The share price of Monadelphous Group (ASX:MND) has suffered over the past year. Most recently, it been impacted by:

i) Lower-than-usual activity levels in its Maintenance and Industrial Services division,
ii) Reduced levels of demand within the oil and gas sector arising as a result of lower offshore/FIFO work,
iii) Uncertainty on the cash impact from an insurance claim by Rio Tinto,
iv) Concerns about a tapering iron ore CAPEX profile and v) The extent to which group margin can recover over the medium term.

With the share price recovering well since our recent report, we consider whether MND still offers value at current levels.

About Monadelphous Group

MND provides construction, maintenance and industrial services to the resources, energy and infrastructure sectors and operates primarily in Australia. They have smaller overseas operations in NZ, China, PNG, Mongolia, and the US. The Company operates through two key divisions: Engineering Construction and Maintenance and Industrial Services (‘Maintenance’).

Key Fundamental Considerations

Factors Supporting Revenue Outlook

The Company reported an 11% increase in group revenue in 1H21, as the Company benefitted from progressive work on resource construction projects, the resumption of work after COVID-19-related delays in 2H20 as well as a significant ramp-up in iron ore activity.

In its outlook commentary, MND noted it was expecting the iron ore sector to provide a steady flow of construction and maintenance opportunities. Offsetting this is declining demand in the oil & gas sector (with a recover unlikely in the short-to-medium term) and a near-term lull in the renewable sector. Maintenance activity is expected to grow steadily.

Looking forward, the pipeline of activity in mining looks robust, notably in iron ore. To this end, we note a number of new contract wins. MND also expects new opportunities to emerge in lithium, gold, and copper.

Gradual Recovery in Group Margin Still Expected

Margin performance is a key focus for investors, given that the Company has faced EBITDA margin pressure over the last 5-6 years as a result of the change in the business mix that has seen an increasing portion of the Company’s revenues being derived from the lower-margin Maintenance division. Further, pre-COVID-19, EBITDA margin growth was challenged by a competitive market, cost-conscious customers and a tightening labour market that resulted in increased labour costs. Relative to historical trends, group margin is at a low base after falling from historical levels.

While higher labour costs likely to remain a constraining factor, we continue to expect EBITDA margin improvement out to FY23, driven by a number of factors:

• MND typically has a solid pipeline of work, supported by new contracts & extensions.
• The Company continues to effectively managing its cost base.
• Industry conditions are now more favourable. Order books are full and terms & conditions for contracted work are expected to be more balanced as the sector seeks to recover from a period of low margins & COVID-19. To this end, MND has one of the best risk management track records in the sector (i.e. in terms of repeat work for repeat clients).
• The mix of work is expected to shift towards the higher-margin Engineering Construction division (i.e. from 37% of group sales in FY20 to 43% in FY21), where the revenue outlook over FY21 to FY23 has improved due to an expectation of further new contract wins; the deferral of work into FY21, as well as the ramp-up of large resources projects.
  How well is MND Positioned to Withstand a Decline in Iron Ore CAPEX?

Recent indications that the iron ore CAPEX profile over the near-to-medium term (in particular from the majors) will taper off is a key risk to expectations of margin expansion. While declining iron ore CAPEX is a risk to margin given that iron ore work accounts for over 50% of group revenue, we note the presence of a number of offsetting factors. Firstly, there remains a significant $3b iron ore mine replacement CAPEX pipeline in large scale Structural, Mechanical & Piping (SMP) and Electrical & Instrumentation (E&I) work. As previously alluded to:

• The Company has a reasonably high degree of success in winning contracts and the competitive landscape for tenders has changed, which potentially advantages MND.
• A solid portion of iron ore work is likely to remain – underpinned by ongoing capital and operating expenditure to sustain high production levels. Thirdly, there is a building pipeline in other resources (i.e. lithium, gold, copper, nickel and hydrogen).

Strong Balance Sheet Position

The strong net cash position and typically high levels of cash conversion have supported dividend payments – allowing the Company to maintain a dividend payout ratio of 70-90%. The balance sheet position also provides the Company with the opportunity to pursue Merge & Acquisition (M&A) opportunities, particularly with respect to infrastructure. We expect MND to resume its pursuit of M&A/growth opportunities given that a recent insurance claim by Rio Tinto has been settled out of court and is covered by the proceeds of insurance (i.e. there is no impact on the current net cash balance).

Fundamental View

There are a number of factors that support a potential re-rating in the shares:

• The premium at which MND has historically traded relative to its ASX-listed contractor peers (CIM, DOW and WOR) has reduced. Over time, we expect this premium rating to be restored, as MND has a high-quality maintenance business and its earnings are better leveraged to a recovery in both mining CAPEX and Oil & Gas activity.
• An improvement in labour availability as the COVID-19 vaccine is rolled out and as borders open up are likely to result in EBITDA margin recovering more strongly than forecast.
• The out-of-court settlement of the Rio Tinto claim removes an overhang on the shares and allows the Company to resume its pursuit of M&A/growth opportunities. In addition, the fire incident (which was the subject of the insurance claim) has not prevented material contract wins by MND with Rio Tinto since January 2019 (the date of the fire incident), including two contracts secured in 1H21 in the Maintenance division.

Charting View

The correction since December now appears to be over. In the last few weeks we have seen MND put in a couple of higher lows and a higher highs. The move higher in the last week has also been on increasing volume. It therefore appears as though MND is at the start of its next rally and we expect the share price to increase further from here.

 

Michael Gable is managing director of Fairmont Equities.

 

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