Before we dig into Master Drilling (MDI) so to speak, I want to thank each person who sent me an email to take part in a friendly wager concerning Rolfes Technology Holdings (RLF). The notional amounts in play will not break the piggy bank of any of us and hopefully my article has stimulated you to think carefully about which share, if any, will outperform Rolfes. An interesting batch of shares are in play – companies such as Consolidated Infrastructure Group (3), Taste (1), Aspen (1), FirstRand (1), Purple Group (2), Master Drilling (1), Omnia (1), Pan African Resources (1), Naspers (1), Sirius (1), and Aveng (1). Lets see what happens.
Master Drilling (MDI) is a rare beast. It is both a fantastic business, and at around R13.50 a share, a dripping roast of an investment opportunity. It is arguably the best driller of holes in the entire world. It has operations spanning four continents, a management team that has been in the business for decades, and the largest fleet of raise bore drilling rigs anywhere. I present my brief investment case for MDI below.
Master Drilling is the world’s largest raise bore drilling operation. It operates on four continents, employing a fleet three times as large as its nearest rival. Its drilling rigs are used for almost any drilling application you can imagine. They own 146 drilling rigs, 43% of the world total. They are able to drill holes ranging in size from that of a tennis ball to one 8 meters in diameter and 1.5 km deep. What is truly impressive is the accuracy with which they are able to drill these holes. Their 8-meter rig drills a hole 1.5 km in depth to an accuracy of 15cm off center! That is like drilling a hole through one and a half Table Mountains and hitting a target the size of a soccer ball.
The company operates predominantly in the mining industry as a services business offering drilling solutions to many of the worlds significant mining companies. In other words, it’s not a mine, but sells its services to the mines. MDI provides a very compelling outsourcing offering to mines. Not only do they save their mining clients big bucks by not having to buy expensive capital equipment, they drill safer than the equivalent stick of dynamite, they do it almost twice as fast, and their machines do not strike. In other words, this company would be economically compelling to a mining house in a boom, in a bust, and in anything in between. In a boom, you want to take advantage of the boom by bringing increased production to market quicker, and in a bust you want to conserve cash by using a cost-effective solution. And whether it is boom or bust conditions, you want to do it as safely as possible.
MDI is involved in every stage of the life of a mine, except closure. They provide drilling services in the exploration phase, the capital phase, and the production phase of mining. The exploration phase is exactly what the name implies; mining companies in this phase are looking to find potential riches under the earth, which requires drilling test wells etc. The capital phase is where new mines are developed in earnest; this is where shafts are sunk to gain access to an exploration stage inferred deposit. The production phase, where 89% of MDI’s 2015 Revenues were generated, involves the ongoing operational drilling requirements of a fully operational mine.
MDI not only differentiates by stage of mining, but by geography (4 continents and counting), type of mineral (gold to coal and every valuable rock in between), and recently they have entered the construction and energy sectors (hydro electric projects). In other words, they are proactively managing the risk inherent in the demand for their services by doing it in different parts of the world, doing it in different commodities, doing it for mines starting out and those almost closing down, and not doing it exclusively for mines anymore. Good Revenue Management.
Equation to keep in mind:
Profit = Revenue – Costs
Demand for the goods or services of a business are its lifeblood and the Revenue figure in the income statement represents this demand monetarily. During the last five years MDI grew revenues at compounded average rate of around 6% (in USD). I must be honest; this is not a great topline (revenue) performance.
During the same five-year period, MDI grew their profit after tax (PAT) at a compounded average rate of 16%. This is a very good performance.
Essentially, MDI managed to grow their revenues (slowly) while managing their costs in providing their services very effectively. More explicitly stated, if their costs increased at the same rate as their revenues during the last five years, then their profits would have increased by an average of 6% annually and not the 16% actual performance achieved. This is an exceptional cost management performance. Lets just say that the chances of bumping into CEO Danie Pretorius or any of his managers at the Ritz won’t be very high – not on company business anyway.
MDI generated $120 million Dollars in revenue (more than 70% in Africa and Latin America) for the year ended December 2015, which is a decrease of 9% from their 2014 performance of $132 million. While one should not be particularly ecstatic about this result, cognizance should be taken of two mitigating facts:
Firstly, 2015 was a horrible year for commodity prices, which means that it was a horrible year for people selling commodities (the mines). As MDI predominantly provides services to the mines, it is small wonder that the mines had a little bit less of an appetite for MDI’s goods. The relatively small decrease (9%) in the revenue of MDI hides the fact that the prices of most commodities dropped like the proverbial stone in 2015. In other words, it is almost miraculous that MDI only experienced a 9% drop in Revenue in an environment where most commodity prices fell by a third or more.
Secondly, MDI presents their results in dollars, and while most of the drilling contracts that they service are in USD, some of the revenue weakness is as a result of the 2015 weakness of currencies such as the Brazilian real and the South African rand.
I am optimistic that the revenue performance of MDI will pick up over the next couple of years for a number of reasons:
In the short term, their acquisition of a significant shareholding (40%) in a European drilling company called Bergteamet for $5 million seems prima facie to have been an excellent strategic foray. Bergteamet is the market leader in the Scandinavian countries (Finland, Norway, and Sweden) and for the one month it was included in the MDI results (December 2015), it generated more than $140 thousand dollars in PAT. If Bergteamet is able to continue this sort of performance for a 12-month period, we can expect it to add around $1.7 million Dollars to MDI’s PAT for 2016 and off course the revenue that leads to it.
In addition, MDI is entering two more countries in 2016 (Columbia and Ecuador) and in 2018 it expects to introduce a machine that will transform the way mining companies sink shafts. If this machine works as intended, mining houses will be able to sink shafts at half the cost and much quicker then other technologies allow at present. In this essay, I am going to attach zero value to this future project even though I think this could be a real game changer for MDI in a game that is already going swimmingly. When the machine arrives, and it works, I will update my investment thesis accordingly.
I have already spoken about the excellent cost management performance of the business during the last 5 years, and I expect this performance to continue in future as MDI continues to improve their offering by automating their current rigs, building more advanced rigs used in new drilling applications, and introduces best practices learnt through the recent acquisition of Bergteamet.
A stellar profit after tax (PAT) performance without an efficient use of assets to generate that performance does not add ANY value to a company. For example, if I employed a million rand in assets in 2011 through 2015 to generate R100 in 2011 growing to R400 in 2015 then I managed to generate PAT growth of 18% per year. This is an enviable PAT growth performance, but a truly horrendous return on the assets entrusted to me. MDI managed a 16% PAT growth performance during the last 5 years, but were they excellent stewards of the assets entrusted to them? Absolutely! MDI used $175 million-odd of assets in 2015 to generate operating profits of around $29.5 million, which is a return on assets (ROA) of 16.8%. Their return on equity (ROE), in effect only taking account of the money provided by the owners of the business (us), we see that MDI generated PAT of $21.1 million in 2015 using equity capital of around $116.5 million for a ROE of 18.11%. The SA government will give a ROE of around 9% on your equity, your bank around 7%, and your local roulette table around 100% if you are feeling particularly lucky and red really does turn out to be the right guess.
Lets pull all the strands of reasoning together in summary. MDI provides a niche service to an industry that will be with us for as long as human nature requires real things in an increasingly virtual world. For as long as the fairer sex wants something shiny (synthetic diamonds excluded – please don’t tell your lady that you won her heart with a diamond grown in a lab – it might not turn out particularly well for you), MDI will have a potential revenue stream. The Revenue side is sorted, at least for a level of revenue not tens of multiples more than the $120 million they generate currently. I am doubtful that there are, or will be anytime soon, Billions of dollars of sustainable drilling services requirements worldwide.
The management of the cost side of the profit equation has been phenomenal, and one would like to believe that Danie and his team would not turn flashy anytime soon. The current profit growth and return on assets’ performance is more than acceptable and I believe the strategic acquisitions and incremental innovation MDI engages in, coupled with the optionality of a possible revolutionary approach to sinking shafts, bodes well for the near term (five years) future of MDI, even as the commodity super cycle has seemingly concluded.
Lets do a back of the envelope valuation of MDI given what I have said in combination with a few simple assumptions:
The “justified” P/E ratio of MDI (the ratio investment theory says it should be) is given by the following equation.
V/PAT = (1 – (g/ROE))/(k-g))
k = the return you and I require for investing our money in MDI as opposed to any other asset
g = growth in profit after tax (PAT) per year
ROE = the accounting return on equity generated by the business (PAT/ave Total Equity)
V/PAT = justified P/E ratio where V = Value and PAT = profit after tax
If we assume MDI will grow their PAT at 6% for many decades to come (the upper bound of SA inflation target), then we see that the justified P/E of MDI is 7.4 times PAT.
V/PAT = (1 – (0.06/0.18)/(0.15-0.06))
= 7.4 X
Low and behold, the current market P/E of MDI is around 7.8 times PAT. In other words, the market (us in general), expects MDI to increase their earnings at around 6%, with a return on equity of 18%, and assuming that people in general want a 15% from a company with the risk/return characteristics of an MDI over the long term (ten years plus). Is this reasonable?
I think this P/E multiple underestimates what MDI will manage over the short term (next five years), and hence I think MDI is undervalued. But by how much? That depends on what you think MDI will accomplish over the next five years. Their explicitly stated goal is to grow PAT at a rate of 20% on average over the next few years (they want to double their market cap from the current R1.96 billion to R4.5 billion in the next few years). They didn’t manage it during the last five years where they achieved 16.6% on average. The last five-year period was very good for commodities early on (2011,2012) and then tragic last year (2015). This year it has picked up a bit but I am skeptical about commodity price sustainability given the opaque state of the Chinese behemoth. I would say that MDI would do exceptionally well if they manage to repeat their 2011 to 2015 performance, but I suspect that a growth in earnings of around 10% in USD will be closer to the truth. Assuming MDI grows their PAT at 10% for the next five years, the justified value of MDI is given by:
Value = PAT(1.1)/(1.15) + PAT(1.1)^2 (1.15)^2+ PAT(1.1)^3/(1.15)^3 + PAT(1.1)^4/(1.15^4) + PAT (1.10)^5/(1.15^5) + PAT(1.06)(1-(0.06/0.18))(0.15-0.06))/(1.15)^5
= $ 20.1 million + $ 19.3 million + $ 18.46 million + $ 17.66 million + $ 16.89 million+ $ 132.52 million
= $ 224.9 million
At a current exchange rate of R14.24/USD, it means that the “justified/intrinsic” value of MDI given my assumptions is R3.2 Billion. Given that the company trades at R1.96 Billion currently, if the scenario I envision or something in its neighbourhood pans out, then potential upside of 60 plus % is possible from current levels. In share price terms, the intrinsic value that I calculate for MDI is in the range of R15.92 (assuming 6% growth in PAT) to R21.2 per share, or upside of 20 to 60% plus. Bottom line; buy some MDI for your bottom drawer.