Top issues for assessing mining services investment opportunities
Mining services presents an opportunity for investors and major lenders to benefit from the full supply chain of mining and resources from exploration drilling through to project construction and mine production.
The 37 largest mining services companies in Australia whose shares are traded on the Australian Securities Exchange have total debt of about $12.7 billion. If you measure those individual debt parcels against the relevant company’s market capitalisation you get a ratio that tells you how much stress the market considers each debt parcel is under.
That analysis indicates that roughly half of these companies with total debt of about $6.5 billion are either in distress or are at risk of getting into distress in the near future. That is just one sector of mining and resources and only looks at listed companies. It doesn’t include the medium to large private mining services companies that tend to be highly geared.
Mining Services presents its own unique risks that need to be understood, especially when managing a debt parcel that is in distress. In our view, the top 6 issues for distressed credit managers to consider in this mining services environment are as follows:
1. Counterparty risk
Where does your customer sit in the supply chain and what counterparty risks may be involved? This analysis should go further than simply understanding the credit position of the customer’s clients. What suppliers is your customer dependent on to provide its service and what is your customer’s plan B if those suppliers fail to deliver. Mining Services contracts frequently include damages provisions for delays that may be outside of your customer’s control.
2. Revenue pipeline
What does your customer’s revenue pipeline look like? Mining Services providers strive for revenue consistence with predictable growth as this avoids the major effects of changes in scale. Major increases in project revenue can cause significant increases in working capital investment for mining services companies and can be difficult to fund. The corollary of that is that major reductions in project revenue require swift action to reduce expenses that can be difficult to rebuild.
Revenue consistency is achieved by having an active tendering capability with a good understanding of upcoming opportunities categorised as either won, tendered or blue sky. Near term blue sky revenue in the forecast should put management on alert of the imminent need to reduce costs.
3. Understand major cash flow drivers
Mining services contractors tend to work with a small number of large customers. Individual issues can therefore have a disproportionate effect on cash flow and it is vital that companies in distressed situations and the lenders, understand the major drivers of cash flow. Examples include:
a. Key equipment that is a major generator of revenue and cash flow. For example, in open pit mining the main excavators which will be few in number, effectively control the speed of operations and often cannot easily be replaced if they break down. A mechanical failure on such a key piece of equipment can have a dramatic effect on cash flow and profitability.
b. Many mining services providers are people intensive businesses and this creates a cash flow profile with relatively large taxation commitments from GST and PAYG. In times of restricted cash flow, these commitments are often not paid and instead used to help fund the balance sheet. If these commitments are not paid regularly they quickly become major issues for the company.
c. Major contracts may include counter intuitive default provisions that require a contractor to continue performing under the contract even in the event of non-payment.
d. It is common for mining services contractors to use equipment finance debt to part fund the balance sheet. These debt parcels are often scheduled to be repaid over a short period of time that should be supported by tenure of contracts. If contract terms change during the life of the equipment finance facility, mining services operators can find themselves unable to service the original repayment schedule. It is vital for companies to understand the repayment profile of their equipment finance facilities and the equipment that becomes unencumbered after completion of each facility.
4. Capturing variations
It is common in mining services contracts for contract variations to arise where the work to be undertaken differs from the original expectation. Often, mining services contractors tender for contracts with extremely slim profit margins on the basis that significant variations are likely to arise and the profitability on variations is much higher than the original contract works.
Contracts typically provide a procedure for the approval and assessment of work to be undertaken that is outside the original contract schedule.
It is critical that mining services contractors follow the contractual procedure for approval and assessment of contract variations; however, this is often where there is a disconnect between on site and head office management. You should try to understand the company’s formal policy for contract management and test the application of this policy in practice.
5. Contract delays
Mining services contracts usually include a schedule of how long the contract works should take and there may be contractual consequences for any delay to this schedule. One of the most common causes of delay is adverse weather conditions and contracts usually contemplate which party accepts the risk of weather delays. Even if the contractor is not liable for delays caused by inclement weather, there will be a contractual procedure to be followed and if it is ignored, it can cause significant dispute at the conclusion of a contract as to which party is liable for the delay. You should understand if the contractor has accepted any weather risk in its contracts. If it has, then you will need to make an assessment of the potential impact on the company’s cash flow of inclement weather conditions. If it hasn’t accepted any weather risk, then you should understand if it is diligently following the contractual procedure to agree weather delays in the schedule.
6. Collectability of receivables and work in progress
The balance sheet of any mining services provider is often dominated by assets classified as either receivables or unbilled work in progress. Assessing the recoverability of these assets is usually critical for any meaningful assessment of the company’s position. When you are considering any enforcement scenario in relation to a mining services company, you should enquire about the ipso facto provisions in the company’s customer contracts. These are clauses that automatically trigger in certain circumstances and are frequently termination or step in rights that arise after an insolvency event. These provisions have a profound impact on the recoverability of contract receivables because early contract termination usually gives rise to liquidated damages that will be offset against contract receivables.
This is a difficult issue that will likely require professional legal and commercial advice but is essential in any distressed scenario.
There are of course many other issues to consider for mining services companies and each borrower will have its own unique issues; however, we have found that the issues that outlined here are the most common recurring themes for distressed mining services companies.
If you would like to know more, please don’t hesitate to give us a call.