The Motley Fool

Mining services: Value or value trap?

Warren Buffett once remarked that you “should try to be fearful when others are greedy and greedy when others are fearful”. However, like so many his insights, this one is often quoted out of context, rendering it trite and impractical.

Though the market is often irrational, it is a dangerous mistake to assume every price fall represents a buying opportunity. Many an investor, having anchored on a previously higher price, has been lured into a so-called ‘value trap’.

Consider the recent debacle with Forge Group (ASX: FGE). When the business’ troubles were first revealed, shares dropped by over 80%. The temptation was significant for many bargain hunters, and in fact for a short time the decision to “be greedy when others were fearful” looked to be the right move. Sadly, it now looks like the business will not recover from its ills and shareholders will likely lose all their money.

Bargain hunters beware

While it may be too late for Forge, shareholders in Austin Engineering (ASX: ANG), which manufactures and services mining equipment, are facing a similar dilemma.

Although the past decade has been truly spectacular for the business, and shareholders, the company has recently experienced somewhat of a fall from grace — shares are presently less than half what they were a year ago and earnings have likewise tumbled. The $64 million question is: are shares in Austin now a bargain or another Forge-like value trap?

The pendulum swings

When customers are cashed up and demand is high, businesses like Austin have plenty of work and enjoy high margins. But when work starts to dry up, both margins and volumes suffer, and the turnaround can be very sudden indeed.

With lots of high fixed cost plant & equipment, a drop in revenue can have a much bigger impact on profit, and indeed this is exactly what Austin has experienced. In the most recent half, revenues declined by 32% which resulted in a 95% fall in net profit. Moreover, the company further downgraded its guidance for the full year.

So is this a temporary setback, or a sign of things to come?

Reasons to fear…

The bears will point out that customers could well continue to defer their expenditure for some time yet, and further work could well be lost in the meantime. In this scenario, Austin is left with lots of idle, and expensive, assets, a reasonably significant debt burden, and plenty of write-down potential.

At the end of the most recent half, the business was perilously close to break even, and it won’t take too much of a decline in revenues to turn the business into a loss-making operation. The best management team in the world can’t alter the fact that the business is in no small degree hostage to the fortunes of the broader mining sector.

If demand does not improve soon, and there is no guarantee that it will, buying at today’s price will certainly prove to be a value trap.

… And to be greedy

The bulls will say that unlike many of the mining services companies, Austin is exposed to the production phase of mining, not the development phase. Mining investment may well have peaked, but the volume of mining is, supposedly, set to substantially increase in the years ahead.

Though Austin’s clients have deferred replacing equipment, this is simply not sustainable. Not only will demand return, they say, but the contribution from recent acquisitions will also help underpin revenue growth.

As such, say the bulls, volumes will lift, utilisation will improve and profit growth will return. In this scenario, the present price does indeed represent good value.

Foolish takeaway

When others are fearful, great bargains can be found. But not all fear is baseless, and in this instance the market is right to be cautious. For those considering buying, don’t base your decision on the fact that shares are (far) lower than what they were, but rather on what has changed with the underlying business, and what you believe the future will bring.

If you get it right, your courage could be well rewarded. If wrong, your hubris could cost you significantly. Over to you.

Attention: If you’re looking for quality shares that have been selected based on quality and strong dividends, Foolish, dividend loving investors can click here to request a Motley Fool free report entitled Secure Your Future with 3 Rock-Solid Dividend Stocks.

 

Andrew Page is a Motley Fool analyst. He owns shares of Austin Engineering. You can follow The Motley Fool on Twitter @TheMotleyFoolAu. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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