Thursday, September 8, 2016

Major Drilling - Stable Drilling Company Trading At Not Elevated Levels

Major Drilling is one of the biggest world drilling companies. The company:

  • sells its services mainly to gold miners (51% of 2016 revenue was attributed to these customers)
  • is focused on specialized drilling - as much as 55% of the company's revenue belongs to this kind of drilling
  • main customers are senior and intermediate miners (85% of revenue)
What is specialized drilling? The company explains:

source: Major Drilling (slide 7)

Well, generally Major Drilling expects that in the coming years, due to depletion of the more easily accesssible deposits, mining companies will have to shift their interest to the remoted and technically more complex deposits. That is why the company wants to be the world largest provider of specialized drilling services.

A few days ago Major Drilling released its 2Q 2016 results. To be honest, these results were not impressive. It seems that the company is still facing an industry slump. Although there is some improvement in the precious metals industry (compared to the beginning of this year) the results delivered in 2Q 2016 show that we are still at the beginning of a new leg up in the gold cycle.

The table below summarizes a few basic financial and operating measures:

source: Simple Digressions

Despite these poor results, the company's shares are trading at quite an elevated multiple EV / EBITDA of 34.4 (calculated at the current share price of C$7.15). Somebody could even say that Major Drilling shares are substantially overvalued. Well, I do not think so.

Major Drilling, similarly to the entire precious metals industry,  is a cyclical company. It means that its results fluctuate  - during good times the company delivers excellent results and during a slump it prints losses or hardly breaks even. In my opinion, to find a fair value of any cyclical company the analyst has to look at historical measures delivered over the gold cycle.

Let me show it, taking "Revenue per rig" and "Margin" as the examples:

source: Simple Digressions

The table shows that during the entire gold cycle (2008 - 2016) in 2012 the company reported the highest revenue per rig (C$1,100 thousand). The lowest value was reported last quarter (C$408 thousand per rig). The average reading over the entire cycle was C$736 per rig. The chart below summarizes all these measures:

source: Simple Digressions

Now, margins (defined as (revenue - direct costs) / revenue) depend on the point of time where the cycle is. For example, when things are fine the demand for the company's services is high and margins are high as well. The highest margin (33.6%) was recorded in 2009, at the beginning of the cycle.

On the other  hand, when things are bad so are the margins. The lowest margin (21.6%) was recorded in 2015 when mining companies were cutting their exploration spendings.

However, over the cycle the average margin was 27.5%.

Now, taking these average measures (revenue per rig and margin) as fair measures I may find the fair value of the company's shares.

The table shows my calculations:

source: Simple Digressions

Note: general and administrative expenses and other expenses are calculated taking 2Q 2016 figures multiplied by 4

Now, as the table shows, using the average cyclical measures and the current rig count (678 rigs), the company would deliver the average EBITDA of C$91.7 million.
With such EBITDA Major Drilling shares are currently trading at a EV / EBITDA multiple of 5.9. It is much lower value than the multiple calculated using today's depressed measures (34.4).

So, in my opinion, these shares are not vastly overvalued as it could seem.

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