Weir’s Strong Mining Business Holding Up Well, But Exiting Oil & Gas Could Take Time (OTCMKTS:WEGRY)
This is a bad time to have exposure to oil and gas capex, and fracking machinery in particular, as the vast majority of the North American fleet is idle and there’s really no demand for either new equipment or aftermarket parts. It’s not such a terrible time to be in the mining equipment business, though, and Weir Group’s (OTCPK:WEGRY) (WEIR.LN) strong aftermarket-driven business has held up quite well during this downturn.
Although I was already expecting a weaker outlook for oil/gas when I last wrote about the company, I wasn’t expecting what COVID-19 would ultimately do to the company’s core markets, and the shares have underperformed, including underperforming other mining names like Epiroc (OTCPK:EPOKY). Although I expect healthier demand for mining equipment in 2021, and I think the negative impact of oil/gas is probably more than amply reflected in the share price, it’s going to be an issue for sentiment until management sells the business. I do still see fairly attractive long-term upside here, but in the near-term outperforming the likes of Epiroc and Metso could be difficult so long as oil/gas remains so weak.
Mining Has Held Up Really Well…
Weir’s strongest business is its mining business (the Minerals segment and the mining-related businesses within ESCO), and it has held up well during this downturn. It certainly helped matters that mines were deemed essential operations in almost every jurisdiction and even at the peak, only about 5% of mines around the world were closed. It also helps that Weir is much more heavily-leveraged to minerals where ongoing activity has remained stronger (copper, gold, and iron, relative to coal). Last and not least, the significant aftermarket leverage of this business (more than 70% of sales) has been a crucial driver, as mines that wish to stay active have no choice but to maintain their slurry pumps, cyclones, and so on.
Revenue in the Minerals business declined only 4% in the first half of 2020, with segment-level margin actually up slightly (10bp) to 17.3%. Orders have weakened, but were down only 7% in the first half (after a 5% decline in the first quarter), with original equipment orders down 9% and aftermarket down 6% – more or less in line with the company’s high-quality European peers. While management didn’t provide specifics, they did characterize the ESCO mining business as “resilient”, though infrastructure-related activity has been weaker.
Again, I believe Weir’s strength is structural. The company has strong share in equipment categories like slurry pumps, dewatering pumps, positive displacement pumps, and other mill circuit components, and many of these components have significant annual aftermarket requirements. While Weir doesn’t have quite the same exposure to wear parts as Epiroc or Metso, it’s not far off and products like slurry pumps generate about 100% of the original equipment cost in annual aftermarket revenue.
Weir is also advantaged in that its equipment facilitates more efficient operations. Companies like Caterpillar (CAT) and Komatsu (OTCPK:KMTUY) have seen mine operators run their truck fleets for much longer than before (nursed along by refurbishments/rebuilds), but mine operators have been more active in investing in mill circuit equipment to improve overall mine efficiency, as more automated ore-handling reduces labor needs, as well as the need for trucks and related equipment.
… Oil & Gas Has Not
In contrast to the mining business, Weir’s Oil & Gas business is putting up some awful numbers. Revenue fell 48% in the second quarter, EBITA dropped to a loss, and orders plunged 68% as E&P companies have stopped drilling and service providers have stacked their fracking rigs. As a leading provider of pumps, flow iron, fluid ends, valves, and so on, Weir is getting hammered by that steep decline in drilling activity, as companies don’t need aftermarket parts to maintain equipment they’re not using (nor do they need new equipment).
I’m not optimistic on a quick turnaround here, as the damage being done to E&P balance sheets is going to linger on and impact capital equipment demand for some time. While the multiyear decline I previously expected may not happen now, it’s only because the initial decline in 2020 has been so much worse – it may well take more than five years for Weir to regain 2017-2019 levels of demand.
I had previously said that I thought that the company should consider disposing of the Oil & Gas business and management announced after fourth quarter/second half results (back in February) that it was their “intention to maximize value from Oil & Gas at the right time,” with subsequent commentary since confirming that the preferred option would be an outright sale of the business.
I don’t envy the decision in front of Weir management now. There’s no way the company could get anything close to real fair value for its Oil & Gas assets today, and I’m really not sure how long it may take. The 2017-2019 period didn’t surpass the prior peak for the business, and the damage done to North American upstream capex spending capacity looks severe. Higher oil and gas prices could fix that, of course (or at least accelerate the recovery), but you can’t count on that sort of windfall. While I think the multiples on Weir shares would expand if they rid themselves of the Oil & Gas business quickly, I think management wants to maximize the value of the asset and they’re going to have a delicate balancing act between the short-term demands of institutional investors and the long-term best interests of the business.
Although Weir has an excellent mining business, that does come with an asterisk. The strong leverage Weir has to “rain or shine” aftermarket spending is great in times like these, when miners aren’t buying new equipment, but it does also mean less leverage to spending recoveries. So while I believe that mining equipment could grow double-digits next year on a sector-wide basis, I very much doubt Weir will see that kind of growth. Longer term, the company is leveraged to ongoing growth in mining capex, particularly as more mining heads underground, but there are other companies that will have more near-term upside from that 2021 capex recovery.
The timing of a sale (or maybe a spin-out) of Oil & Gas is a significant complicating factor when it comes to valuation, but I’m valuing Weir as though the business remains. I’m expecting Weir to remain a mid-single-digit grower long term, with better results in mining offset by weaker results in oil/gas and somewhat weaker growth from the infrastructure side of ESCO. A greater skew to the higher-margin mining business will help margins, and I believe management will be able to successfully neutralize the drag from the Oil & Gas business – obviously the company produce the margins it could as a pure mining/infrastructure company, but I think there’s a lot management can do cut costs and drive long-term FCF margins into the low double-digits, supporting mid-to-high single-digit FCF growth.
The Bottom Line
Weir isn’t clearly undervalued on a near-term basis, though it does seem more reasonably valued than Epiroc. If you want bargains, you need to look at names under even more stress like FLSmidth (OTCPK:FLIDY). Still, I do see the potential for high single-digit annualized returns here, and I do believe the shares would rerate higher if management found a way to exit the Oil & Gas operation on a faster timeline. As is, I’d call this a borderline buy, but with the shares having been pretty strong over the last three months, I’d prefer to wait for a better entry price.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.