Is ALQ still a value trap?

ALS Ltd (ASX:ALQ) shares recovered from a 1-year lows in November. However, the recovery was short-lived. Recent weakness prompted us to research ALQ in The Dynamic Investor to assess whether current levels present a more attractive entry point.

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 FY23, the Company now has two operating divisions:

i. The Life Sciences division, which provides analytical testing and sampling services and remote monitoring for several markets. These include Environmental, Food, Pharmaceutical, and Consumer Products.
ii. The Commodities division, which 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). It also has the largest and best network of geochemistry locations and largest investment in capacity of any peer in recent years.

Key Fundamental Drivers

Several Factors Supporting Margin for Commodities Division

There is upside risk to EBIT margin forecasts (currently above 30%) for the Commodities division over the medium term. The upside, from both continued organic growth and further pricing/mix benefits. To this end, ALQ expects positive organic growth across its Commodities portfolio, with EBIT margin to be maintained above 30%. Over the medium term, we expect EBIT margin to be supported by several factors:

i. Sample volume cycles have been shortening and peak-to-trough changes have moderated.
ii. The revenue base is becoming less reliant on sample flows, with increasing importance of value-added services, downstream offerings and technology. As evidence, exploration drilling metres in Australia have fallen however the amount spent has remained elevated.
iii. Decarbonisation tailwinds will help keep a floor on volumes (and margins in downcycles), as exploration of metals like copper continues to grow. In particular, the shift to energy transition metals such as copper/ lithium is supportive of price/mix strength.
iv. ALQ’s geochemistry market share (based on revenue as % of exploration spend) is currently only ~4%, As such, the Company is well placed to benefit from any increases in exploration activity/spending. This is because the latter is likely to be higher-margin work given the trend towards improved pricing and mix.
v. Capital raising activity is expected to be higher in FY24 after a deceleration in activity over FY23 due to higher interest rates and financial market volatility. In context, capital raising activity in the resources sector is an important determinant of junior exploration activity and hence sample flows. ALQ tends to see sample flows 2-3 months after raisings.

Underlying Performance for Life Sciences Undermined by Recent Acquisition

The Life Sciences division comprises 58% of group revenue. Similar to the Commodities division, the Life Sciences division has diversification via several verticals. It is also quite defensive given that a high portion of revenue is derived from Environmental testing. The latter is a higher-margin vertical and has strong growth prospects due to the recent introduction of legislation designed to prevent the health effects of Per- and polyfluoroalkyl substances.

In July 2021, ALQ acquired a 49% interest in Nuvisan. Nuvisan is a Euro-based pharmaceutical testing business, with six sites in Germany and France. Nuvisan is a lower-margin business compared to ALQ’s core businesses and its performance since acquisition has weighed on overall earnings and margin for the Life Sciences division.

ALQ has announced it is undertaking a strategic review of Nuvisan, with a decision expected in early calendar year 2024. The Company has a call option to acquire the remaining 51% interest in Nuvisan.

Balance Sheet Capacity Remains for Further Acquisitions

Gearing (on a net debt to EBITDA basis) as at 30 September 2023 was 2.0x. While gearing remains at the upper end of the post-COVID range, 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.

The Company previously commented that it 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 forecast, 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, which is at a discount to the average multiple over the last two years of ~19x. We contend that the current multiple is unappealing in the context of an EPS growth profile of ~5% over FY24-26 on a CAGR basis, as well as uncertainty around whether ALQ exercise its purchase call option on Nuvisan, which remains an overhang on the shares.

Further, while there is scope for EBIT margin expansion in the Life Sciences division, these are not likely to be evident until FY25. To this end, we contend that these factors are unlikely to drive a re-rating in the shares, given that:

i. EPS growth in FY24 is expected to be slightly lower than FY23 and
ii. Nuvisan is likely to continue to weighing on sentiment – regardless of the outcome of the strategic review.

Charting View

ALQ has traded sideways since mid-2021 and it has formed a clear line of resistance during that time. It is currently sitting right under that line which means we need to see whether it wants to break higher or not. A weekly close above $13 would be an upside break and that would indicate that the stock is ready to trend higher again. In other words, an break above $13 would be a buy signal. Otherwise, we could see ALQ drift back towards support under $11 which would provide investors with a cheaper entry level.

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


Michael Gable is managing director of Fairmont Equities.


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