Equity Analyst Oscar Oberg and I recently headed west to Perth where we met with various company and industry representatives. We gathered a range of valuable investment insights into the state of the Western Australian economy and in particular its mining services sector.

Our main observation: the consensus view in WA is that the worst of the state’s economic woes are over. This optimism is tempered, however, with most believing they will not see a return to rapid growth in the near-term.

Rallying on hope
Shares in mining services companies rallied strongly over the last six months. For example Ausdrill Limited (ASX: ASL) has seen its share price rise around 300% in the last six months to its peak in September. The strong share price performance of companies in the sector has been in anticipation of future earnings growth.

While investors can expect earnings growth from some mining services companies, in our view this could occur later than the market is currently expecting. It generally takes time for the big mining companies to regain confidence before they start awarding contracts. This has happened at a very slow pace.

The exception is the gold sector where there has already been a return to confidence. Businesses with exposure to the precious metal are performing well and we expect they will continue to do so into the foreseeable future.

It is hoped that the recovery of spot iron ore and coal prices in recent months is sustainable and that this translates to an uptick in work for mining services companies. To gain more confidence in the sector, we now need to see the delivery of earnings growth, which we anticipate could happen over the next one-to-three years.

Property very weak
The property market remains very weak with Perth’s median property price at its lowest point in three years. In particular, high end property values have tumbled sharply over the last few years with falls of 20% to 30% commonplace. About five years ago, basic fibro houses in the Pilbara town of Karratha were selling for around $1 million. The town has been highly
exposed to the downturn in mining and in the current market these same dwellings are only fetching about $300,000.

Banks are now paring back their lending to the property industry, particularly for high rise apartment developments. Developers’ inability to source funding from major lenders has led to increased levels of mezzanine financing arrangements being adopted.

Deleveraging trend
Another key theme we observed was the rapid deleveraging of balance sheets by WA-based companies across all industries. For example, Ausdrill has a considerable number of operational drilling rigs now in the field generating a significant amount of cash, which the company is deploying to pay down debt.

Economic outlook
In summary, a sustainable economic recovery in Western Australia will be contingent on iron ore maintaining its current price of around $60 a tonne. At this price, iron ore is well below its highs of recent years, but well above its long-term average price of around $40 per tonne.

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