Description

Elevator Pitch

Mitchell Services (MSV:ASX) is a drilling services company for gold, coking coal, and various metals.  In the past six years, revenue grew 500% by selling shares and raising debt to acquire rigs.  Recently, MSV has shifted strategy to lower growth capital expenditures and intends to return up to 75% of earnings to shareholders via share buy back and dividends.  Estimated FY24 FCF yield is 22%.

Investment Thesis

All drilling occurs in Australia, a historically more stable country.  Revenue is diversified with 43% from coking coal, 40% gold (vs 53% in 2021) and the remainder from a mix of copper, lead, zinc and silver.  For FY24H1 (financial years start and end around 1 July and assume that I’m referencing financial years whenever I mention a year), 89% of revenue was from more reliable Tier 1 miners, the same percentage as the average from 2016-23.

Chart 1.  Relevant financials and data from 2017-23.

Figure 1.  Revenue and EBITDA by year.

From 2017-23, revenue increased every year, in part because MSV acquired rigs five times from 2013-23 to upgrade or diversify revenue. While net debt increased 80% and fully paid ordinary shares increased ~50% from 2017-2023, revenue has increased ~500% and EBITDA from $2.2M to $41.2M.  EBITDA increased less steadily due in part to COVID-19 and higher costs in 2021.  However,  EBITDA and its margin have increased from 2021-23 where 2023 EBITDA margin was 17%.  2024H1 EBITDA increased 21% year-over-year.  In 2023, MSV sharply reduced growth capex and shifted focus to shareholder return.  Net debt was also low at $9.1M as of 12/31/2023 and stock buyback is underway for up to 10% of shares.

Estimating FY2024-25 FCF

To estimate FCF in 2024-25, I’ll take the average of 2022 and 2023 where depreciation was similarly high in both years, but 2022 financials were adversely affected by heavy rainfall more than 2023.  To test the effect of rainfall, I would ideally have location and financials for each rig.  However, management has not responded to my questions, so I’ll look at historic rainfall across Australia as a crude way to see if it's reasonable that rainfall could affect financial results.

Figure 2.  Annual mean Australian rainfall.

2022 had the highest rainfall among the previous 10 years and was 13% higher than the mean over the same period.  In contrast, 2023 was only 1% above the mean, so it’s plausible that rainfall lowered results more in 2022 than 2023.

I estimate 2024 and 2025 by taking the average of FCF from 2022-23.  Setting FCF = net inc + D&A - mcapex, FCF is $19.5M, or a 22% FCF yield.  While maintenance capex will likely increase in the future, management says that “maintenance capex continues to support high levels of availability across all equipment with breakdown rates remaining negligible."  MSV has also stated that it plans to use up to 75% of NPAT for buy back and debt payoff, which should further raise FCF yield.  ~75% of FCF is credible given that in 2023, net debt dropped from $44M to $21M and MSV repurchased 3% of fully paid ordinary shares.  MSV bought another 2% of shares in 2024H1.

Estimating FCF after 2025

FCF in 2026 and beyond will differ because the company has been taking advantage of a tax law to take higher deductions on depreciation through 2025, temporarily lowering accounting NPAT while raising FCF.

Figure 3. Annual depreciation.

Starting around 2026, depreciation will drop, increasing EBT and raising tax from approximately zero during 2020-23.  Again, using the average FCF from 2022-23 to model 2026 and beyond, I’ll adjust FCF by assuming depreciation drops 50% and EBT is taxed at 30%.  Estimated FCF yield is 17%.  Assuming that in 2024-25, management follows through on its commitment to use FCF to pay off debt and buy back shares, FCF yield should be higher.  I estimate P/E = 6.7x in contrast to the much lower and often negative earnings from 2020-23.  While earnings are expected to vary widely due to weather, economy and a host of other factors, I still expect higher average FCF than 2020-23, which should rerate the stock.

Various issues

• MSV said that it will reduce debt payoff and buy back to buy more rigs if it sees a good opportunity.

MSV’s track record on acquisitions is unclear because the company doesn't provide returns by rig.  Fully paid ordinary shares also suffered dilutions of 12.5% (FY2021) and 14.3% (FY2020) during the last two large rig buys.  However, from 2017-23, rev increased ~500% and EBITDA increased from $2.2M to $41.2M, while share count increased less at approximately 50% and net debt increased 80%.  The number of options is not excessive either at less than 4% of fully paid ordinary shares, so options weren’t included in the analysis.

• Commodity price volatility

More stable tier 1 clients make up 89% of revenue, revenue is diversified across different commodities, and the company can switch commodities in case there’s a multi-year slump in one commodity.  Also note that while MSV mines coking coal, the majority of steel production still requires coking coal and is unlikely to change soon,  Commodities can still be very volatile over a one-year period, but I expect higher prices over 3-5 years.  The U.S. is trapped on inflation because lowering interest rates will cause inflation, while maintaining or raising interest rates means higher future interest payments which are inflationary and currently projected to surpass even national defense spending in under 10 years in ideal economic conditions.  Deglobalization also requires duplicate assets which in turn require energy and raw materials even though production capacity for energy and materials is low relative to historic standards.  Both factors lead to higher inflation and rising gold and commodity prices.  Miners and mining services are a leveraged play on rising commodity prices and MSV is among the better service companies given its relatively low capex and high FCF.

• Higher commodity prices attract more competitors.

 Barriers to entry aren't as high as I would like, so increased competition is a risk.  That said, lenders are generally unwilling to lend to new mining companies, new build lead times for rigs and other equipment are increasing and talent has recently been more difficult to hire.

• Costs rise faster than revenue

Little is known about the structure of MSV mining contracts.  Assuming revenue is not tied to costs and given the 17% 2023 EBITDA margin (15% 2017-23 average), higher costs quickly cut into earnings  The largest expense in 2023 was employee and contract labor expenses at 52% of revenue, so a slight increase in expenses would meaningfully reduce earnings.  At least in the near-term, MSV reported in early 2024 that inflationary pressures have continued to ease.

• The CEO holds only 0.3% of ordinary shares or 1.1% of shares plus options.

While not ideal, the Chairman owns 19.1% of fully paid ordinary shares and the company has his name on it.  Also, an executive owns 7.4%.

Catalyst

Investors notice that the company is using most of its high FCF to pay for dividends and to buy back shares.