Description

Gold is at an all time high-but you have no idea how to 'play it.' Based on conventional metrics, most mining companies are expensive on cash flow and earnings. If gold keeps going higher, you intuitively know that junior mining companies are all going to go up five-fold, but they're illiquid and you need to know geology. Even then, many are pretty much frauds. How do you play what will be a mining boom? I think you just buy the casino and let others spend the money drilling holes, hoping to find something.  

Energold is the best operator in the hard rock drilling industry exploring for metals. With a cost structure significantly below the competition and an environmentally friendly method of drilling, they are taking significant share from other drilling companies in the worst bear market in drilling in a decade. When the business turns, these guys should ramp up to full capacity and be worth at least 4-fold today's price.

Energold manufactures and uses drills that are considered, 'man portable.' What this means is that the drill rig can be disassembled and moved to a job site using an army of laborers and then reassembled to drill a project. Previously, all drills were truck mounted. This meant that if you had an interesting green field prospect, you had to build a 'road' and get your rig to the site. For 99% of the 7,000 or so drills in the world, this is still how business is done. It's expensive, and often difficult to get permits to bushwhack a road. This holds back a drill program and costs money. Finally, modern multi-national mining companies are all trying hard to improve their environmental image, which means that 'man portable' rigs are quite popular and often command a premium. Finally, 'man portable' means that you can do a drill program in a difficult to access place, like the side of a mountain where you simply cannot get a truck mounted rig to go. Outside of green field projects, Energold rigs are still cheaper to use and often quicker per meter than most truck mounted drills. That is what creates such a strong competitive advantage for the company.

With the recent market collapse and credit crunch, many exploration programs were cancelled or significantly scaled back. This is simply unsustainable. In the end, if you have a mine and you do not drill around it, you cannot do the grade control work that is necessary to plan your mine. A mining company without new ore quickly stops being a mining company. The producers cancelled all non-critical work last fall in order to conserve cash. Historically, half of Energold's business was gold exploration. Now with gold at an all time high and many metals bouncing significantly from crash levels, these mining companies are beginning to spend. This spending should show up in Energold's earnings starting in early 2010.

At the current price of 2.40, you get a company with 34.128m shares or a market cap of $82m. The company has $22m in cash and $5.5m in investments. There is no debt, so the enterprise value is $54.5m. In 2008, the company earned $6.5 million. Included in that figure was $736k of investigation expenses for a potential merger that did not go through and $1.828m bad debt expense of which half has already been recovered this year. In 2008, Energold spent considerably on growth and finished the year with 75 rigs after starting with 41. If not for this spending, earnings would have been higher. The current rig count is 78, which would imply quite a bit more earning power for the company than 2008-though 40% of the rigs are currently idle.

Let's look at 2008. In 2008, which includes a weak Q4, the company had an average gross margin of 41.6% with corporate expenses at 18.7% of revenues, which includes that bad debt expense and the business investigations expense. Meters a rig ranged from 1,387 in Q1, 1,298 in Q2, 1,064 in Q3 and 611 in Q4 when demand collapsed. Over the 4 quarters, the company had average revenue per meter of $177.65 which peaked out in Q3 at $194.28

Now let's assume that the mining world does not recover, and the company is forced to bid low for contracts. Since they are the low cost provider, they can bid 35% gross margin which is where everyone else breaks even. At a 35% gross margin, a 20% corporate expense rate, $165 price per meter drilled and 5,000 meters drilled per rig, you get about $6.76m in after tax income or 8x enterprise value for a best of a best of breed business. Clearly this is cheap. Notice that I used $165 a meter drilled. This is because per meter rates are holding steady or starting to increase-even in this environment. Q2/09 contracts, signed at the nadir in early Q1/09 had a $168.34/meter average price. Since then, pricing has improved a good deal. When looking at meters per rig, the company tells me that full capacity is somewhere between 6,000 and 7,000 each year. The reason that quarterly numbers always look lower is that a rig enters the 'rig count' when it is commissioned in Canada, but doesn't usually enter the workforce where it is shipped for at least another quarter. This means that the denominator is always overstated when dividing meters drilled by starting drill counts. That's why I feel that 5,500 meters a rig is conservative and why I used 5,000 meters a rig for the worst case scenario.

Now let's look at a more likely scenario. In this scenario, each rig does 5,500 meters, at $175 a meter. Margins come in at 40% and corporate expense is 18%. On 78 rigs, you get $11.56m in after tax income which means that the company is trading at 4.7x enterprise value.

Energold has not stood still during the prior metal boom. The company grew from 24 rigs in Q1/2006 to 75 at Q4 2008 when they slowed growth dramatically. How many other companies have grown 300% in 3 years? I think that once demand resumes, the growth will resume as well-though at a slower rate. Let's look at a scenario 2 years in the future when they hit 100 rigs.

In this scenario, each rig does 5,500 meters a year, at a price of $180/meter, with a 40% gross margin and with some synergies, they get corporate expense down to 16% of revenues. In that case, you get $16.63m of income or 49c a share. I have no idea how to value this thing, but a company that can likely grow 30% a year for years in a bull market in commodities can probably be valued at a mid-teens multiple or $7 within 2 years and likely a lot higher as they add to their rig count.

The question then is; when will the drilling market return to 2007-2008 levels? I would say soon. Q2/2009 had the most financings by junior mining companies since Q4/2007. Majors have all budgeted $1.70 copper, $800 gold, $12 silver, etc. for 2008 and they now have significant cash flow and from what I know of mining companies, they don't sit around with cash. They spend it growing their empires.

In that sense, Energold is like owning Vegas. I don't care if people find what they're looking for in the ground. I just care that they keep spending. In summary, you get a great way to play the continuing bull market in commodities without taking any individual commodity risk, political risk, financing risk or valuation risk. Even if the world ends, Energold probably goes higher as they gain market share. If commodities continue to go higher and people start spending more on exploration, I could see Energold having 200+ rigs in 5 years and trading at over $15 a share. In the meantime, even in a worst case scenario, the company is cheap and still growing.

                        Scenario 1                         Scenario 2                                Scenario 3

Meters                       5,000                                5,500                                      5,500

$ price/meter              165                                     175                                         180

Margin                        35%                                   40%                                        40%

SG&A                        20%                                   18%                                        16%

Rig #                           78                                      78                                           100

Revenue (mil)        64.350                                 75.075                                     99.000

Gross                      22.523                                 30.030                                    39.600

SG&A                    12.870                                 13.514                                    15.840

EBIT                       9.653                                  16.516                                     23.760

Taxes                      2.896                                    4.955                                       7.128

Net                          6.757                                   11.561                                    16.632

Shares                     34.1                                      34.1                                        34.1

Per Share                 20c                                       34c                                          49c

Catalyst

Mining companies stop acting like the world is ending and start spending money again. Hopefully, a new all time high in gold will be enough to do it.