Last year, I wrote how Master Drilling Group’s cylinders were beginning to fire. Perhaps the most pertinent paragraph was where I noted that:
“In H1:21, not just has Master Drilling’s utilisation rate across its fleet began to rally (and, indeed, according to management it has continued to rally in H2:21 so far), but the group’s order book and pipeline have shot up to a whopping $232 million and $602 million versus H1:20’s $144 million and $281 million order book and pipeline. Given that the pipeline converts into order book (before the order book converts into revenues and then cash flows), the fact that the pipeline has tripled in the last 12 months is material.”
You can see more details regarding the utilisation rates, order book and pipeline in the global drilling group’s interim results presentation here.
Businesses like Master Drilling have a high fixed cost component to their cost-base with a lower variable cost component.
What does this mean?
Well, fixed costs are exactly that: fixed. Once they are spent, they do not change. If revenue rises or falls, they do not change. Something like Master Drilling’s world-class fleet of drill rigs is a classic fixed costs component; whether the group is running at 10% or 100% utilisation, this rig’s fixed cost remains the same.
Obviously, if the fleet is being utilised then it will be using drill bits, fuel, maintenance and labour to operate it (and logistics costs to move it to new projects), thus the group’s variable costs do exist (but in a lower proportion than fixed costs).
Why is this important?
Well, high fixed costs create something called ‘operating leverage’. This is where a small change in revenue creates a much larger change in profits, and this occurs due to the fixed nature of fixed costs.
Thus, when Master Drilling speaks about rising utilisation rates (i.e. the fleet being used to generate revenue) and an order book that has tripled (which foreshadows revenue being generated), I get very excited because the actual return to shareholders (i.e. profits) could be much more than a mere tripling …
This was confirmed in a trading update by Master Drilling in late November last year where it saw FY 21 profits rising by at least 400% (in US dollars) and at least 350% (in rands). Given the above explanation of operating leverage, Master Drilling’s fixed-cost structure and the interim comments around rising utilisation and order book, this huge rise in profits is surely not a surprise?
The group also left this FY 21E trading update uncapped to the upside. At least just means it won’t be lower than but could be much, much higher.
What may be a surprise to the market is that the stock remains on a price-earnings (PE) ratio of only 6.4x (assuming that headline earnings per share in rands are exactly +350% y/y). If earnings are much, much higher than +350% y/y, then this PE just gets lower and the stock more attractive.
Is a 6.4x PE high or low for Master Drilling? Well, Major Drilling Group International shares off in Toronto trade at a 29.8x PE.
Master Drilling management has confirmed that it will be releasing its results on March 22 this year. Thus, nearer this date, I expect a more defined earnings update to come out – and, yes, I do expect it to shoot the lights out.
Keith McLachlan is investment officer at Integral Asset Management.
* McLachlan and some of Integral Asset Management’s portfolios hold shares in Master Drilling Group.