Are shares in ALQ a value trap?

Shares in ALS Ltd (ASX:ALQ) have struggled this year, as several Company-specific factors continue to weigh on sentiment. Having said that, the shares have generally found support after a period of weakness. Interestingly, ALQ is trading at that point now. But as astute investors would know, this can often be a value trap. With this in mind, we consider whether there are strong enough reasons to be in ALQ at these levels.

About ALS Ltd

ALS Ltd is a leading testing, inspection, certification and verification company, with operations in over 65 countries. Following the sale of the Asset Care business in late financial year 2023 (FY23), the Company now has two 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. ALQ maintains a leading global geochemistry testing business (>30% global share) with largest and best network of geochemistry locations and largest investment in capacity of any peer in recent years.

The Commodities division is expected to account for ~60% of group EBIT in FY24.

Key Fundamental Drivers

Commodities Margin Likely to be Supported Despite Softening Volume

Geochemistry sample volume growth declined significantly towards the end of FY23. This was due to financial market instability and uncertainty regarding exploration/production financing.

As sample volumes tend to correlate with margins, a downturn in volumes is likely to lead to margin contraction in the medium term. However, EBIT margin performance is likely to be supported by several factors over the medium term:

i. Sample volume cycles have been shortening and peak-to-trough changes have moderated.

ii. Decarbonisation tailwinds will help keep a floor on volumes (and margins in downcycles). This is because exploration of metals like copper continues to grow.

iii. ALQ’s geochemistry market share is currently only >4%. As such, the Company is well placed to benefit from any increases in exploration activity/spending. Notably, the latter is likely to be higher-margin work given the trend towards improved pricing and mix.

iv. Capital raising activity is showing signs of improvement. In context, capital raising activity is an important determinant of junior exploration activity and hence sample flows. Capital raisings decelerated over FY23 on higher interest rates and financial market volatility. However, this is expected to be relatively short-term. An improvement in activity levels is expected over the remainder of this calendar year, supported by growth in copper and lithium projects. Further, junior financings have shown more recent signs of improvement, particularly in Canada.

Recent Acquisition Negating Strong Underlying Performance for Life Sciences

The major disappointment from the FY23 results was the larger-than-expected decline in EBIT margin for the Life Sciences division, to 15.5%. This compares to 16.9% in FY22. Notably, the EBIT margin for 2H23 deteriorated to 14.1%. The main reason for the larger-than-expected decline is that the acquisition of Nuvisan has been adversely impacted by a more challenging European macro backdrop.

The material impact from Nuvisan obscured some otherwise solid momentum for the division. Around 70% of divisional revenue is generated from the Environmental sub-segment. The latter reported revenue and margin growth over the course of FY23.

In its recent trading update issued at the AGM in July, ALQ noted that the broader Life Sciences division continues to be resilient. In particular, environmental testing has shown both strong organic revenue growth and margin expansion across all regions. Excluding Nuvisan, the division has delivered solid organic growth & maintained margins in comparison to the prior corresponding period.

Balance Sheet Capacity Remains for Further Acquisitions

As at 31 March 2023, gearing (on a net debt to EBITDA basis) was 1.8x, down from 1.9x in 30 September 2022. The level of gearing remains at the upper end of the post-COVID range. However. it is still well below the covenant level of 3.25x. Accordingly, the balance sheet has ample capacity for future Merger & Acquisition opportunities. To this end, the 5-year targets outlined by the Company include planned acquisitions totalling $1b over FY23-27. Typically, ALQ aims to target acquisitions that fit with existing capabilities or expand into attractive adjacent markets.

ALQ expects gearing to fluctuate between 1.6x and 2.3x over the FY23-27 period. Even gearing at the top end of this range likely to be comfortably managed. This is because of typically strong level of cash conversion (~90%) expected over the next five years.

Importantly, given the strong level of free cashflow forecasts, there is potential for the Company to fund the majority of the potential acquisitions through free cashflow.

Fundamental View

ALQ shares are currently trading on a 1-year forward P/E multiple of ~17.5x. This is at a discount to the average multiple over the last two years of ~20x. We contend that the current multiple is unappealing in the context of an EPS growth profile of ~3% over FY23-26 on a CAGR basis.

The uncertainty around whether ALQ exercise its purchase call option on Nuvisan remains an overhang on the shares. In addition, the underperformance of Nuvisan calls into question whether: i) The Company can achieve its group FY27 EBIT margin target of >19% and ii) The Life Sciences division can support group earnings on a through-the-cycle basis as earnings from the Commodities division moderates.

Charting View

ALQ has been stuck in a range for nearly 2 years now. Currently it is near the mid-point of that range. This means that for an entry point, we need to either see it back towards support near $10 where investors can run a tight stop just under $10, or it needs to push past the recent peaks near $13.50 in order to prove that it is back into the long term uptrend.

ALS Ltd (ASX:ALQ) weekly chart
ALS Ltd (ASX:ALQ) weekly chart


Michael Gable is managing director of Fairmont Equities.


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