Description

Is This Innovator a Dilemma for Everyone Else?

Swick Mining Services, based in Australia, is the fifth largest mine drilling operation.  According to its website, “Swick Mining Services is one of Australia's largest mineral drilling contractors, providing high quality, high value underground and surface drilling services to a diverse group of mining houses in precious and base metals, and bulk commodities. The Company specialises in Underground Diamond drilling, and has a reputation for pioneering innovative rig designs that deliver improvements in productivity, safety, versatility and value. Swick has provided drilling services to many of the world's largest mining companies, including BHP Billiton, Rio Tinto, Xstrata, Glencore, Newmont, Barrick, Vale, Gold Fields, Newcrest, Goldcorp and Agnico-Eagle Mines.”  The company is headed by founder and large shareholder Kent Swick.  Swick is primarily an Australian company, though it is attempting to duplicate its success in additional international mining regions.  The company operates in three markets:

• Underground drilling (diamond core hole)
• Surface reverse circulation
• Underground longhole

Fleet Details:

            81 Total Rigs

            78 Owned Rigs (3 client owned and Swick managed)

            54 Underground Australia (66.7%)

            13 Underground International (16.0%)

            7 Surface RC (8.6%)

            4 Underground Longhole (4.9%)

Summary Thesis

Swick Mining Services operates in the beaten-down mining services space.  It shares are trading at 62% of tangible book value.  The company’s focus on the more stable underground core drilling market will make the company more resilient in this downturn compared to the more exploratory global peers.  Swick’s recent struggles internationally should prove temporary.  The company’s significant focus on innovation will continue to prove to be an advantage relative to other players and its conservative financial position will allow it to take advantage of distressed peers.  Further, the company is run by an owner operator with a great record of ingenuity and, more recently, capital allocation.  Owning the shares allows a shareholder to participate in a mining recovery and partner with an innovative operator likely to take market share over the long term at a meaningful discount to a growing asset value.

Innovator’s Dilemma

I believe Swick has taken a page from The Innovator’s Dilemma, by Clayton Christianson (which unsurprisingly I recommend).  The company is delivering on customer needs that even some customers don’t know they need yet.  From a standing start, Swick grew from essentially 0% market share to approximately 25% market share of the Australian underground core drilling market in 8 years.  The innovation that drove this performance was the mobile rig which substantially exceeds the capabilities of the skid-based rigs common in the industry.  Swick rigs are substantially more efficient in terms of cost on a per-meter drilled basis.  Unfortunately, sometimes the rigs are too efficient for its customers.  In contrast to most rigs, the more powerful Swick rig is self-propelled mobile platform that doesn’t need to be broken-down to move inside the mine and it operates with diesel instead of the mine’s electricity.  High mechanical availability is driven by these features and few makes and breaks of hoses and cables.  Swick has conceived of and delivered a better machine (which it designs, researches and builds in-house).  It continues to invest heavily in R&D (in contrast to other players) in an effort to double the meters drilled per man hour and is continuing to deliver innovations to the industry, including automatic rod handling tools and automated drilling, which will continue to widen the company’s advantage, reduce costs and expand its market.

I believe this is a textbook example that one day may be added as an example to a later edition of The Innovator’s Dilemma.  Swick is delivering capability far beyond customer needs and as the company continues to drive down its capital and operating costs, it will reach a point where current drilling techniques and rigs will be at such a disadvantage that Swick will be able to garner further significant market share.

Capital Allocation

While most of the mining world is licking its wounds, Swick is in an envious position with a strong balance sheet and an ability to invest in itself and innovation.  In FY 2013 Swick repurchased 21.13 million shares at an average cost of A$.303 per share.  This reduced the share count by 8.9% and increased the Swick family’s ownership stake to 21.2%.  The 2013 repurchases were conducted at 68% on tangible book value.  So far under the 2014 plan, the company has repurchased a further 1.02 million shares at an average cost of A$.328 per share.  It continues to repurchase shares on a nearly daily basis, though at a slower pace compared to last year and that is my expectation given some pressure on cash flow this year.  We highly respect the allocation of capital to share repurchases at such meaningful discounts to tangible book value and the company recognizes that right now it “is cheaper to buy our rigs in the open market via our shares than buy new rigs or competitors.” 

The company continues to also devote significant capital to the aforementioned product development.  In 2013 these expenditures totaled $5.2 million.  We believe over time these expenditures will further enhance Swick’s competitive posture and position the company to re-accelerate its growth in market share (including in international regions).  The company is also excited about a recent investment into a new technology that would take x-ray technology to the drilling environment to provide real-time, on-site assay analysis. 

The company is currently paying a dividend, which, while I prefer went to share buybacks, is yielding 4.3% based on last year’s payment.  Swick has not indicated its likely course of action regarding the dividend this year.

Why is it Cheap

Well, that is the easy part.  Mining services are, as anyone might imagine, a difficult place to be at the moment.  Mine capital and operating expenditures are under stress.  While Swick is not completely immune, the firm is more insulated than many players in the market given its weighting toward underground production.  Underground diamond core drilling is essential to the ongoing operation of a mine.  While a mine can delay some spend and reduce rig counts a bit, a reduction in drilling ultimately inhibits production.  Many of the larger players have small weighting to underground core drilling (typically around 10%), while the vast majority of Swick’s revenue comes from underground core drilling (approximately 83% of the rigs and a similar percentage of revenue address this market). 

A reflection of the current stress is reflected in a selection of comparable drillers which are trading at a median P/TBV of .58x… the selection includes:

• Boart Longyear (ASX: BLY)
• Swick Mining Services (ASX: SWK)
• Energold Drilling (TSXV: EGD)
• Foraco International (TSX: FAR)
• Major Drilling (TSX: MDI)
• Orbit Garant Drilling (TSX: OGD)
• Capital Drilling (LSE: CAPD)

Also, Swick’s recent effort at duplicating the company’s success internationally has not fared as well as their early efforts in Australia.  While this past year has seen better tender activity, performance and delivering on these deals has been challenging.  I expect this to impact H1 results.  Further international discussion is below.

Additional Items of Note

• Swick’s has guided to 2014 revenues of $125-135 million and EBITDA margin of between 18-20%.  This compares to $146 million last year and an EBTIDA margin of 20.8%.  At the low end of guidance earnings would approximate $.025 per share and EBITDA would be about $22.5 million.  The company would be trading at 11x net earnings and an EV/EBITDA of 2.8x.  At the high end that would be about $.04 per share, though I would be surprised to see the company at the high end of guidance and given recent international challenges there could be some risk to the guidance.  Revenue capacity for the current fleet is approximately $160 million or 28% above this year’s low estimate.

• Utilization at the end of Q1 was 61.7% compared to 82.7% last year.  Underground core-hole utilization was 68.5% compared to 96.0% last year.  The comparison is slightly skewed by the addition of some rigs late in the quarter and a few rigs awaiting Q2 deployment to new mines.  For reference to an operator with more exploration exposure, Boart disclosed that mid-September rig utilization was about 45%.  Given Swick’s exposure to production and the company’s high efficiency, the big risk the company faces is firms going from 3 rigs to 2 or 2 to 1, not eliminating drilling (unless mine clients begin to close mines). 

• At the end of Q1 mineral exposure was 40% gold, 33% copper, 4% copper/gold, 9% other base minerals and 14% other.  The exposure to gold, which reached 60% in 2012, may be attractive for those bullish on gold.

• International has proven so far to be a tougher nut to crack.  The mobile rig so well suited for the Australian market tends to be a bit more difficult to maneuver in the shaft access mines typical in North America.  Additionally, the Australian market is much more fly-in, fly-out oriented and shift productivity may be more highly prized.  The skid-based rigs have, to-date, been better suited therefore for the North American market.  International lost about $1 million last year and so far in 2014 has caused a fair bit of pain with one contract being mutually-terminated that was performing quite poorly.  The company’s operation performance has also fared less well in Europe where it won a recent contract (Portugal) and there has been some delay at the company’s deployment in Indonesia at the world-class Grasberg mine (this could be a very significant win for the company).  A new director of international operations has been brought from Australia and additional expertise is being directed at the international mines where Swick is operating.  Additionally, the company is developing a smaller, modular rig that can be broken-down and transported through shafts more easily.  This may come to market in 2015 and prove to be quite valuable in North America.  So overall, international could very well be a drag over the short term.  Longer term I think the company will begin to replicate a degree of the success it has seen in Australia.

• Goldfields recently acquired three gold mines from Barrick in Western Australia.  While Barrick was using Barminco (a large private Australian driller and service company), Swick has a strong relationship with Goldfields and is hopeful about the possibilities.

• Swick’s history is not without its blemishes, though I believe the company has learned a number of lessons from the experience during the financial crisis.  At that time the company was growing rapidly and taking market share.  It also expanded into surface drilling, which is mostly exploration oriented, and it did so without any rig advantage.  The balance sheet was over-leveraged when everything came to a halt.  The company was forced to sell some assets and do a dilutive equity offering.  After the financial crisis, the company divested of the surface exploration assets and rebuilt its balance sheet.  Conversation with management and their track record suggest the company has learned from what was a painful period.

• Full-cycle returns on capital are tough to determine given the differing company profile during the last down cycle in the financial crisis.  I am under no illusion that this is a great business, but I do expect full cycle returns on capital can approximate 10-12% as the company executes on the share buyback and continues to drive down rig and operating costs to the point where wider adoption is more probable.  As such I believe the company will command a premium to tangible book value in the future.

• The biggest disadvantage at this stage for the Swick rig is its capital cost.  The current design costs just under $1 million compared to $400-500,000 for a conventional skid rig.  So while the firm can deliver lower cost per meter drilled, a mine looking for the cheapest cost for drilling in a given month without regard to productivity will not choose Swick at this stage.  As mentioned, the company is working on smaller, modular rigs which would further serve to reduce their initial capital cost while still delivering many of their advantages.  Also, continued innovation will drive operating costs down further which should allow them to compete more effectively in markets where efficiency historically has been valued less.

Returns

• A low case of growth in tangible book value of 5% a year for 3 years and a 10% valuation premium to tangible book results in a double.

Below is a 3 year return matrix based on average growth in tangible book value per share:

Risks

• While I don’t believe the company will lose money this year, guidance may not be met.  The considerable stress in the market doesn’t seem to be abating. 

• Commodity prices may continue to weaken.  The company has significant exposure to the gold market.  Swick is heavily tied to the success of clients completely dependent on commodity prices.  We may be facing a long period of lower commodity prices, the adjustment for which may be more difficult than imagined.

• For the un-hedged, the investment is priced in Australian dollars the exchange rate of which is likely to correlate with the company’s end market exposure.

• Full cycle returns on capital may not be able to reach what I think they can and if they do not then perhaps the company will ultimately be worth less than tangible book value.

• The recent minority investment in Orexplore AB (portable x-ray mineral scanner allowing for real-time assay and analysis) which cost $1.1 million and commits Swick to commit up to $5.4 million in research and development spending over five years may prove wasteful.  While overall I’m drawn to the entrepreneurial nature of Kent Swick, there is no precedence for the company successfully investing in new technologies.  Several years ago the company wrote-off an investment in a water-hammer drilling technology (though I believe the technology is still kicking around the firm’s development office). 

• While a prudent use of capital, the company’s aggressive stance toward share repurchases may be providing support to the company’s shares.  An elimination of the program or reduction in pace may result in pressure in the company’s shares.

• The company has yet to really be successful outside of Australia.  While contract wins in 2013 were encouraging, performance in 2014 has not been great.  The company is completely committed to replicating its success in Australia in other regions.  This effort may be costly and prove unsuccessful.

• Other drillers may more aggressively expand their rig fleets that exhibit characteristics and performance metrics that are similar to the Swick mobile rig.

Catalyst