Description

 Long master drilling

Master drilling is a JSE-listed company founded in 1986 by its current CEO. It is the world’s largest player in the raise-bore drilling space. They are the best when it comes to drilling large holes in the ground.

Raise-boring sounds like a commodity kind of business. You drill a hole in the ground for an underground mine to connect the mining shaft to the surface and use it to hoist equipment, men and ore up and down the mine or use it as a ventilation shaft.

The reason Master-Drilling manages to earn above average rates of return is two-fold:

They develop and own all of their equipment (and don’t sell it in an effort to protect their Intellectual Property as much as possible). The other reason is that they are willing to accept certain risks in mining which other parties are not very comfortable with (raise-boring in some more politically unstable countries or being willing to take on projects for which they have to develop or adapt equipment). They regularly fill in requests of mining companies and work together to make previously impossible things work

This can do attitude forms the basis of much technological progress and innovation at Master Drilling (more about that later).

There is also another reason. They are very efficient at running their business.

Quite a stable business:

Raise-boring is also quite unique because it is not related to exploration spend and the capex cycle in mining. Over the last 20 years the Raise-bore division has even managed to grow revenues every single year.

Most underground mines can only continue to be in operation by developing such new vertical shafts. Mines have to go deeper or move away further from the main shaft. Due to increasing efficiencies or just out of necessity they need new vertical shafts.

Despite the last 3 years being quite trying for mining companies, Master Drilling hasn’t really experienced any hardship when you look at the results. Even though utilization is at historical lows, they still manage to produce remarkable returns and results (15-17% ROE and 40% gross margins). They even managed to grow earnings every year, even on a slightly lower revenue (part of this is due to the high cost base in Rand, which has fallen pretty hard over the years).

The valuation:

It is very hard to ultimately determine what this business is worth, other than saying that right now it is cheap on any metric. The company is almost debt free, has a historical ROE of about 15-30%, depending on which part of the commodity cycle you are in, and has managed to grow earnings by 18% a year in the last 7 years. I think very few mining or mining services companies have grown earnings over the period 2010-2016, which makes this all the more remarkable.

A few rough numbers:

P/E: 9 times

EV/EBITDA: little under 6

P/OCF: 7

I have seen a few valuation attempts of the company and the only way they can come up with a share-price around the current level is when you take a cost of capital of 13-15% and a 2% to 6% growth rate.

Both assumptions seem quite preposterous.

The 15% discount rate:

The logic goes like this. SA government 10 year bond rates have been between 6 and 10% the last few years. So the cost of capital should be around 8%, and you need a 7% risk premium due to the nature and sector of the business (no mention is made of the superior nature of the company and the high ROE). This seems quite faulty since Master Drilling reports in dollars, and only has between 30-40% of its revenue base in SA. This percentage is likely to go down in the coming years given the continuing international expansion. As an aside, many SA listed companies are valued at a discount rate which is a lot lower than the 15% allotted to Master Drilling, even in the same sector.

The growth rate:

While there is indeed reason to believe that the core Raise-boring division will not continue to grow for 15-20 % going forward, they have a few projects in the very near future which should be able to more than double revenues the next decade.

The 2 most solid growth projects in the near term are:

- Horizontal Raise-bore drilling: When a mine gets developed, the horizontal shafts still get drilled and blasted, after which they are reinforced with shotcrete and bolting. This is a very time-intensive process since they have to check for geological stability after the blasting which takes time. The horizontal raise drills should be both a faster and safer alternative to the current drill and blast method. The size of this market is probably as large as the current Raise-bore market. There are alternatives in the market (think Herrenknecht) but these designs are a lot more complicated and cumbersome.

- The Blind Shaft Boring system: A machine which should come on the market by 2018. A blind shaft is very similar to a raise-bored shaft, except for the fact that there is no underground access available. This makes the basic concept of a raise bored shaft impossible, since there is no way to pull a reamer up to the surface (or to remove the ruble that is created by the reamer). That is why a blind shaft takes a lot more time to be made compared to a raise-bored shaft.

The annoying part about developing a new underground mine is that it takes years between the sanctioning of the project and the first mining of ore. A major reason is because it takes such a long time to bore blind shafts and declines (years is the usual timeframe to think about here). And as long as there is no first shaft or decline, it is impossible to start the underground development of the mine. This new machine should be able to more than halve the time that is needed to develop a first shaft for an underground mine. This has dramatic effects on the NPV of a mining project. Even the most efficient and lowest cost green field underground mines in the world have an IRR of only 15-20% because they take many years of development.

Because of this, the BSBS should be able to seriously increase the NPV of a greenfield/brownfield mining complex and Master Drilling should be able to take a part of this increase in NPV in the form of profits.

Both these projects should be able to maintain the current growth rate of the company a decade or more to come, and maybe even grow faster than the past few years.

Besides these 2 pretty concrete projects (both have been extensively tested, the Horizontal machine has even drilled a shaft for Petra Diamonds last year and has been given an extension this year) there are many more initiatives in different stages. What will come from these initiatives is too hard to predict, but there is more upside optionality.

Another avenue of growth is branching out into other industries. Raise-boring machines can also be used in infrastructure projects. This year the company has done a few bores for hydroelectric projects and aims to get around 30-40% of its revenue from infrastructure projects in the near future.

It would be very surprising if this company won’t grow by more than 2-6% a year, given the fact that they aim for an ROC of 15% and have invested close to 70 million in the last 3 years into the business. This 70 million of investments haven’t yet shown up in the income statements but will show up at some time (an increase in utilization or new projects starting to generate revenues)

Management:

The company is run by CEO and founder Danie Pretorius, who still owns 53% of the company. Other directors together own 6% of the company, and 2 funds that have invested in the IPO still own large chunks. All of this leaves a very small free-float, and low liquidity (in total, 3 funds own around 28,4% of the shares outstanding, leaving a free float of under 10%)

The CEO is a very disciplined capital allocator. He is very outspoken about his focus on ROC. Projects need a certain ROC hurdle before they are sanctioned. The drills are run as many hours as possible a day (which requires a lot of planning, from personnel to logistics) to increase the ROC. The company doesn’t pay out a dividend because they can generate a higher return by investing it in the growth of the business. The company has looked at many acquisition candidates in the recent downturn, but only acquired one company, the Swedish Berteamet AB. In the last AR, they even mentioned the annualized return on this acquisition.

Besides this, management takes the long term view. The cost of firing personnel in a downturn is also considered with the opportunity cost of losing the experience. The Bergteamet acquisition was done because they were a cultural fit and there is an opportunity in learning about some operating procedures of the company (Bergteamet manages to operate the Raise-Bore rigs using less personnel per rig). The company doesn’t want to enter markets which are too competitive (Australia for example) because it is not worth going after that business for a lower return, even though Australia is one of the larger markets in the world.

They are also very focused on which clients they go after, focusing on serving low cost producers in order to lower the counterparty risks.

More than raise-boring:

Master drilling has a small division which offers other drilling services. Those are mostly grade control (Reverse Circulation), blast hole drilling and exploration. This business has a lower utilization currently than the historical average and should provide some optionality when the mining market recovers.

Risks

The company is active in a cyclical business. It also has very short backlogs. Despite this, they have always been able to keep the rigs at decent levels of utilization. They even go this far by stating that they are comfortable with a 6 month backlog. They are active in some less stable countries (Congo, Mali, …).

Catalyst

The market recognizing the superior characteristics of the business.

Increasing revenues and profits because the turning of the mining cycle and increases in utilization.

Another catalyst is more management promotion. The CEO has stepped up his media appearances in the last year or 2. He has also been very vocal about what he perceives to be the undervaluation of the company.