Master Drilling gained 34% over the past 12 months – more or less since our previous buy call on this company – but we still think there is good value left in its shares, which are still on a single-digit price:earnings ratio (PE). While Master Drilling’s business model has some cracks – overdependence on one sector, order-book driven revenue model and some cyclicality – we feel its management has done a lot to counter some of these negatives. Despite being overly exposed to the mining industry, Master Drilling is now well diversified across countries, commodities and clients. Its earnings performance does not seem to show any cyclicality. Despite the gruelling conditions endured by the mining industry since 2013, Master Drilling has never failed to grow earnings. It has grown dollar headline earnings at a compounded 17.1% a year or 40% a year in rand terms since 2012. We do not think such a stock should be trading on a PE of 9.4, less than half that of the all share index.
Revenue for the year to end-December shrank 1.5% to $118m (FY15: $120m), which management attributes to unfavourable foreign exchange movements, poor market conditions, pricing pressures and clients opting for shorter-term projects. The operating margin took a knock to 21.9% (FY15: 24.7%), weighed by costs related to the launch of new projects in several countries and inefficiencies caused by clients opting for shorter-term projects. The group had a windfall from its conservative provisions for taxation in some jurisdictions in the previous years. This helped headline earnings grow 3.6% to 14.3c/share (FY15:13.5c/share). The group declared its maiden dividend of ZAR 30c/share.
We issue a buy opinion on Master Drilling shares. Our valuations show that the current share price undervalues the company by 19%. Investors will, however, have to contend with the fact that Master Drilling’s shares are highly illiquid. Management holds 59% of the issued share capital, while fund managers (often employing buy-and-hold strategies) and other company directors hold a significant portion of the balance. Over the last few years Master Drilling has invested heavily in research and development to find better ways to mine, lower costs, reduce project time and boost productivity. Some of the technologies are now coming to fruition. We see potential to monetise some of its technologies, particularly related to reef boring, the RD8 and the horizontal raise boring technologies. The RD8 is one of the largest raise bore rigs in the world, while the horizontal raise boring rig can develop tunnels in a fraction of the time it currently takes. The reef boring technology allows mines to extract ore within six months, as opposed to the conventional system that takes between 18 months and two years to reach the same level.
With the mining industry under pressure from low commodity prices and rising costs, innovations that boost productivity and lower costs will be in demand. Management says it is rolling out these technologies internationally and has received several inquiries.
Master Drilling is in talks with the Industrial Development Corporation to fund the development of its blind shaft boring and vertical shaft boring systems ahead of a planned rollout in 2019. The project requires initial capital of about R220 million.
We also expect acquisitions to help earnings growth. Management indicates that it is open to acquisitions should there be opportunities. In the meantime, we expect the improving commodity prices to be a key earnings driver. Should commodity prices continue improving we expect to see an uptick in exploration stage and capital stage mining activities, which will certainly be great news for the company. Master Drilling generates most of its income (about 90%) from production stage mining activities. Exploration and capital stage activities, which used to contribute about a third of the group’s revenue prior to the commodities crisis, now contribute 10%.
With the group utilising just 73% of its capacity, an uptick in mining activity will help Master Drilling increase its rigs utilisation capacity, which will be significant to the bottom line.
- Established client base of major international exploration and mining companies
- In-house design, manufacturing and maintenance capabilities.
- Continued weakness in commodity prices affects profitability
- Exposure to foreign exchange fluctuations
- Intensely competitive space may put pressure on margins.
Nature of business: Master Drilling is an investment holding company whose subsidiaries provide specialised drilling services to the mining, civil engineering, construction and hydro-electric sectors. It operates in Africa, Europe and Latin America.
Disclosures: The analyst has no financial exposure to the instrument discussed. The opinion represents his true view.