ALS Improves Strategy For Earnings Diversity

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ALS continues to make good on its strategy to increase earnings diversity, acquiring two businesses in the global energy sector: Reservoir Group, a global provider of oil and gas services, and Australian based niche gas testing business Earth Data. These acquisitions make strategic sense.

In addition to exposure to large and growing sectors, it provides opportunities for ALS to grow revenue and profitability by leveraging its brand and expertise in analytical testing, a small part of Reservoir’s current business. The AUD 579 million paid for Reservoir and AUD 18 million for Earth Data will be funded with a combination of new debt, existing cash reserves, and a 1 for 11 renounceable rights issue.

The announcement also provided a disappointing trading update. Weaker-than-expected minerals earnings and a softer outlook for coal are driving first-half fiscal 2014 NPAT guidance down 23% to 30% on last year. But our thesis of competitive advantages through technical expertise, reputation, costs in establishing a global network, and accreditation approvals remains intact. Adjusting the forecasts to include the acquisitions, equity raising, and reduced earnings in mineral and coal testing, the fair value estimate is reduced to AUD 7.00 from AUD 8.00.

With the theoretical ex-rights price of AUD 9.28 at AUD 1.3 times our fair value estimate,  ALS is overvalued, and a return to strong growth is likely in the near term, with exploration activity of recent years buoyed by record commodity prices. High earnings uncertainty from exposure to volatile commodity markets additionally warrants a larger margin of safety before recommending the stock.

Given the downturn in commodity prices and strong cost focus by the miners,  sample volumes for the first two months of the first half are down 33% on last year, and the decline in activity has been sharper. Life sciences continue to perform well, with revenue up 13%, and while coal earnings are only slightly down on last year, with a more meaningful decline in the second half, with lower volumes and contracts renegotiated at lower prices.

Benefiting from the opening of new laboratories many expect Reservoir to achieve average revenue growth of 10% per annum over the next five years, with earnings before interest tax depreciation and amortisation (EBITDA) margins of 27%, in line with the trailing three-year average. ALS created the energy division back in April 2012, and while until now it has only housed the coal testing business, but provides evidence that this acquisition is not a spur-ofthe- moment decision to offset falling mineral testing earnings. We had expected ALS to buy its way into the oil and gas sector, then using that foothold to grow organically.

Despite additional knowledge and equipment required to provide monitoring, testing, and well development being minimal, a smaller number of businesses in the oil and gas sector (compared with mining) makes winning new customers without an established reputation difficult. But this added leverage to energy, particularly the exploration phase, does little to improve earnings certainty or build on competitive strengths. We would have preferred capital be directed into more defensive food, consumer, environmental and pharmaceutical sectors. The acquisition doubles the contribution to group EBITDA from the energy division to 20% from 9%.

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