Three ASX stocks that sell ‘shovels’ to the miners

The Australian resources industry is on a tear, with the December edition of the Department of Industry, Science, Energy and Resources’ Resources and Energy Quarterly forecasting that overall export earnings will surge to a record $379bn in 2021–22 – streeting the previous record of $310bn – before falling back to about $311bn in 2022-23.

On the back of this boom, the Federal government forecasts that mining investment will grow by 4% in 2021-22 and by 8% in 2022-23, powered by the demand for Australian metals in “clean energy”. Australian investors are always looking for the share price gains to be had in mining; that has been a tradition on the Australian stock exchange since the Gold Rush. But perhaps investors should remember that wise saying from the Gold Rush, that the best chance of economic success in a Gold Rush comes from “selling shovels to the miners”. After all, whether the miner hits gold or not, they used your shovel. The Australian exchange has quite a large cohort of companies that sell some kind of shovel to the miners – here are three quite different suppliers, that all look to offer attractive value at present.

1. Alliance Aviation Services (AQZ, $4.00)

Market capitalisation: $651 million

12-month total return: 6.3%

Estimated FY22 dividend yield: 2.4% fully franked (grossed-up, 3.4%)

Analysts’ consensus valuation: $5.15 (Thomson Reuters), $5.30 (FN Arena) 

Source: nabtrade

Australian investors are attuned to the strategy of investing in the businesses that serve the resources industry as suppliers, but Alliance Aviation is often overlooked by share-hunters looking for engineering or drilling contractors.

Alliance Aviation is a plane charter business – it describes itself as a “wholesaler of aircraft capacity” to a number of sectors within Australia, and its main business is moving fly-in, fly-out (FIFO) workers around the country for mining companies.

This business generates about 70% of Alliance’s revenue, and about the same proportion of flight hours; it is spread across a wide base of mining and petroleum clients, and is predictable and recurring revenue (the average contract life over Alliance’s history is 12.1 years.) When most airlines around the world were devastated by COVID-19, the Australian mining industry was deemed an essential service: this meant that Alliance’s FIFO service not only continued, but was busier than ever, due to COVID-safe protocols limiting passenger numbers on each flight.

Alliance has 15 major clients – after adding four new FIFO contracts in FY21 – and the operation is quite well diversified among commodities, with iron ore the biggest business, at 29% of revenue, followed by gold at 19%, copper/gold/uranium (that is. BHP at Olympic Dam) at 15%, manganese 9%, nickel 8% and oil and gas at 6%.

Alliance’s other businesses include “wet-lease” flights, where it operates flights on behalf of carriers such as Qantas, and provides not only the aircraft, but the crew, to the client; as well as regular passenger transport (RPT) flight services that it operates on behalf of governments, routes where major airlines don’t fly; and also ad hoc charter flights, and aviation services.

Far from struggling as the airline industry was hammered by the pandemic, Alliance actually used the industry’s dire straits to its advantage, striking two very advantageous deals in FY21 to buy 30 Embraer E190 jets, 14 from Panamanian flag carrier Copa Airlines and 16 from American Airlines. The deal transforms Alliance’s jet fleet: most of the new aircraft will go toward expanding the company’s wet-lease work with both Qantas (which owns 19.9% of Alliance), and Virgin, servicing at least 13 new domestic routes, operating from AQZ’s bases in Adelaide, Darwin and Townsville. (Alliance tripled its debt load, to $156.3 million, to buy the new planes.)

The new aircraft will be deployed throughout FY22 and are expected to generate an extra 80,000 flying hours per year. To put that in context, total flight hours in FY21 were 37,913.

Growth in the resources sector, expansion in the wet-lease work and the return of Alliance’s own inbound tourism charter work when Australia’s border fully re-opens, post-Omicron, all underpin Alliance’s prospects. Alliance posted a record net profit of $33.7 million for FY21, up 25%, and analysts see profit rising strongly over the next few years. The company did not pay a dividend, but analysts see that resuming in the current financial year. AQZ’s outstanding performance appears to have the shares well-positioned for very solid price gains.

2. Mitchell Services (MSV, 38 cents)

Market capitalisation: $85 million

12-month total return: –31%

Estimated FY22 dividend yield: no dividend expected

Analysts’ consensus valuation: 66 cents (Thomson Reuters), and (FNArena)

Source: nabtrade

Mitchell Services is a major provider of drilling services to the global exploration, mining and energy industries, with a fleet of rigs strategically located in the world’s key exploration and mining hubs – although Australia is home to most of the business. Mitchell’s revenue mainly comes from large, multinational, Tier 1 mining clients, and is also mainly earned from work at producing mine-sites – that is, resource definition, and the mining development and production stages – as opposed to greenfield exploration drilling.

Mitchell has worked hard to diversify its revenue streams. At the overall level, underground drilling represents 55% of revenue (FY21) to surface drilling at 45%. Gold work accounts for 52.8% of revenue, with steelmaking coal at 30.7% and copper the next largest, at 9.7%. With approximately 70% of FY21 revenue derived from the gold and base metal sectors, Mitchell says it is well-placed to take advantage of any further uplift in these markets.

And it seems clear that this uplift will come. Mitchell says the outlook for drilling services demand is “the strongest we have seen since 2008”.

In August 2021, Mitchell raised $10.5 million through a rights issue, with the funds earmarked for buying up to 12 new state-of-the-art drilling rigs, which would take the fleet to just over 100. Of course, no matter how many rigs you have, they have to be working to earn money: in FY21, average operating rigs rose from 67.7 in FY20 to 71.6. For context, only seven years ago, MSV had 7.8 average operating rigs. But as broker Morgans puts it, “growth in the drilling fleet to over 100 at rising utilisation improves MSV’s leverage to the best demand conditions seen since 2008”.

The company expects the growth strategy on the back of the new rigs to deliver anticipated FY22 EBITDA (earnings before interest, tax, depreciation and amortisation) of between $40 million and $44 million – compared to underlying EBITDA of $35.7 million in FY21. Based on the anticipated size of the fleet post implementation of the growth strategy, the company expects to potentially generate between $50 million and $60 million in EBITDA, and to deliver “material” EPS (earnings per share) growth.

On the basis of this potential, Morgans describes Mitchell Services as “dirt cheap” – priced at just 6 times expected FY23 earnings. There are reasons for that – a protracted legal fight last year with contractor SMS Mining Services, in which Mitchell ultimately prevailed – hammered the share price, and as Morgan puts it, the relatively smaller size ($85 million market capitalisation) and share liquidity likely restrict institutional investor interest in the stock. Morgans says the stock “offers significant financial leverage to the current recovery.” At 38 cents, MSV looks to be a very attractive speculative buy.

3. Emeco (EHL, 92 cents)

Market capitalisation: $494 million

12-month total return: –19.1%

FY22 estimated dividend yield: 5% fully franked (grossed-up, 7.1%)

Analysts’ consensus price target: $1.51 (Thomson Reuters), $1.385 (FN Arena)

Source: nabtrade

Emeco is an equipment supplier that rents out mining equipment and machinery to companies and contractors mining coal, gold, copper, bauxite and iron ore. Emeco also provides maintenance services through its subsidiaries Force Equipment and Matilda Equipment.

The total rental fleet is close to 1,000 machines, including trucks, excavators, bulldozers, loaders and other heavy earthmoving equipment, supplied by leading brands such as Caterpillar, Hitachi, Liebherr and Komatsu. The equipment fleet is supported by Emeco’s network of maintenance and component rebuilding workshops across the country, and powered by its own proprietary asset management and fleet optimisation technology. Emeco has invested heavily in recent years to harness “big data” analytics and global benchmarking to help customers achieve optimal productivity from every machine.

The company has built a fleet optimisation technology platform called the Emeco Operating System (EOS), that tracks shift performance in real-time, enabling under-performance to be rectified immediately. EOS measures payload, dig rates, shift efficiency and machine utilisation, so that customers can both drive the productivity of the equipment harder, and strip costs from their operations. EOS is available as part of the rental service, or can be installed on customer-owned fleets.

Emeco is on the road back from a near-death experience, after the early 2010s downturn in the resources sector nearly killed it. From levels above $18 in 2007, By mid-2016 Emeco’s share price had dropped below 2.9 cents (the equivalent of 29 cents, following a ten-to-one share consolidation in November 2018), losing more than 95% of its value in just over two years as its debt level mushroomed, and the market appeared to expect it to go under. But there has been an impressive turnaround since then.

In February 2020, Emeco bought Pit N Portal, which brought with it a comprehensive hard-rock underground mining services offering, and more than doubled the company’s exposure to gold-mining. Pit N Portal has enabled the company to win projects that were beyond its capabilities previously, and has opened-up further opportunities for the core business. Emeco has been keen to more effectively diversify its commodity exposure, and Pit N Portal has done that.

In particular, Emeco had found itself over-exposed to coal, which accounted for 65% of its revenue in FY19. Pit N Portal has greatly helped with this: coal represented 38% of revenue (coking, or steelmaking coal at 24%, and thermal, or electricity coal, at 14%) in FY21, and Emeco expects this to head toward 33%–35%. However, for investors whose ESG focus precludes coal exposure, look away now: Emeco has reiterated its commitment to the coal sector, stating that coal would remain a key element of its business. “As the coal industry evolves away from Tier 1 miners, we believe our business model of providing cost effective equipment supported by a strong maintenance capability will be attractive to the new owners of coal assets in Australia,” Emeco managing director Ian Testrow told the company’s annual general meeting last November.

Iron ore is a robust part of the business, contributing 18% of revenue, with base metals and civil work making up the remainder.

In FY21, Emeco lifted revenue by 15%, to $620 million, but saw a 42% fall in reported profit, to $57 million. But analysts see a rebound ahead in profits. Emeco paid its first dividend in eight years, testament to the effectiveness of the turnaround. From here, EHL looks like it will reward buyers.

All prices and analysis at 17 January 2022. This information was produced by Switzer Financial Group Pty Ltd (ABN 24 112 294 649), which is an Australian Financial Services Licensee (Licence No. 286 531This material is intended to provide general advice only. It has been prepared without having regard to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice. This article does not reflect the views of WealthHub Securities Limited.