Now that I’ve done a few consecutive posts on US companies, I hope my readers will indulge me as I profile another foreign stock. Today’s topic is Capital Drilling, a former high-flier that now trades at a discount to asset value. Capital Drilling’s earnings have suffered along with other terrestrial drillers, but the company is in fine position to weather the slow period with little debt, a modern fleet and multiple contracts with blue-chip operators.
Capital Drilling owns a fleet of drilling rigs that it provides to mining companies. The company focuses on emerging and frontier markets, with the large majority of its rigs operating in Africa. These rigs are contracted to major operators such as BHP Billiton, Kinross, and Barrick. Capital owns six different categories of drilling rigs, all suited for different types of drilling activity such as blasting and grading. Capital Drilling was founded in 2004 with only a few rigs, but the company now owns 96. Capital Drilling went public in 2010, using the IPO proceeds to expand its drilling fleet. Capital Drilling also provides drilling management and communications services, though the great majority of revenues and earnings are attributable to its rigs.
Rocketing gold prices following the financial crisis had Capital Drilling riding high. Its rigs were in great demand and the company enjoyed high utilization and contract rates. Revenues and earnings rose steadily as the company expanded its fleet. However, it was all too good to last. Gold prices took a tumble, leading miners to curtail their exploration and production programs. Capital Drilling’s rig utilization fell from the upper 80%s to below 50%, and operating income dropped to nil. Below are figures showing Capital Drilling’s results for the past five years. Note the extent of the drop-off in revenues and earnings in 2013, the price of gold having fallen 25% during the year. Figures are in USD, Capital Drilling’s reporting currency.
While 2013 was undoubtedly a disappointing year for Capital Drilling, a few factors helped keep the company alive to drill another day. First, Capital Drilling never leveraged itself to the hilt in order to build its fleet. Even at its most leveraged, Capital Drilling’s net debt never surpassed 22% of equity. While competitors were forced to scramble to stay solvent, Capital Drilling simply used its operating cash flow to reduce its net debt as business slowed. At year end, the company’s net debt stood at only 10% of equity. Second, Capital Drilling’s young, efficient fleet allowed it to maintain a higher utilization ratio than its competitors. As of year-end, the average age of the company’s rigs was only four years. In any commodities slow-down, the first projects to be mothballed are those with the highest operating costs, and the same holds true for drilling equipment. Capital Drilling’s ability to offer more efficient, reliable rigs than its competitors enabled it to keep more of them in the field and earning income while its competitors’ rigs sit rusting.
All this is not to ignore the fact that 2013’s results were decidedly uninspiring. Rig utilization for the year may have been higher than competitors’, but was still just 55%. Fortunately, there are signs of improvement in Capital Drilling’s fortunes. The company has not yet released official results for the first half of fiscal 2014, but it has released interim trading updates. These reflect multiple positive data points.
- Revenues for the first half of 2014 were approximately $52.9 million, an increase of 21% over the second half of 2013. The company is nowhere close to achieving its previous revenue highs, but the boost in revenues is an encouraging sign that the worst of the washout in mining activity is over.
- Average revenue per operating rig rose to $194,000 in the second quarter of 2014, compared to $186,000 in the same quarter a year earlier. This 4.3% increase helps the company’s margins, even as utilization rates remain tepid.
- The company won two new five year contracts, one a drilling contract for AngloGold Ashanti in Tanzania, and the other a production contract for Centamin in Egypt. The company spent $11 million acquiring suitable rigs for these contracts, but still managed to avoid increasing its leverage.
- The company expects strong free cash flow in the second half of 2014, having already completed most of its capital expenditures for the year.
So what’s Capital Drilling Worth? Shares currently trade hands at 28.5 GBp, giving a market cap of £38.4 million , or $64.5 million. At year-end, Capital Drilling had a tangible book value of $88.4 million. The company’s current trading price represents a discount to tangible book value of 27%. Assuming the company’s cash and receivables are worth book value, the current market cap implies a haircut of 41% to the book value of Capital Drilling’s rigs and rig-related assets. That figure might make sense for distressed rig operator with poor quality, aging rigs, but I’d argue it’s far too conservative for a modern fleet like Capital Drilling’s. If Capital Drilling is capable of earning its cost of capital over time (and I believe it is) then the proper value of the company is much closer to the book value of its assets.
Alternatively, we can value Capital Drilling by normalizing its return on invested capital and comparing the company’s current enterprise value against normalized operating income. From 2010 through 2013, Capital Drilling’s EBIT/Invested capital (which I am defining as EBIT/(Net Debt+Equity)) ranged from -0.2% to 37.6%, averaging 22.6%. These figures represent both boom and bust years, so we can reasonably assume the company’s long-term average ROIC will fall between these numbers. I shy away from choosing a number toward the top of that range, believing gold’s rocket trajectory from 2006 to 2012 to be something of a fluke and not likely to be repeated any time soon. That said, I also believe it to be unlikely that Capital Drilling will stagger along earning mid single-digit returns on capital indefinitely. Such poor returns over a long enough period of time would decrease rig supply and tilt the competitive balance more toward rig owners’ favor, sending ROIC numbers upward. I think the most likely case is the Capital Drilling’s long-term return on invested capital settles between 10% and 15%, neither of which is an aggressive figure.
The chart below illustrates Capital Drilling’s implied valuation at various long-term ROIC rates.
At a very modest normalized pre-tax EBIT/Invested Capital estimate of 10%, Capital Drilling’s implied valuation is an undemanding 7.3x normalized EBIT. In this case, 10% is a very conservative estimate of ROIC, as the standard post-tax ROIC calculation would be well below 10%. Higher but still quite reasonable estimates of 12.5% and 15% imply bargain EV/Normalized EBIT ratios of 5.9 and 4.9 respectively.
Capital Drilling’s short-term returns will likely be determined by levels of mining activity in Africa and by the movement of gold prices, but today’s price may represent an attractive value for long-term investors. Buying well-financed cyclical companies during business troughs can often work well, provided investors forecast normalized earnings power conservatively and management is reasonably competent.
Alluvial Capital Management, LLC does not hold shares of Capital Drilling Limited for client accounts.
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Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.
Thanks for the interesting article.
Have Capital or any of their competitors been selling off equipment to give us an idea of the current saleable value of the rigs?
You mention gold quite a few times, which I’m always a bit cynical about, but I presume the rigs can be utilised for any mine is that correct?
Interesting article. A few quick thoughts/questions
1) is a 5 year contract normal in this industry?
2)What made AngloGold and Centamin decide to secure rigs for such a long period when there are literally numerous unused rigs sitting idle waiting for work, and assuredly mgmt teams would bid aggressively for this work. Is it location (no competitors near by), or a buddy system (Capital CEO knows AngloGold CEO) And what are the margins on these contracts?
3) I think looking at discount to book for drillers is a dangerous option. A couple of good drillers have lost significant money for shareholders and with similar discount to book argument. Energold and Geodrill come to mind.
4) previous poster asked about two good questions. First selling rigs now is likely a bad idea. Everyone in the industry is struggling so you will be faced with low demand and high supply. Major drilling just did an acquisition so that may give readers a sense of prices. Second, most drills can be used for other materials, and base metals are doing better now than precious, however gold drilling has historically made up 50% range of business for drillers. This poses a problem because you now have numerous unused drills bidding on only a few jobs if you exclude gold and only look at base metals.
5) do you know the customer mix? How well are customers doing and what are their plans for projects?
Thanks
Thanks for your comments, and for providing some input on the questions of rig sales and alternative uses for the drilling equipment.
I view Capital Drilling as a “best house in a bad neighborhood” sort of company. As you pointed out, the entire industry is suffering from severe oversupply. What makes Capital Drilling more likely to endure the slowdown better than competitors is its young fleet with its lower capex requirements and it minimal debt obligations. Even if the slowdown should prove more protacted than expected, Capital Drilling is in virtually no danger of insolvency. I tend to agree with you about evaluating drillers on a book value basis. After all, used equipment rarely fetches book value in a liquidation. However, I think Capital Drilling’s book value is somewhat more reliable, once again based on a newer fleet.
I think Capital Drilling’s success in obtaining new contracts is based on a few things. I do believe that relationships play a role. Capital Drilling’s CEO is an Australian ex-Macquarie guy and probably well-connected in the mining sector. Second, I think Capital Drilling’s geographic focus allows it to provide rigs to African operators more quickly and reliably than competitors. Capital Drilling has years of experience working with local governments and mining company staff, and probably understands the regulatory and cultural factors in play.
Excellent write-up. I’m a college student interested in value investing and your blog has been an invaluable resource.
When you measure ROIC, why do you not define it as: EBIT/(Net PPE + Operating Working Capital) – like Greenblatt?
Once again, I appreciate your posts being succinct and impactful.
Regards.
Hi,
The two are the same, depends if you calculate using asset components or debt:
http://en.wikipedia.org/wiki/Invested_capital
Greets,
T
What do you think about Ausdrill? Selling for 0.4x book. Solid returns over the past 10 years. Obviously, these are commodity firms. Economics predict that they won’t earn any economic profits over the long-term, except for boom periods like the past decade. So generally they shouldn’t stray too far from the fair value of their net assets. Many companies, though, won’t even earn their cost of capital if the management doesn’t time the commodity cycles well by buying low and selling high. Seems like the management factor is amplified for these companies, as it is with insurance.
Could not agree more with you about the importance of savvy management in a commodity industry. Nearly the entire economic surplus or deficit the company earns can be attributed to management’s skill in recognizing industry cycles and investing accordingly.
In my view, the market is entirely too pessimistic on the energy and materials services sectors in Australia. Many of these companies are trading well below liquidation value. That said, few management teams are taking advantage of the situation. Provided their balance sheet is stable, I think these firms ought to be investing any and all excess cash into buying back their own stock. How many other chances will they get to deploy capital into equipment at such a steep discount to market value?
Excellent write-up, thanks. I’m scrutinizing the Balance Sheet…
Interesting small print on page 65 of AR 2013:
http://www.capdrill.com/wp-content/uploads/2014/04/CD-AR-2013.pdf
This does not look very conservative:
‘As of 31 December 2013, the Group did
not record any provision for the likelihood of not recovering these funds.’
Contingent liability
Capital Drilling Mauritania SARL is a party to various tax claims by the Director General of Taxation (Direction Générale
de Impôts) of Mauritania totalling $785,000. On 16 May 2012, the Company received a tax assessment from the
Mauritanian Director General of Taxation. The tax authorities made certain assumptions based on incorrect information
obtained from third parties and assessed the company for taxation based on these assumptions. Payment was made
to the Mauritanian Director General of Taxation on behalf of Capital Drilling Mauritania SARL by a third party. Capital
Drilling Mauritania SARL appealed against the assessments. The erroneous recalculations by the tax authorities could
result in the funds owed to Capital Drilling Mauritania not being recoverable from the Mauritanian Director General of
Taxation. These claims are subject to substantial uncertainties and, therefore, the probability of loss and an estimation
of damages are diffi cult to ascertain. Consequently, the Group is unable to make a reasonable estimate of the expected
fi nancial effect that will result from the ultimate resolution of the proceeding. As of 31 December 2013, the Group did
not record any provision for the likelihood of not recovering these funds.
Thanks for pointing that out. It’s unfortunate and I do think it deserves at least some balance sheet reserve, but ultimately it’s not material to the investment case.
What about Capital Drilling being a Bermudan company and the founders being a 70% majority shareholder?
Being a Bermudan company is not an issue. Bermuda is a common jurisdiction for companies that trade in London and operate on the broadly global scale that Capital Drilling does. Bermuda has a strong legal system and is the home of many reputable companies, especially insurers.
As for the high insider ownership, well that’s a topic that has been debated and studied for decades and is nowhere near settled. Some investors love to buy companies with high insider ownership, figuring that management is more likely to make shareholder-friendly decisions and less likely to try to increase their own salaries rather than the company’s stock price. On the other hand, some investors avoid insider-controlled companies, believing that management will screw minority holders with a low buyout bid at some point, or else have free reign to engage in related-party transactions without any mechanism for shareholders to object. In a controlled company, your vote doesn’t matter after all.
Personally, I rather like companies with high or majority insider ownership, provided I trust management to make smart decisions and treat minority shareholders well. That’s always a bit of a leap of faith, but I think management’s historicaly behavior is a good a guide as any. I don’t see evidence of management treating shareholders unfairly here.
Thanks, I was a bit quick combining the two factors.
Knowing nothing about Bermuda, it should be logical that international companies wishing to attract capital base themselves in fair jurisdictions. As for minority shareholder, same here.
Management expense is certainly not excessive.
@other comment: it’s true it is not a material issue, but W.Buffett’s quote about Cockroaches in the kitchen scares me a bit.
Very nice write-up, I will probably buy a bit. I asked investor relations for the shareholder structure as I could not find it online.
do any of you have any info about the OTC US listed companies and OTC:GLAG ? if yes plz share so share the info with me.