ALS Limited (ASX:ALQ) shares have re-rated significantly since our buy recommendation in July of this year (You can get an 8-week free trial to our top recommendations here). We then recently reviewed ALQ after results for the six months to 30 September 2019 (1H20) were announced. Our key focus was on the extent to which recent operational performance, as well as the outlook, would support a further re-rating.
About ALS Limited
ALQ is a provider of professional technical services, primarily in the areas of testing, measurement and inspection across a wide range of sectors, supporting environmental monitoring, food & pharmaceutical quality assurance, mining and mineral exploration, commodity certification, equipment maintenance and asset care operations. The Company reports across three divisions: Life Sciences, Commodities, and Industrial, which account for 53%, 39% and 8% of earnings (on an EBIT basis), respectively.
Key Fundamental Drivers
Life Sciences Division Showing Continued Margin Improvement
One of the market’s long-held reservations about ALQ has been the progressive deterioration in EBIT margin to FY18 and the perceived slow pace of recovery in the EBIT margin towards the Company’s target range of 16-17%. Over the period from FY12 to FY18, the EBIT margin declined from 21.7% to a low of 13.9% in FY18. Indeed, there was some evidence of an improvement in EBIT margin in FY19, to 15.0%, albeit this was still below the target range.
Pleasingly, there was an even greater quantum in the EBIT margin improvement in 1H20, to 15.8%, as a result of the Company’s focus on cost control.
Further, ALQ commented that, despite evidence of cost pressure, it expected a further (minimum) 50 basis points expansion in the EBIT margin in FY20. This guidance was maintained at the 1H20 result release and ALQ is targeting this quantum of EBIT margin expansion annually. As such, the recovery in margin for the Life Sciences division appears to be occurring quicker than expected. In addition, the near-to-medium term outlook for the division is supported by strong organic growth and contribution from recent acquisitions.
Commodities Division Showing Resilience
The Commodities division is a leading full-service provider of testing services for the global mining industry in four key service areas: Geochemistry, Metallurgy, Inspection and Coal Quality. The Commodities division has an extensive client base that includes exploration companies, miners and traders.
Revenue growth for the division has re-based from peak levels of +20% in FY19, with low single-digit revenue growth expected in FY20. The Company has been able to withstand challenging conditions in the Commodities division, by, firstly, improving the performance of the Life Sciences and Industrial divisions and secondly, generating improved revenue performance in other segments within the Commodities division.
In 1Q20, the Company was able to mitigate the impact of declining geochemistry sample volumes from improved pricing and volume mix. A similar price/mix benefit is expected in 2H20.
Balance Sheet Capacity to Support Both Acquisitions and Capital Management
Gearing (on a net debt to EBITDA basis) was 1.9x as at 30 September 2019. With the gearing level below the maximum target of 3.0x and the covenant level of 3.25x, there is enough balance sheet capacity to support a combination of capital management initiatives (i.e. additional share buybacks) and bolt-on acquisitions.
In regards to potential acquisition opportunities, Life Sciences businesses continue to remain a key focus, especially as there is a strong pipeline of bolt-on opportunities in the Food and Pharmaceutical sector. The Company expects to execute on some of these acquisition opportunities over the next 6-12 months.
We remain positive on ALQ’s fundamental outlook. However, given the significant re-rating in the share price since the release of the interim results means that it is not cheap anymore. Having said that, there may be an entry opportunity given that the share price is typically volatile around corporate announcements (i.e. half-year/full-year results, AGM and Annual Investor Days).
The shares had been stuck in a range for the last couple of years between about $6.50 and $9. It has now broken free of that range. What we need to see now is some price volatility back towards $9 to retest the breakout and show us that it has found a new level of support. If that is the case, then we can be confident that from a charting point of view, the shares are ready to head higher.
Michael Gable is managing director of Fairmont Equities.
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