We recently reviewed ALS Ltd (ASX:ALQ) after the Company released its results for the financial year to 31 March 2020 (FY20). With a 31 March balance date, the result did not encapsulate any real impact from COVID-19 and so in itself is not as significant as the outlook for the Company’s three operating divisions in light of COVID-19. The key factors we consider in this note are: i) The extent and timing of a recovery in earnings and ii) The scope for the Company to use its balance sheet to both withstand the earnings decline in FY21 and continue its strategy of pursuing acquisitions.
About ALS Ltd
ALQ is a leading testing, inspection, certification and verification company, with operations in over 65 countries. The Company has three operating divisions:
i. The Life Sciences division provides analytical testing and sampling services and remote monitoring for the Environmental, Food, Pharmaceutical, and Consumer Product markets.
ii. The Commodities division is a leading full-service provider of testing services for the global mining industry across Geochemistry, Metallurgy, Inspection, and Coal Quality.
iii. The Industrial division is a leading provider of diagnostic testing and engineering solutions for the energy, resources, transportation and infrastructure sectors.
Key Factors Underpinning the Outlook
The Company has not provided formal earnings guidance for FY21, which is a move away from traditional practice. However, the Company noted that group sales for April fell by 9% in comparison to April 2019. This is despite solid exploration-related equity raisings and exploration activity in April.
The Company noted stable trends in both Minerals and Life Sciences over the past several months despite meaningful volume declines. ALQ’s ability to hold these trends over the next several months will be key to the Company’s recovery trajectory over 2H21.
Life Sciences Earnings Leveraged to Volume Recovery
The division’s revenue stream is highly defensive. However, it is not totally immune from a slowdown in volumes. Around 80% of divisional revenue is derived from Environmental testing. The remaining portion of revenue is derived mainly from Food & Pharmaceutical testing. Within the Environmental sector, 70-80% of work is driven by regulatory requirements and is relatively stable. This is because it is driven by services deemed essential to support critical infrastructure (i.e. energy, defence) and human health (water, food & medicine). The other 20-30% is project driven and thus more discretionary. Further, trends in Food & Pharmaceutical are resilient.
EBIT growth in FY21 is expected to be ~15% lower on the back of volume headwinds. This is especially given that the macro backdrop is likely to remain muted once restrictions are lifted through its Environmental segment.
Prior to the COVID-19 outbreak, the Company was making solid progress towards its EBIT margin target of 16-17% for the Life Sciences division. However, the EBIT margin for FY20 came in at 15.3% as a result of the temporary and mandatory lockdowns brought about by COVID-19. EBIT margin is not expected to recover back to the 16-17% target until in FY22
Can Commodities Recover Quicker than Expected?
The main reasons for the 3% earnings decline for the Commodities division in FY20 was that geochemistry sample flows declined by 9% in FY20, as both established mining customers and junior explorers reduced their activity spending levels. Subsequent to FY20, geochemistry sample volumes for April were down 30% at the end of month, as a result of global mining restrictions from COVID-19.
In terms of the outlook, ALQ commented that gold, iron ore and copper-related services remain solid, however oversupply in coal and low process are reducing market activity in the short term.
With headwinds from COVID-19 to persist through 1H21, we expect a strong recovery in earnings in 2H21. This would be underpinned by:
i. More stable operating conditions in mining markets as site operating restrictions are lifted. Some of the deferred metallurgical projects are expected to commence in FY21.
ii. Continued strong gold price action. Gold price strength is supportive, given that ~50% of geochemistry volumes are related to gold.
iii. An increase in global mineral equity raisings, which are a positive lead indicator for sample flows, improved in April. In particular, equity raisings in Australia increased by 149% in the six months to May 2020 despite the number of deals being 24% lower.
At present, market sentiment towards ALQ has been impacted by concerns about the extent and timing of a recovery in earnings, which are expected to trough in 1H21. However, we consider that the key upside risk to earnings include: i) Leverage to a faster-than-expected recovery in earnings for each of the key divisions, as well as ii) A strong pipeline of bolt-on opportunities in Life Sciences, which is supported by a comfortable gearing and liquidity position.
With the shares having re-rated since our recent review and currently trading on a 1-year forward P/E multiple of ~19x (and slightly below the 5-year average of 20x), ALQ shares are likely to present more value should it weaken from current levels. Having said that, it is worth noting that the share price is typically highly volatile to corporate announcements.
ALQ has traded well off the March lows. We can see that it has been making higher highs and higher lows. The trend looks sustainable for now, and price action in the last couple of weeks is indicating to us that it wants to break the June high and continue trending. The next major area of resistance for the stock is near $8.
Michael Gable is managing director of Fairmont Equities.
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