Shares in Monadelphous (ASX:MND) have recovered off their recent lows, as evidence has emerged that labour constraints were easing. We recently researched the Company in The Dynamic Investor to assess whether a recovery in the shares was sustainable.
Overview of Monadelphous Group
The Company provides construction, maintenance and industrial services to the resources, energy and infrastructure sector. It operates primarily in Australia, with smaller overseas operations in NZ, China, PNG, Mongolia and the US. The Company operates through two key divisions: Engineering & Construction (‘E&C’) and Maintenance and Industrial Services (‘Maintenance’).
Key Fundamental Drivers
Labour Constraints Appear to be Easing
At an industry level, labour availability pressures over the past 24 months have constricted mining contractor industry productivity and the ability to source new contracts and resulted in cost inflation pressures. This has ultimately impacted earnings and margins, despite record levels of activity.
MND expect a softer revenue outlook for the E&C division over the remainder of FY23, before ramping up towards the end of FY24. The softer revenue outlook is due to continued delays in both contract awards and commencements in projects, especially given significant labour constraints in Western Australia (WA). These delays are broad-based across MND’s sectors and mainly due to delayed approval and front-end engineering (i.e. ongoing labour challenges), as opposed to project economics or costs. To this end, significant labour constraints/shortages represent the key challenge to new project awards/commencements. As such, there was an expectation that lower project awards as a result of delays in the timing of project awards. Commencements would weigh on the short-term earnings outlook, before a potential recovery into the back end of FY24.
At the time of the 1H23 results release, MND were not seeing any meaningful improvement in the labour market and commented that they had expected the labour market will be tighter over the following 12 months. However, there has been recent evidence that some key hurdles to higher skilled mining labour availability such as visa turnaround times and slower wage growth have recently diminished. This is a positive catalyst for the mining services industry and the trajectory for underlying EBITDA margins heading into FY24. Accordingly, this underpins expectations that labour pressures may ease over the next 6-12 months through 1H24, with the first indication of this to be seen through lower industry job vacancy rates.
Company-Specific Measures to Manage Cost Pressure
MND is managing wage inflation well through robust pricing as demonstrated by rising margins, notwithstanding that increasing labour costs can be difficult to recover from the customer. This is particularly in relation to the E&C division where often contract prices are fixed.
These factors support an improved EBITDA margin outlook over the medium term, as i) The proportion of higher-margin engineering construction work increases relative to lower-margin maintenance and industrial services work and ii) Labour shortages ease.
Well Placed for Further Contract Wins
Aside from improving labour conditions supporting expectations for a recovery in revenue growth in FY24, elevated commodity prices underpin supportive conditions for new project investment. The Maintenance division is expected to report low double-digit revenue in growth in FY23/24. Maintenance activity should continue to be supported by buoyant energy/mining production, and ageing assets across all resources and energy sectors.
Aggressive competition for projects has seen MND miss out on some larger opportunities over the last 12 months. However, it is worth noting that management have been more conservative over the last 12-24 months when it comes to bidding for new work, given little spare capacity within the business.
Whilst missing out on some large opportunities is a short-term cost to earnings, this is arguably positive over the medium term in order to preserve MND’s scarce labour capacity and optimise margin opportunity.
The Company is seeing a significant number of prospects across a broad range of commodity markets, highlighting opportunities from high battery metals demand and Australia’s energy transition (hydrogen and wind). MND also notes favourable conditions in Oil & Gas.
According to MND’s 1H23 results presentation, the outlook for key end-market exposure is mostly favourable, with the Company considered well placed to win a good share of work in iron ore, lithium, gold, copper, nickel and hydrogen.
Fundamental View
Key fundamental attractions include: i) Additional evidence of easing labour constraints, which provide upside risks to current consensus earnings forecasts, ii) Exposure to a strong CAPEX outlook for key end markets and iii) Yield appeal, as a strong net cash position ($190m as at 31 December 2022) and typically high levels of cash conversion have supported dividend payments – allowing the Company to maintain a dividend payout ratio of 70-90%.
At current levels, MND is currently trading on a 1-year forward P/E multiple of ~18.5x, which is below its 5-year average but above its 2-year average of ~17x. MND shares have historically presented better value when its discount has been larger. Accordingly, we consider lower levels to be a more attractive entry opportunity. This is especially as a lower P/E multiple relative to an EPS growth profile of 10% over FY22-25 on a CAGR basis would make the risk/reward profile more appealing.
Charting View
Monadelphous has traded well since the March lows, and recently it broke above resistance near $12.80. However, volumes have been light on the way up so it has been no surprise that MND has struggled to make much more progress. By falling back under that $12.80 level, we are now expecting it to swiftly head back into the high $11’s. Investors are advised to wait for that cheaper, and more sustainable entry point.
Michael Gable is managing director of Fairmont Equities.
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