities and sell off its assets.

Of course it’s never that simple.

Forge also stated it had work in progress assets of more than $150 million. The company is performing this work but has yet to bill its clients for it. After the disasters revealed in its two power station contracts, it’s doubtful that that asset is worth the value stated on the balance sheet. Additionally, June was five months ago, and a balance sheet is only a snapshot in time. A lot of water has passed under the bridge since then, and the $90 million of cash on the balance sheet then has been whittled down to $44m by the end of October.

Taking a simplistic view of comparing the current price to net tangible assets using data from Capital IQ, suggests that Emeco, Boart Longyear and Forge are trading at just 26%, 22% and 31% of their tangible values, respectively. That could offer potential investors a large margin of safety, given the high risks involved.

Further research and investigation would obviously need to be conducted, but on face value it appears that investors value these companies’ assets at much less than they are recorded on the balance sheet, and are disregarding the viability of these companies going forward by valuing the actual business at less than zero. And in many cases the market may be right.

With ongoing cuts to mining capex, the pool of contracts for mining services companies will get smaller. Those companies that survive are likely to see their margins pressured until the cycle turns once more.

Foolish takeaway

This is only a simplistic overview of the cigar butts in the mining services sector, but for those Foolish (uppercase ‘F’) investors keen to get their hands dirty, a dig through the market’s trash may reveal one or two gems hidden amongst the dross.

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Motley Fool writer/analyst Mike King owns shares in Forge Group. You can follow Mike on Twitter @TMFKinga

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