Stocks
This ASX share has been awarded a moat by our analysts
Along with the narrow moat rating we raised our fair value by 12%.
We upgrade ALS Limited’s ALQ moat rating to narrow from no moat, and accordingly, our fair value estimate rises by 12% to $10.20 per share. ALS may not be a household name but over the past 5 years the shares have delivered 14.72% returns per annum.
Founded in the 1880s and listing on the ASX in 1952, ALS operates three divisions: commodities, life sciences, and industrial. ALS commodities traditionally generated the majority of underlying earnings, providing geochemistry, metallurgy, inspection and mine site services for the global mining industry. Expansion into environmental, pharmaceutical and food testing areas and commodity price weakness have lessened earnings exposure to commodities.
What is a moat?
A moat is a sustainable competitive advantage. The imaginary of moat as a body of water to protect a castle is apt as a moat protects a company from competition. To offer effective protection the moat must be sustainable. A company may benefit from a first mover advantage but without the protection of a moat those advantages will be eroded over time by competitors eager to get a piece of an attractive opportunity. A company that our analysts believe will sustain a competitive advantage for 10 years receives a narrow moat rating. A wide moat rating denotes am expected 20-year sustainable advantage.
To be a great investor is to be a student of business. We are evaluating businesses when we consider which share to buy. Once we’ve purchased a share we are an owner of a business. And any evaluation of a business starts with the environment the company operates within.
For most of the world that environment is capitalism. And capitalism is synonymous with competition. When functioning correctly competition benefits consumers. Companies invest in creating better products and services for us to buy. And they compete on price so we get better deals.
The problem is that competition isn’t great for companies. It means spending more money on research & development and marketing. It means eroding profit margins as prices on goods and services are cut. The combination of that spending and lower prices means lower profits.
We can see the impact of competition in the financial statements of companies. A company funds itself using loans from banks, by issuing debt and by selling shares. This funding has a cost and when it is invested in growing the business it earns a return. If that return is below the cost eventually the company would go bankrupt. If the return is higher than the cost of capital the company thrives over the long-term.
These outlier scenarios are rare. Over the long-term most companies find their cost of capital and the return achieved from investing that capital roughly even. This is the impact of competition eroding returns and the fact that a company is a self-perpetuating entity that will constantly keep struggling to grow.
Earning returns that match the cost of capital is not a great outcome for investors. However, the company can keep growing and keep paying management and employees as long as enough discipline is maintained to not let the return on invested capital dip below the cost of capital.
To find a great business is to find one that earns higher internal returns than competitors in the same industry. A business that keeps more of their revenue through higher margins. That is the pathway for compounding returns over decades.
Why the moat upgrade?
ALS is one of only a handful of global firms in the testing, inspection, and certification sector, operating across multiple subindustries. The market is highly fragmented, with many local/regional players that lack the capabilities to operate across multiple industries and, as such, struggle to successfully service the needs of multinational companies.
While ALS is around one third the size of the smallest of its three larger global peers, its scale is nonetheless sufficient to enable it to leverage its network of industry experts and testing sites to offer a broad service and to bid for larger contracts at a lower cost than smaller rivals in a fragmented market.
We have assigned a narrow economic moat rating to ALS, based on cost advantage. The moat source differs from narrow-moat-rated peers SGS AG, Bureau Veritas, and Intertek for whom intangible assets and switching costs are the underpinners of competitive advantage. These companies focus more heavily on the certification sector where accreditation and brand reputation for high quality are essential (intangibles), and where changing providers may necessitate scrapping the existing system, incurring significant costs (switching costs).
While ALS derives advantage from these elements for some segments, the company’s greater focus on product testing—for which the average contract length is shorter (often annual) and for which the financial costs of switching are lower—makes cost advantage more important. Smaller competitors generally lack the scale to compete with the larger players' research and development, capital equipment investment, and capacity.
ALS’ global operating footprint of experts and laboratories expands as the company’s revenue base increases. This acts as a virtuous circle. As the network expands, the customer offering and brand value increases in step.
In minerals, ALS has the largest and best-distributed network of standardized laboratories. Data consistency and detection limits are unmatched as clients are assisted with increasingly complex data sets. ALS continuously develops new innovative testing methods to meet evolving requirements. It can deliver the best scientific analysis available at a commercial price. Exploration clients require increasingly lower detection limits and increased precision. ALS can measure and detect deeper than the competition.
Procurement and other capacity synergies are leveraged across ALS’ portfolios. ALS is the second-largest provider of environmental testing services globally. The environmental business supports mining clients with specialized sets of analyses to characterize mine waste behavior and for ongoing environmental testing. There are also strong client synergies between environmental and food and pharma divisions.
ALS’ returns on invested capital, or ROICs, exceed the weighted average cost of capital, or WACC, and are expected to continue to do so. The current risk-weighted approach to capital allocation sets a minimum return on capital employed, or ROCE, hurdle of 15%. The company did overspend during the China boom, which, in combination with a subsequent retreat in commodity prices, led to sub-WACC returns from 2015 to 2020.
However, improved commodity prices and a successful life sciences acquisition strategy—the latter coincidentally reducing assessed WACC to 7.9% from 9.1% given the lower associated volatility and risk—means returns are higher. ROIC was 10.6% in 2024 and expected to increase to 11.6% by midcycle. We don’t think ALS will overspend again given minimum return hurdles and its strategy for selective and opportunistic mergers and acquisitions. We don’t expect the next commodity downturn to be as impactful, given the growth in importance of the life sciences segment.