ALS Ltd (ALQ) recently upgraded its earnings guidance for the 12 months to 31 March 2023 (FY23). The upgraded guidance reflects the underlying strength of the core divisions and its leverage to resilient key end markets. The Company also noted that economic headwinds continue to be well managed through price and cost discipline. With the shares having recovered since the release of the trading update in late March, is there scope for further recovery in the shares?
Overview of 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. 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.
iii. The Industrial division is a leading provider of diagnostic testing and engineering solutions for the energy, resources, transportation, and infrastructure sectors.
Key Fundamental Drivers
Commodities Division Supported by Favourable Macro Trends
The Commodities division reported organic growth of 27% for 1H23, with EBIT margin of 31% ahead of expectations. At the 1H23 results release, ALQ noted that while Commodities volumes were flattening, enquiry levels were high, which supported further price rises in 2H23.
The outlook for the Commodities division has improved in recent months. This is seen by continued growth in financing for junior exploration companies, stronger commodity prices supporting miners’ balance sheets and cash flow generation, major and mid-cap mining companies reporting ongoing or expanded exploration budgets for the current calendar year and a growing contribution from battery metals. Further supporting exploration investment has been the depleting reserve rates across the mining industry, with miners shifting away from shareholder returns and back to growth. These factors support earnings upgrades for the Commodities division in FY24/25.
Pricing Strength & Acquisitions Support Margin Growth for Life Sciences
The Life Sciences division reported a 99 basis points decline in EBIT margin in 1H23, to 17.0%. The decline in EBIT margin was due to economic conditions, geopolitical conflicts, and dilution from recent acquisitions. In the 1H23 period, ALQ completed eight acquisitions, seven of which were in Life Sciences. At the 1H23 results release, the Company pointed to an improvement in EBIT margin over 2H23, on the back of procurement initiatives, resilient demand for essential Testing, Inspection and Certification (TIC) work and price increases in order to better recover higher costs.
Long-Term Targets Support Investment Appeal
As per the financial targets for FY23-27 outlined by ALQ in August 2022, the Life Sciences division will be the key pillar of future revenue and earnings growth, with the expected growth rate of 14% over FY23-27 to exceed the rest of the group. This rate of revenue growth is expected to be achieved equally from organic growth given increasing regulatory demand (i.e. global sustainability) as well as further bolt-on Merger & Acquisitions.
The key factor underpinning group revenue growth to FY27 is that the global TIC market is expected to grow from US$221b in 2022 to US$269b in 2027, with drivers including more regulation & outsourcing, greater consumer awareness, technology development, sustainability and energy transition related demand. ALQ expects its key markets to outpace overall market growth given exposure to higher growth environmental, life sciences and food markets.
Over the FY23-27 period, ALQ also expect to achieve its FY27 EBIT margin target (>19%) by further margin expansion in Life Sciences, via price management, a shift to higher-margin businesses, a focus on hub and spoke model, as well as achieving cost efficiencies via the standardisation and automation of operational processes.
Further, the earnings cyclicality of the Commodities division is likely to reduce, with earnings to become less reliant on cyclical commodity pricing/financing conditions for junior miners; and more subject to larger demand themes like ‘decarbonisation’ and ‘electrification’.
Balance Sheet Capacity Remains for Further Acquisitions
As at 30 September 2022, gearing (on a net debt to EBITDA basis) was 1.9x and unchanged from 31 March 2022. While the level of gearing remains at the upper end of the recent range, it is still well below the covenant level of 3.25x. The receipt of proceeds from the sale of the Asset Care business ($80m) has since reduced the gearing level to ~1.8x.
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, with gearing at the top end of this range likely to be comfortably managed given the 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.
ALQ provides an attractive alternative exposure to the resources sector, as well as a defensive earnings profile via the Life Sciences division. Further, the EPS growth profile (6% over FY23-26 on a CAGR basis) appears be conservative in light of:
i. The potential for earnings upgrades on the back of evidence of a steadier earnings profile for the Commodities division. The 5-year growth targets outlined by ALQ assume minimal growth in Commodities which reflects an elevated point in the cycle and likely conservatism. Accordingly, there is potential for upward earnings revisions in the event that the Commodities division can demonstrate earnings growth on a ‘through-the-cycle’ basis, and
ii. The likelihood of further acquisitions in the Life Sciences division, which is supported by significant balance sheet and free cash flow capacity.
Following the recent gain in the share price, ALQ is currently trading on a 1-year forward P/E multiple of ~19x. While this multiple remains below the average over the last two years of ~21x, ALQ shares have historically presented better value when the discount has been larger. The FY23 results are due on 29 May 2023, and this may provide the next catalyst for the shares. It is also worth noting that ALQ has a history of beating guidance.
ALQ has rallied hard in the past few weeks and it is now coming up to a major resistance level just under $14. An upside break would be very positive from a long-term perspective and should lead to higher prices. Otherwise a shorter-term dip back towards $12 would provide better value.
Michael Gable is managing director of Fairmont Equities.
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