Description

DDH1 is a mineral drilling company that went public on the ASX in March 2021. Shares have been under pressure since April in line with the broader market, despite improving fundamentals. DDH1 is a levered play on copper and gold mining Capex, which is rising. Peer MDI CN just reported its strongest quarter in many years. There is >50% near term upside once DDH1 rerates back to their historic 9x P/E, which I expect to happen once they report combined earnings of their recent acquisition of Swick Mining, which should make the low valuation apparent. Most importantly, I think the next years should see a steady increase in mining Capex which could provide further upside.

With a 330m AUD market cap it is very much under the radar, trades at 5-6x P/E or around book value while it earns a high-teens ROIC and will pay an ~8% dividend. DDH has a net cash balance sheet and has historically been a good allocator of capital. It is managed by the various founders who all have significant skin-in-the-game. There have been some recent inside purchases by 2 directors above current levels, at 0.87 AUD and 1.00 AUD.

I can’t verify this, but I can imagine that the shares issued for the Swick acquisition created a bit of overhang on DDH1 shares as well.

This writeup will briefly discuss the value opportunity of DDH1 versus peers and in light of a likely industry recovery.

Business

Oaktree invested in DDH1 in 2017 at undisclosed terms and still owns close to 20% of the shares, down from 50% in 2017. DDH1 has since grown organically by adding rigs, and through 3 acquisitions of Australia based drilling companies. Each company is managed separately with only 4 people working at the DDH1 headquarters (CEO, CFO, head of Procurement, head of Treasury). Every drilling business is still managed by its original founder and every founder still owns significant equity in the firm. Everyone is renumerated based on the performance of their individual business unit.

DDH1 goes to market under 4 different brands.

-         DDH1 focuses on deep section, underground diamond core drilling.

-         Ranger Drilling was acquired in April 2019 and focuses on iron ore drilling.

-         Strike Drilling was acquired in June 2018 and focuses on air core and reverse circulation drilling.

-         Swick Mining Services. Swick is the latest acquisition and closed on Feb 18th 2022. This was an all-share deal that valued Swick at 3.9x EV / EBITDA, or 2.7x using today’s share price. Swick adds predominantly underground drill rigs. They had stand-alone EBITDA margins of 19% in 2022 vs mid-20s for DDH1.

DDH1’s earnings are a function of Capex related to gold and copper mining (both production and exploration) and to a lesser extent nickel and iron ore. 60% is surface drilling and 40% underground drilling.

DDH1 earns mid-20s EBITDA margin, which compares favorably to its peers MDI CN (low teens) and BLY AU (high single-digit). Only the Western-Africa focused GEO CN comes close. MDI and BLY have a much more international business, with high SG&A costs in various countries where they currently lack scale. In addition, BLY has probably been underinvested in due to its previously overleveraged balance sheet. Both have much more torque to a recovering industry but that’s arguably priced in. GEO and DDH1 have a geographic focus. In the end, costs are heavily tilted towards labor. A driller can lose a lot of money on missing spare parts which have to be flown in last minute by helicopter while the drilling crew sits idle. DDH1’s focus on predominantly Australia means they operate efficiently. Furthermore, they (claim to) have state-of-the-art equipment that is well maintained. DDH1’s exposure to underground drilling (40% of revenue) helps their margins. In short, DDH1 runs the highest revenue / rig in the industry. Finally, DDH1 is more exposed to the production stage of mining, and has various long term (1-3 years) contracts which reduces earnings volatility.

I like DDH1 because even at today’s mid-cycle margins they trade at 5-6x P/E, they will pay 30-50% of Net Profit out as dividend (~8% dividend yield) and I believe the retained capital will be reinvested accretively. The last 6 months pro-forma Net Profit was 25m AUD. With 2-5m AUD of synergies, a strengthening market and 13 additional rigs coming online in FY2022, run-rate earnings of 60m AUD seem a conservative estimate. Pricing this year is up 7-10% YoY. As with any industry, there will be some costs pressures, but I think this can be passed on to customers.

Synergies are 2m AUD of overhead, 3m AUD of savings on drilling consumables. On top of this there should also be revenue synergies. Swick has in-house rig maintenance and manufacturing which can be applied to DDH1 rigs.

The Q3 update on May 3rd showed low utilization and slightly lower margins, both due to excessive wet weather, staff contracting Covid and Covid related travel restrictions. While this could in part have led to the recent sell-off, I don’t believe this is indicative of any structural problems to the business.

Cycle

There has been a lack of exploration from 2013-2019. With gold and copper prices now being at levels that justifies new drilling, senior gold companies are slowly increasing their exploration budget. Copper sees steadily growing demand due to the electrification trend, while copper production is expected to peak in 2023. It’s a commodity I want to be exposed to.

Margins were supposedly in the high 30s in the last bull market (2012) when junior gold miners were spending wildly. Will that happen again in the next up cycle? Who knows. As for now, customers are still very cost focused. All I know is that while gold and copper prices remain high, next year’s earnings will be better than last year’s. This week MDI reported its strongest quarter since the last downturn. And given the long lead time to develop new resources (>10 years), a bull market can last a very long time. In an upcycle, the availability of labor will probably be the bottleneck, not the availability of drill rigs. This should again prolong a potential bull cycle  as there will be no immediate supply catchup, and it should benefit the companies with strong operations (DDH1).

The underinvestment is probably best illustrated by the following graph from MDI’s investor presentation.

Catalyst

Integration of Swick and reporting as a combined entity. Net Profit and DPS should be materially higher YoY by YE 2022.

In time, S&P ASX300 index inclusion. There currently are only 9 companies with a smaller market cap than DDH1, but if my rerating plays out, it will be followed by passive buying of ~5% of the market cap.