- Engineering and Contractor sector results met expectations
- Weak macro outlook a threat to earnings
- Higher costs and margin pressures also an issue
- Brokers highlight their sector preferences

By Chris Shaw

For Australian engineering and contracting companies the recent FY11 reporting season was largely a case of delivering results in line with expectations rather than beating market estimates. Earnings per share growth in average came in at 15.7% according to UBS, while balance sheets improved as debt levels declined.

Highlights in the period were sales growth and some margin expansion, BA Merrill Lynch noting this was particularly the case for early cycle plays, these companies benefiting from higher capacity utilisation.

The major issue to emerge from reporting season according to BA-ML is a worsening macroeconomic environment threatens to derail what are currently optimistic earnings growth forecasts. This suggests some economic stability and a re-acceleration of global growth will be the major sector driver from here, as at present it is difficult to justify being more optimistic regarding forecasts.

For BA-ML this uncertainty means late cycle plays offer the greatest opportunity to outperform as new contracts should deliver some increase in margins. In contrast, early cycle companies will be more heavily reliant on capex to deliver incremental earnings growth.

At the same time, Deutsche Bank notes increasing levels of competition are generating some margin pressures on new contracts. This is especially the case in relation to electrical and mechanical work in the resources sector and infrastructure maintenance work.

A key risk in Deutsche's view is labour costs, as companies that need to increase their headcount in Australia in particular may experience additional margin pressure given the ongoing wage rises in recent years.

The other issue for Deutsche Bank is the prospect of a further deterioration in operating cashflows across the sector in FY11, thanks to both problematic contracts and weak market conditions. Deutsche sees scope for this trend to extend through FY12.

UBS is more positive, suggesting the outlook for the mining services industry in general could be strengthening given a solid level of contract announcements recently, contractors being locked in for significant periods of time and ongoing tendering activity on projects yet to reach a final investment decision.

For UBS, investors should focus on quality, growth and valuation when considering investing in the mining services sector. Building a matrix including these variables leads to NRW Holdings ((NRW)), Monadelphous ((MND)) and Fleetwood ((FWD)) generating the highest scores according to UBS. All three stocks score Buy ratings.