My friend Ryan O’Connor of Aboveaverage Odds and managing partner and co-portfolio manager at Whetstone Capital Management, gave me permission to post his excellent write up on Energold. It is a very long (but easy to understand) write up (22 pages in word without using bigger fonts like I did in my HS days). enjoy!
Energold Drilling (EGD) is an obscure, under-appreciated micro-cap franchise that possesses both a large margin of safety and what we believe is an incredibly favorable, highly skewed risk/reward equation.
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An investment in Energold at or around the current price possesses nearly all the qualities we look for in a great long-term investment. In particular (1) an unsustainably low valuation (both absolute and relative to peers) (2) a good, fully incentivized management team (3) near to medium-term operating momentum (4) a highly attractive long-term business model (5) multiple internal and external high probability catalysts (which we expect will drive substantial near to medium-term upside) and (6) a situation where a variety of temporary issues converge to mask a significant inflection point both in regards to the company’s corporate development and future prospects as well as in relation to its industry as a whole.
Other attractive attributes of Energold include…
- A dominant competitive position in a rapidly growing niche market
- An unlevered balance sheet
- Improving economics on an attractive and fast growing asset base
- A high likelihood of experiencing meaningful improvements in near-term profitability and cash flow
- Opportunity to invest capital at (1) a very high rate and (2) for a very long time
- Valuable hidden assets – their stake in Impact Silver could potentially be worth more than Energold’s entire current EV
- A natural inflation hedge/low risk way to participate in minerals/commodity bull market
Why is it Mis-Priced?:
It’s small, unknown/under-followed, illiquid, Canadian, and run by a non-promotional management team
The combination of conservative accounting and depressed operating results over the last two years – due to a once in a generation recession and the lingering effects of the credit crisis – make the company look expensive based on TTM math
Brief Business Description/Operational Overview:
Energold is an operator of environmentally friendly man-portable drilling rigs that service the mining industry. With its operations in over 20 under-served countries throughout the developing world, Energold emphasizes an environmentally and socially sensitive approach to contract drilling. The company’s primary competitive advantages are its permanently lower operating costs and its use of proprietary, highly portable rigs in serving frontier-drilling regions. Long-term, the company seeks to become the worlds leading specialty driller.
Unlike most of its competitors, Energold’s operations are managed in a way meant to consistently protect and grow shareholder value regardless of the environment or where the company is in the cycle. The companies operating principles reflect this, and are intended to both maximize flexibility and the ability to capitalize on opportunity over time.
Energold’s core business is offering drilling services in “frontier” markets by utilizing a proprietary fleet of “man-portable” rigs. “Man portable” rigs are high quality, low cost drills that Energold designs and manufactures in house which possess a variety of unique (and game changing) attributes – attributes that have been at the heart of why Energold has been able to rapidly penetrate over 20+ under-served markets in an impressively short period of time. What we mean by “under-served” in Energold’s sense is developing nations with high mineral drilling potential and minimal competition.
The company’s use of an innovative modular component technology allows them to create small, highly portable rigs that aren’t mounted on trucks and hence don’t require roads and/or trees to be cut down for access to drilling properties (notably, the vast majority of the ~7000 rigs in the world today are truck mounted). This not only saves a significant amount of time and money, it allows drilling to take place without leaving a large environmental impact in its wake. In other words, Energold’s mineral drills possess dramatically lower all in costs to build, transport, and/or operate, and equally as importantly, leave an essentially non-existent environmental footprint in an industry plagued by the secondary effects of its inability to operate in an environmentally friendly manner. Of course, Energold’s revolutionary rigs also provided the company with a high return business model and a tactical advantage in a rapidly growing market.
Framing The Opportunity:
There is couple of helpful ways to think about the unique attributes of Energold’s business model and long-term opportunity. The first relates to how when we think about this company’s prospects for sustainable value creation over time, we just can’t help but draw comparisons to both Geico and Walmart in certain respects. Like Walmart, you have a business that has grown over time by expanding into under-served markets with minimal competition, which in turn allows them to quickly entrench as the low cost producer based on economies of scale. Like GEICO, you have a business with very low market share, a tremendously long runway for growth, hard to replicate cost advantages, and compelling incremental economics. Hkup881 also compared Energold’s investment proposition to be akin to “betting on CSCO in 1995 knowing that the Internet thing would work, but refusing to buy pets.com or anything like that” which we believe to be an apt comparison as well. Feel free to take the above comparisons with a grain of salt, but we wanted to mention it here in brief because – like the excerpt below – we think it’s helpful as far as framing the opportunity and helping others “see what we see,” if you will.
The second is about how history has taught time and again that the low-risk way to make money in any gold rush is to sell the “picks and shovels,” and our how our expectation is that this time around should be more of the same. With that in mind, the gentleman over at Praetorian Capital who (1) notably did most of the heavy lifting here (2) also happen to be the purveyors of one of our absolute favorite blogs Adventures in Capitalism and (3) recently put how this historical reality relates to Energold in a recent Sum-Zero write-up better than we ever could.
That said, rather than try and regurgitate our own inferior articulation on the matter, we will just quote an excerpt from Mathew Goodman’s fantastically insightful take below….
“I’m an equities guy, but I want gold exposure
If you are still reading, you are aware that gold is in a multiyear bull market that is unlikely to let up anytime soon. Even if you are no gold bug, but are traditional value and subscribe to Jeremy Grantham’s ideas, particularly his recent piece “Time To Wake Up: Days of Abundant Resources and Falling Prices Are Over Forever”, this may work for you. If you are scared of the commodity sector because you don’t want to participate in putting a future price on something without financial statements, you might want to look elsewhere. While understanding gold’s bull market, I set out to find a way to get leverage to the price of gold. This would cause one to turn to the mining sector; the companies that actually set out to find and then produce the shiny metal. My conclusion upon studying the mining industry is that it fell in the too difficult pile. I did not have a geology degree. I did not want to pay a massive amount of money to bet on a consultant’s word on the prospective geology. In my opinion, every single factor determining profits was based on commodity prices. Betting on mining meant that I wasn’t only betting on gold but on the relative outperformance of gold versus other commodities. Then we get to the mining.
Mining is “a series of problems”, quite literally. We can start with the amount of guesswork that incorporates the geology side; let’s just say it would make Nostradamus blush. Then we get into community relations; convincing a tribe of indigenous Amazonians that an international company extracting billions from their community really is best for everyone in the long term. Oh, and we also need to build a road thru your rain forest. This is just the beginning. The capital outlay is incredulous. A bank won’t even talk to you until you’ve pissed away millions on a non income-producing endeavor. Yes, that means dilution is an issue. Mines can take 3-5 years to build, and lots can happen between then and now. So what kind of management does such an industry attract? You have the Ibankers who are there simply to raid the treasury. And you have the geologist; he knows the gold is there, but doesn’t have the slightest clue in how to obtain financing or exploit the value chain. Part of the business plan is to spend all your money in the name of exploration, which is, based at least 50% on luck; I kid you not.
When playing bull markets I constantly look for the trickledown effect. I turned to history to find out where the money was made in previous mining booms. Samuel Brannan was the first millionaire of the California gold rush. Must have been a big deposit? Brannan actually opened town stores next to the mines and after having bought as many shovels in the state of California as he could, proceeded to sell them to the miners. Another gentleman who in my own opinion left the largest legacy of the gold mining boom, died with an estimated fortune of $6M (in 1902). This gentleman was Levi Strauss. By using copper fastenings, his jeans stood up to the hard labor of mining. Those who came in search for gold, left with little more than they came with; if they were lucky. A sawmill operator, Marshall, was the first to discover the gold that set off the gold rush. He shared this information with his boss, who owned the land and mill. Neither of them ever profited from the discovery of gold. In fact Marshall died penniless, after he became the partner in a gold mine that ultimately failed. His boss shared a similar fate. As stated at the California gold rush Wiki page, “recent scholarship confirms that merchants made far more money than miners during the gold rush”. If you were not convinced reading annual reports that mining is a tricky business, maybe your mind has now changed.
A friend who is more familiar with the mining industry than I calls jr mining “drill hole roulette”. Once you own land the remaining job is to get as much of other peoples’ money as possible; and spend it all drilling holes. The more money that is attracted to the gold industry, the more holes will be drilled. Following mining industry financings are a telling tale of the trickledown effect of money spent on drilling. Majors are finding it almost impossible to replace reserves which will lead them to playing the game themselves or supporting others who are in. The world produced approximately the same amount of gold at $1200 gold as we did at $300 gold 10 years ago. On the other side of this sits the casino, or the service companies. I’m a fan of investing in the house. There is also a second driver here for the service industry. The general population is unfamiliar with the gold mining industry, as it had been dormant for so long. It is thought that the cost of gold is about $500 or so per oz. This is the cash cost of mining the gold. This comes after the shit show of spending and dilution I mentioned earlier. Most knowledgeable analysts believe the price to locate new gold is upwards of $1200 today, and growing rapidly as we mine what is easiest to find, and are forced deeper into the earth, and to more remote locations (read: more expensive). At a recent mining conference, an HSBC precious metals analyst put the marginal cost at $1200, “the long term floor”. Mining companies have done an awful job replacing gold over the last 10 years because they were paid less than the cost of finding new reserves. Money does not flow into unprofitable ventures. Very little exploration occurred and the service industry made few advancements. There are many statistics out there talking about how little the allocation to gold is in worldwide assets; as this is readjusted upwards, money will flow into mining. Now that mining offers an appropriate return on invested capital, more capital will again find its way into mining. This money will be used to explore for gold.”
Opportunity Overview – Key Points:
Sustainable Cost Advantage
One of the most important aspects to understand when analyzing Energold’s business is the fact that it possesses a sustainable cost advantage, which is a function of their decision early on to build their own drills. Realizing that vertical integration and owning their own assets was integral to establishing a sustainable cost advantage, the company made an early transition. This has allowed them to squeeze out the manufacturing middleman, more effectively control their production profile, and continuously wring out increasing amounts of cost efficiencies as they have scaled. The company also possesses a lower operating cost structure due to a local, less skilled work force and due to superior scale achieved in developing markets, which enables leveraging of fixed costs. The end result is a business with the lowest operating cost and hence the highest margins in an extremely fragmented industry.
Again, the fact that their drills can be made internally at lower cost allows Energold to (1) offer the same services to clients at lower prices (2) operate with a permanently lower cost structure and (3) rapidly innovate and deploy new technologies at a much faster clip. The end result allows them to quickly become the dominant business within the markets it serves, where by “dominant” we mean a business that can be highly profitable at a price level that leaves smaller competitors (in terms of local mkt share) with permanently higher than average costs, which in turn makes the company nearly impossible to compete against long-term. Again, consider for a moment how powerful the ability to run its business at a permanent 10% differential to its closest competitors really is, as it not only provides the company with an ability to bid contracts at a level that allows them to operate at a profit where others cannot, but also to more effectively preserve and/or steal share in difficult market environments.
The key take away here is that competitors operating within their markets can try to take share, but eventually they will either go bankrupt or just end up walking away after the eventual realization that attempting to compete is truly absurd given what is a permanent and insurmountable cost disadvantage.
Overly Conservative Accounting
Unlike most companies, Energold is incredibly conservative from an accounting standpoint and chooses to immediately expense all of what would normally be considered maintenance cap ex (such as the purchase of rig modules for existing rigs that have useful lives which exceed one year). This results in huge hits to the income statement and artificially depressed earnings. Therefore, during periods of high growth, investors can (obviously) expect periods of particularly depressed earnings. We mention it, only because it is policies like this that often provide a fruitful source of opportunity for the bargain hunting investor, who often looks for situations where high growth is penalizing today’s earnings and in particular, situations where that high growth is being employed at high and improving ROIC.
Anyhow, Energold has a high return business that’s been in rapid growth mode. Currently the market is (as expected) failing to notice the fact that operating cash actually includes significant growth cap ex since growth in inventories (changes in non-cash capital) is directly related to rig unit growth, in favor of a myopic focus on depressed operating income. Of course, such a focus is mis-placed, as once the high margin/high growth stops, the hugely artificially depressed operating income numbers will normalize. As it does, the multiple will naturally begin to expand rapidly.
Point being, for those who are focused on what matters, i.e., the normalized earnings power of the existing business as is (assuming no growth), and can see past the accounting related distortions, a very different picture emerges. By our calculations, the company is trading at only ~5x owner earnings, or earnings after they have been adjusted for growth capex in order to approximate the company’s steady state earnings power. In other words, stupid cheap for a non-distressed business with highly attractive underlying economics and a huge runway still ahead of it.
Tremendous Incremental Economics
Perhaps even more interesting is that we think we are at a crucial inflection point in the company’s evolution, where its huge growth investments over the last few years have resulted in a level of scale within the company’s key markets that should begin to unlock a significant amount of operating leverage going forward as the company’s top and bottom lines accelerate and the benefits of fixed cost utilization really begin to kick in.
In other words, the company has just started to hit critical mass and we expect that the combination of (1) a much larger drill fleet (2) improving asset utilization (3) rapidly improving day rates (price/meter) and (4) a positive mix shift (as lower margin brownfield services start to transition towards the company’s higher margin “frontier” drilling), should result in significant gross margin expansion within the near to medium term – the primary effect being that as gross margins expand, the company’s high incremental margins will finally begin to fall to the bottom line. Of course the price doesn’t reflect any of these temporarily hidden dynamics, yet given how these high margin revenues have an increasingly outsized impact on earnings as they increase, it’s a good bet it won’t take long before the company’s rapidly growing earnings and cash flows start becoming incorporated within the financials and in turn quickly priced into the stock.
Favorable Long-Term Market Dynamics
To appreciate the growth opportunity here we think it’s crucial to understand a couple of things, namely (1) how a structural problem facing the world’s major gold producers has resulted in a permanent change in their spending habits going forward and as a result, a likely permanent improvement in Energold’s underlying economics and long-term growth prospects and (2) the fact that Energold is firmly in the pole position to capitalize on this transition. A solid understanding of the likely effects of the transition on Energold’s top and bottom lines (and the growth potential of “frontier” drilling as a whole) is in our opinion, fundamental to developing a proper appreciation for Energold’s long-term investment potential.
The structural issues referred to above relate to the Majors’ difficulties associated with successfully replacing (let alone growing) their reserves going forward. Importantly, with major producers at this point unable to even replace annual depletion, the only way they will be able to maintain, let alone grow production long-term is by devoting an increasing amount of their growing capex budgets towards greenfield work in “frontier” markets. The reason for this mix shift in capex spend is because it is really only within these markets that the major gold producers are likely to find deposits big enough to alleviate what is a large and growing problem. Keep in mind that the vast majority of the world’s existing production comes from a relatively small amount of massive, low cost deposits, all of which are currently in decline. This fact alone essentially ensures that “proving up” the world’s well known existing mineral assets won’t come anywhere close to bridging the widening deficit between what’s been found and what’s actually needed (in order to simply keep overall production steady). The implication being that there is a very high likelihood that all of the proverbial low hanging fruit within the world’s existing asset base has already been picked, and as a consequence, the only way to stabilize and/or reverse this dynamic long-term is through ratcheting up exploration spending in hopes of discovering new deposits of sufficient quality, size and scope to close the gap.
In sum, most of the world’s incremental production currently being brought on line has much higher finding and development costs than miners current cash costs would indicate. It’s not so much that the world is running out of gold per se, as much as it is that we are running out of “cheap” gold (or the massive deposits that produce at prodigious rates at low costs). As these older “super” deposits produce less and less each year, the worlds major producers have been having an increasingly difficult time making up for this lost production. This dynamic should support the price of gold in our opinion and will result in higher exploration spending in remote locations in an effort to counteract this reality (cue, Energold ). Again, there is no other way that we are aware of for producers to alleviate the current bottleneck other than by spending tens of billions of dollars collectively over the coming few years and beyond on exploring/drilling for new high impact deposits. To further this point, we would make the case that this isn’t really discretionary spending going forward, as without it, they will fully deplete their resource base and in the process, cease to be a viable going concern.
Let’s review some high level figures exploration spending wise in order to paint a better picture of how we feel the above dynamic will effect the future prospects of the frontier drilling market and EGD in particular. First, total exploration spending amongst all base and precious metals producers looks to be coming in around ~$14B in 2011, and with Jr. miner’s raising U.S. $12B last year for gold related projects, spending should remain stable, if not improve in 2012 (potentially surpassing the all time spending record set in 2008). Again, overall activity and hence spending is, in our minds, highly probable to remain strong/firmly in an uptrend over the next few years with (1) commodities and mineral prices high across the board (2) the structural reserve issue getting worse and (3) both majors and juniors having the cash and resources necessary to ramp up spending. Of that ~$14B, roughly ~50% of that spending – or ~$8B – is currently being allocated towards gold exploration (which may be higher going forward, but is essentially in line with gold’s historical % share of the overall exploration pie). Also, the % share of total spend allocated towards frontier drilling has been decreasing over the last few years but importantly looks to have stabilized around 33% of the total. We think this is interesting as it appears that right about the same time frontier drilling’s % share is set to normalize (i.e., begin to revert towards its natural LT equilibrium closer to say ~45%), the structural issues discussed above are set to kick in, which should naturally turbo charge the share gains that accrue to the frontier market. In other words, the ~$4.62B ($14B in total metal exploration * 33% to frontier) dollars of total frontier drilling spend should grow materially in the coming few years, and Energold is almost certain to garner a growing % of this growing pie.
Another point worth mentioning is that at the margin the absolute dollar amount that this incremental demand increase will likely bring about is massive, and our expectation is that the resulting incremental demand for frontier drilling rigs will overwhelm incremental supply. This is a really crucial point, as the dynamic described above should lead to both (1) incredibly high/sustained demand for new “frontier” rigs and (2) significant pricing power for rigs already deployed, which is pretty much as good as it gets for pretty much the only company capable of supplying both pieces of the above puzzle. The result should be huge increases in both volumes and pricing on existing and new rigs, which will lead to an explosion in Energold’s underlying operating performance as this dynamic plays out.
All in all, given that EGD is the dominant player in a variety of relatively unexplored, mineral rich “frontier” markets, and because their “man portable” rigs are both environmentally friendly (unlike competing rigs) as well as possess the ability to drill in remote, hard to reach places (i.e., where their competition can’t), we don’t think it necessarily takes a genius to realize that (1) the company is perfectly positioned to exploit the above dynamic and (2) holding such a key position within what is an abnormally profitable, rapidly growing niche market – on the cusp of accelerating growth due to structural change – is almost certain to be an immensely lucrative venture.
Additional thoughts on Energolds Market Position…
Remember that Energold is pretty much the only game in town at this point, and its position as essentially the sole source provider in regards to “man-portable” rigs is likely to stay that way for at least the next few years, if not indefinitely. After all, the company’s more mature (read bureaucratic/slow moving), structurally less efficient peers have been built in a way that makes successfully competing in remote, difficult to reach locations (that lack traditional infrastructure) practically impossible. Also, local competition within Energold’s core markets doesn’t stand a chance long-term, as Energolds unmatched financial flexibility, superior size and scale, the breadth and depth of its service offerings, etc. practically ensures that threats from local mom and pops will always be a non-issue. As things stand then, we don’t see any serious potential competitors anywhere on the horizon that have a prayer in our opinion of taking a non-negligible amount of market share.
To understand why this is, consider that in order to seriously compete in attractive new “frontier” markets in the future, Energold’s larger comps would have to radically transform the way they have always done business, literally from the bottom up. Granted, success is theoretically possible with enough time, money, and determination but such an outcome is highly unlikely in our opinion, and even under the chance that such a low probability event comes to be, it should take a couple of years at least before these efforts would gain any real traction.
A few of the factors as to why we think the odds of Energold’s comps successfully engineering such a transition are so low include the majors’ (1) entrenched culture (2) radically different fleet composition and core “target” market (3) lack of fully interchangeable skill sets between the two companies crews and mid-level management (for example, the material differences related to differing training requirements for personnel, the typical target crew member, etc.) and (4) lack of the requisite in house manufacturing and logistical expertise, back office systems, political contacts, and other unique “on the ground” experience that is fundamental to effectively produce, mobilize, transport, and train “man-portable” rigs & crews around the globe (at least in an efficient, cost competitive manner). Of course as things stand, the fact that many of these comps have chosen not to enter the market at all, and perhaps even more telling, of those that have, none have been able to make any real progress over what has been a sufficient period of time to make a good run at it is quite telling as well.
Value Proposition (Continued Market Share Gains are a High Probability Event)
Given that Energold’s safe, low cost, and high quality rigs are (1) cheaper (2) more productive (i.e., quicker per meter) and (3) better for the environment than the average drill (read 99% of the market), the value proposition here is obviously significant. In other words, it seems a near certainty that the company’s suite of drills/services is intrinsically beneficial to producers operations on nearly every level.
It’s a similar story for the local communities they serve. Unlike the company’s comps whose drill crews are primarily foreigners and whose equipment is certain to leave the local landscape scarred long after they have packed up and gone home (after extracting a few billion dollars for the trouble of course), Energold appears to truly care about and actually improve the communities which they operate in. For example, not only do they leave the surrounding environment essentially as it was, they are able to act as a source of job creation and in the process meaningfully improve the local economies they serve. After all, roughly 80% of Energold’s drill crews are comprised of locals who are both trained and provided with a competitive and steady paycheck in a world where such things are sadly nearly nonexistent. Additionally, the company usually sets aside 1-2% of revenues in order to reinvest in local community projects.
Best in Class Management
No discussion on Energold would be complete without mentioning CEO Fred Davidson, who is arguably the best CEO in the industry and is in our opinion responsible for almost the entirety of Energold’s historical (and future) success. Of course we also want to discuss his paper trail because we are, after all, talking about a micro cap operating within the mining/commodity industry, so mentioning why we feel he has what it takes to deliver over time is absolutely crucial in our minds for other investors to properly calibrate the overall risk/reward equation here. So with that said, let’s get to it.
First, we wanted to quickly discuss Davidson’s paper trail and how his leadership has not only facilitated high return rig growth of ~30% annualized since the company’s inception, it also resulted in Energold – unlike nearly all of its drilling peers – consistently generating cash throughout the worst financial crisis in a generation. Clearly he has proven himself capable of (1) running the company to make money regardless of the market environment or where the company is within the cycle and (2) grinding out market share gains year in and year out, both of which are an incredibly impressive testament to his skill as an operator as well as in regards to his dedication to preserving/growing shareholder value.
Second, we want to discuss his incentives and uniquely capable background in order to add some insight into why we think he is fully capable of executing the company long-term plan. For example, his historical dedication to maintaining…
(1) A strong balance sheet (net cash) – provides sufficient liquidity/financial flexibility to weather the vicissitudes of a cyclical, commodity industry, as well as to opportunistically capitalize on the mistakes/misfortune of competitors when and where the opportunity presents itself.
(2) Capital discipline – for example, by focusing on ROIC and conservatively growing the company at an appropriate rate (given the appropriate top down and bottom up considerations), an investor doesn’t have to worry about the immolation of shareholder value typical of the avg management team within the space/industry. Of course the fact that he owns a ton of stock might have a lot to do with his prudence as well.
(3) The establishment of – and improvement upon – the company’s permanent cost advantage. A management team that not only excels at operations but that actually gets competitive strategy, and that is continuously focused on widening the moat is almost “unicorn” rare in our experience when dealing with micro cap managements operating in the commodity/mineral industry.
(4) A capital light operation with a variable cost structure – this augments the companies ability to quickly react to any significant detonation within the company’s fundamental outlook and in turn to preserve profitability much more easily than most over a full cycle (2009 was a perfect testament to the power of this model).
…Have all played key roles in his tremendously impressive operational success since Energold’s creation in 2006 and should continue to as Energold evolves over time.
Another crucial element to Energold’s success is Davidson’s uniquely capable background. His experience as an economics undergrad, International finance MBA, CPA and public company auditor, finance professor and consultant to mining companies, before being asked to run Impact Silver, and eventually – once he had the big idea – a specialty driller (Energold), has all been integral to his success and we think offers important clues to understanding why he is so capable/uniquely qualified to lead and execute Energold’s long-term vision. First, his business background helps in all the obvious ways (capital allocation, strategy, etc.) and second (perhaps more importantly), his experience running both a highly successful commodity/mineral producer and service company (at the same time) over the last half decade or so allows an understanding of the needs and wants of both businesses (i.e., his customers and competition) that is unmatched in the industry.
Attractive Inflation/Macro Hedge
In light of structural credit risks and the large amount of quantitative easing/money printing that has been occurring and, all things considered, will likely continue, it is reasonable in our minds to be concerned about the future buying power of the U.S. dollar and the paper currencies of these economies in general. The truth is that continued money printing in the developed world is very likely the only politically feasible solution to dealing with the large and growing liabilities that the world’s major economies have racked up over the previous four decades or so.
Luckily though, the effects of such policies on Energold’s business and future prospects are not only not harmful, they are actually beneficial on a variety of different levels. After all, this business (1) earns the vast majority of its profits globally (2) has pricing power given its market position and the “man-portable” rig supply/demand bottleneck currently underway and (3) its huge leverage to the price of commodities/minerals generally, but in particular, to gold and silver. All of which make it a natural hedge against inflation and in some sense, a play on the current fiscal and monetary irresponsibility of our various leaders continuing uninterrupted.
Consider the secondary effects that our present fiscal and monetary policy has on Energold and the virtuous cycle of operating tailwinds that result. For example, continued money printing all things the same equals higher precious metal prices. Higher prices mean above average and improving ROIC for mineral/commodity producers, which equals increasing capital inflows/investment in mining companies, which equals increasing exploratory budgets/capex and hence more drilling demand. More drilling equals more demand for Energolds service’s, which is interesting but especially in light of the limited supply of experienced and capable drilling crews, the majors structural issues related to reserve replacement, and the weak to non-existent competition in the companies large/growing core market, all of which should result in not only high growth, but in a significant amount of untapped pricing power for the company going forward.
Taken together then, Energold offers investors (1) tremendous leverage to the price of precious metals without all of the operational, commodity and financing risk typical of mining industry and (2) short to intermediate-term optionality on the continued depreciation of the dollar and developed world currencies and the significant currency tailwinds that would result (remember that almost all of Energold’s markets are by definition mineral/commodity rich, so rising prices should result in rising currencies relative to our own).
In sum, A Low-Risk, High-Return Investment Opportunity:
Given Energold Drilling (EGD CN) (1) is currently trading hands at ~5x our estimate of normalized owner earnings and (2) will likely continue to organically compound book value at a rapid rate – say 20%+ – for the foreseeable future, the company’s current valuation is stunningly cheap on an absolute basis and relative to (1) comps (2) other business service companies with similar growth prospects and returns on capital (3) to the 10 yr. treasury or (4) relative to the S&P as a whole.
Preposterously, the current valuation assigns absolutely no value to the company’s premier contract drilling franchise or its significant high margin secular growth prospects. In our experience, rarely does one get the chance to purchase a competitively entrenched, high return growth business at a no growth price. Even rarer still, when the company in question operates in a secular growth industry, has a recent history of high growth, favorable near to medium-term operating momentum, and various top and bottom line tailwinds firmly at their back.
After all, businesses that typically trade at 20%+ maintenance FCF yields are almost always businesses that are undergoing financial distress and/or are in terminal decline with very little, if any hope of value accretive growth in the future. For a competitively entrenched, high return business with an above average secular growth profile to trade at a similar valuation makes no rational sense. Clearly then, our view is radically different than the markets regarding the value of Energold’s growth prospects and/or in relation to the presence of a durable competitive advantage. It’s this mismatch (expectations wise) that we think is primarily responsible for the magnitude of the current mis-pricing and hence for what is in our opinion a truly one of kind opportunity to purchase a wonderful business at an almost impossibly cheap price.
Note all figures are in Canadian Dollars
Adjusted EV Value Calculation:
Current price – $3.79
F/D shares outstanding – ~46.5m
MKT Cap – ~$176.25m
Debt = $10m
Value of Impact Stake today – 6.9m shares @ ~ $2.02 = ~$13.9m
Value of Dominican Republic mineral deposit = ~$1m (wild ass guess)
Value of Bertram acquisition = ~$18m (accounted for at cost)
Cash – ~$22.4m
Adjusted EV = ~$130.9m
Notes: In order to get a feel for what we are paying for Energold’s core mineral drilling business (and b/c its not consolidated within the company’s financials yet, which could lead to a decent amount of noise post deal for a few quarters) we have deducted the acquisition cost of Bertram from our Adj. EV calculation. Our take is that management likely got a steal here and that long term the 2.5x normalized EBITDA multiple that the company paid will look like a ridiculous bargain in retrospect, especially as the strategic and financial benefits become increasingly clear. Regardless, the assumption here is that Bertram is worth at least the ~$18m they paid.
Also, Energold’s true adj. EV could be significantly lower (potentially negative even) depending on a couple of issues.
First, one could potentially justify canceling out some, if not all of the $10m in debt related to the recent Bertram acquisition with the 10m backlog acquired from the recent Dando purchase (bringing the adj. EV to ~$120.9m).
Second, the Dominican Republic land/deposit could be worth materially more than the $1m listed above, as other producers continue to prove up their own high quality parcels surrounding EGD’s claim. The thought is that (at least as we understand it) as these producers continue to de-risk EGD’s play the accretion of value here could be both quick and material. Fwiw, Thompson has stated he intends to be opportunistic and that they will monetize this asset in the near to medium-term as the above dynamic unfolds.
Third, and this is where things get intriguing, EGD’s stake in Impact Silver could potentially be worth somewhere between ~ $25m to $130m (maybe more) over the next 3-5 years depending upon the amount of oz. the company produces and the price of silver (obviously). We can run the the numbers on a variety of scenarios, but at minimum we think that it’s really hard to rationally argue the IV of this stake is worth less than $25m (vs. Our current mark of 13.9m). Anyhow, our back of the envelope calculations leads us to believe that the optionality associated with EGD’s ~10% Impact stake is significant. Notably, if things go reasonably well over the next few years – which fwiw we think is likely given management’s history of operational excellence, low cost producer status, ability to internally self fund organic growth, and numerous levers available to them to help finance a massive production ramp through 2015 – Energold’s stake is worth at least ~$50m (again, based on what I think are plausible estimates, i.e. 1.5m in 2012 production, $50 silver, etc.). If we assume $30 silver, a static $13 cash costs, and a production ramp that amounts to only half of its 2015 production potential of 6k ounces – i.e. 3k ounces (and a 10x multiple), investors would be getting Energold’s operations essentially for free.
Clearly then the Impact stake is a material hidden asset that in many ways amounts to an embedded call option leveraged to higher silver prices and managements ability to execute the company’s huge production ramp over the medium-term. It appears entirely reasonable to us that we may look back two years from now and realize we actually got paid to own a best in class, rapidly growing niche business for less than nothing. Not saying it’s probable, but it’s certainly possible and better yet, we aren’t paying a dime for it.
For a more granular look at Impacts valuation, the recent and well-done write-up by friend of the blog Mario Skonieczny of the superb Classic Value Investorsis posted below. His discussion of the valuation under differing scenarios provides a great, quick and dirty overview of what IPT is/could be worth under a variety of potential future outcomes, and is particularly helpful in our opinion as far as thinking about the value of the optionality/embedded call option here. The full write-up can be found here.
IMPACT Silver increased silver production from 348,949 ounces in 2007 to 823,571 ounces in 2009 which represents a 136 percent growth. All this growth was financed by internal cash flow, which is absolutely amazing. Also, let’s not forget that the price of silver was nowhere near where it is today. In 2010, production dipped to 750,259 because the company revised cut-off grades and mined more medium grade ore as it took advantage of high silver prices. In 2011, silver production is on track to reach 1 million ounces. During the first quarter of 2011, the company already produced 260,970 ounces. By 2012, the company projects a production level of 1.5 million ounces of silver. Considering that so far, the management is executing flawlessly, I have no doubt that they will be able to execute again.
Let’s first look at how much money IMPACT Silver can make with the production of 1 million ounces of silver. I will use a silver price of $30 per ounce even though it is $36 per ounce as of the date of this report.
Revenues = 1 million production x $30 per ounce = $30 million
Expenses = 1 million production x $13 per ounce = $13 million
Profit before Taxes = $17 million or $0.24 per share
Using a multiple of 10 on this number gives us a value of $2.40 per share.
Now let’s take a look at how much IMPACT Silver can make with the production of 1.5 million ounces of silver which is scheduled to occur in 2012.
Revenues = 1.5 million production x $30 per ounce = $45 million
Expenses = 1.5 million production x $13 per ounce = $19.5 million
Profit before Taxes = $25.5 million or $0.35 per share
Using a multiple of 10 on this number gives us a value of $3.50 per share.
What if Eric Sprott is right and silver reaches $50 per ounce?
Revenues = 1.5 million production x $50 per ounce = $75 million
Expenses = 1.5 million production x $13 per ounce = $19.5 million
Profit before Taxes = $55.5 million or $0.77 per share
Using a multiple of 10 on this number gives us a value of $7.70 per share.
What if Eric Sprott is even more right and silver reaches $100 per ounce?
Revenues = 1.5 million production x $100 per ounce = $150 million
Expenses = 1.5 million production x $13 per ounce = $19.5 million
Profit before Taxes = $130.5 million or $1.81 per share
Using a multiple of 10 on this number gives us a value of $18.10 per share.
As you can see the value of IMPACT Silver will depend on the price of silver and its underlying production. Consequently, if we assume silver production levels of 1.5 million ounces of silver, then we arrive at values between $3.50 and $18.10 per share. While I have no idea where it will fall, buying it for $1.70 per share does not seem like a bad idea.
But the story does not end here. The above production calculations are only from the Zacualpan Silver District. They do not include Mamatla Mining District, which as I mentioned before could add over 4.5 million ounces to the company’s silver production levels. Running the same number using 6 million ounces of production can get you a stock price that is significantly higher than any of my conservative estimates. Because the company is cheap based on the current production, I won’t bother calculating it and I will treat it as a free option that might have some value in the future.”
Net Asset Value:
Given the myriad of risks/headwinds that still face the global economy we think it makes eminent sense for investors to look for low-risk investments with rock solid downside protection along with certain other defensive characteristics that in combination, will likely ensure the business in question should continue to do well under any reasonable future outcome we can imagine. With that in mind, we believe purchasing EGD at or around NAV (at current prices) and/or a mid single digit to its steady state earnings power offers investors exactly such an opportunity.
After all, its pretty hard to lose money purchasing a fast growing franchise business with 20% + EBIT margins and the ability to grow organically at high double digit rates at roughly its readily saleable tangible asset value.
Quick and Dirty Pro Forma NAV:
Current Mineral Drilling Rig count of 118, assuming a private market value of ~750k/per rig = $88.5m
EGD’s adj. net working capital = ~$34m
Bertram NAV at cost = $18m
Dominican Minerals = $1m
Total Assets = $141.5m
Less: $10m Debt
NAV = $131.5m
NAV per share = $2.83
Price to NAV = 1.35x
Energold’s NAV is calculated by adding the private market value of the mineral drilling fleet, the value of Energold’s net working capital (less inventory), and the book value of the rigs recently acquired through the Bertram acquisition. Note that our private market value calculation is based on the value of the rigs being sold along with their contracts (which is why it is higher than the 500k/rig replacement cost) – as the remaining cash flows from the existing contract in place will always be included in a private sale.
NAV should approximate roughly $131.5m, implying a net asset value per share of 1.35x. We note that given the build out of twelve more rigs and cash generation, Energold is likely trading at or slightly below our estimate of NAV for year end ’11. Although an earnings power valuation is the more appropriate metric, the fact that investors are paying NAV for a franchise business should provide an additional layer of comfort/downside protection. Generally speaking, buying businesses that can generate +30% ROIC near the saleable value of their assets is a very good strategy.
Normalized Earnings Power (Base Case):
We believe the following assumptions are conservative as far as normalized pricing, utilization and rig count is concerned (for some historical context, Energold has grown revenues over 900% over the last five years). Notably, we have purposefully attributed no value to the ~100+ rigs acquired in the Bertram acquisition for conservatism’s sake. In other words, the normalized earnings capacity listed below is entirely a function of what we expect the core mineral drilling business alone to earn in a normal year going forward on Energold’s existing asset base (everything else is gravy).
So with that said, Q1 11 pricing was $170/meter. $190/meter assumes 5% price increase and 5% from improvement in mix shift.
Energold is adding roughly 25% to its rig count. If we assume that only four out of five are frontier drilling rigs (it will likely be all of them) and frontier pricing is $250 versus $140 for brownfield, then average revenue per meter could be raised by another $30MM. This would add +$10MM in net income.
|Valuation – Normalization of Existing Asset Base|
|Meters Per Rig||6,500|
|Average Revenue Per Meter||$190.0|
|Total Revenues (MM)||$145.7|
|Cost of Drilling||$87.4|
|Shares Outstanding (MMM)||46.5|
|Unadjusted Enterprise Value||$186.2|
|Impact Silver Stake||$15.4|
|Adjusted Enterprise Value||$130.4|
|EV / NI||5.08x|
|EV / Operating Income||3.41x|
We think such a yield is mouthwatering, rub your eyes and check again attractive, especially given the tremendous qualitative attributes of this business and the fact that this ~20%+ maintenance FCF yield will likely grow at a low twenties double digit clip over time. Personally we find it incredible that EGD’s tremendous high margin/high growth potential is currently being assigned zero value by the market, especially given that above avg, highly profitable growth going forward is a high probability event given Energold’s dominant market share, sustainable cost advantage, superior value proposition, etc.
From a financials perspective, we think this is one of the most important elements.
|Comparison of Historical ROIC with Normalized Operations on Existing Asset Base|
Note: Inputs for normalized conditions include: 118 current rig count, 6,500 meters per rig annually, $190 revenue per meter, 26% operating margins, $10MM add to asset for Bertram Acquisition convertible issue and $2MM contribution to NOPAT from Bertram division)
Historically, Energold’s ROIC has ranged from mediocre to downright bad. This is attributable to two major factors (1) a significant lag in the time between capital investment and revenue generation and (2) a catastrophic hit to the industry in ’09 and ’10. Over the last two years Energold has added 40 rigs to its fleet count. This investment, along with acquisitions, has total $40MM, yet until the end of 2010 and into the beginning of 2011 revenues had actually declined from 2008 levels. With rigs now built and being delivered to their work site as we write this and utilization in full recovery mode thanks to +$1700 gold, this trend is set to reverse. Fast.
Energold possesses highly attractive opportunities to reinvest its cash, resulting in high contribution margins and further improving returns on invested capital. Assuming that each new rig consists of $350,000 investment in capital assets and $250,000 in working capital, we estimate that Energold’s investment in new rigs has a strong chance at generating +50% after-tax returns.
Cost of a New Rig $600,000
Meters Drilled 6,500
Revenue Per Meter (Frontier Pricing) $215
Annual Revenue $1,397,500
Gross Margin 40%
Gross Profit $559,000
Incremental SG&A 5%
SG&A Load $69,875
Operating Income $489,125
After-Tax Incremental Cash Flow $327,714
After-Tax ROIC 54.6%
Normalized Earnings Power (5+ years):
The following long-term scenario assumes that Energold is capable of tripling its current man-portable rig count looking out long-term. This is supported by what we believe is the entirely reasonable assumption that this superior high return, capital light business, with its innovative, proven, fully incentivized jockey, durable competitive advantage, and a long, high-return growth runway should be able to grow it’s overall industry wide market share from the current ~2% (118/7000) to ~5%+ (354/7000) within the next 5 years.
So given the above and assuming similarly conservative assumptions similar to our base case, we get a total rig count of 354 rigs. Assuming they do 6.5k meters per drill at rates averaging ~$190/meter, normalized revenues should equal $437,190,000.
If we also assume a conservative normalized 40% GM, SGA at 10% (to reflect the considerably larger scale and inherent operating leverage within the business), and a 30% tax rate, Energold’s core mineral business alone should generate NI of ~ $91.8m.
Compared to its current Adj. EV of ~$130m, Energold appears to be presently trading hands at little more than 1x core 2017 owner earnings. Not a bad outcome for long-term investors who possess the willingness to wait patiently for management to deliver/execute the plan, no?
YE 2017 total rig count = 354
6.5k Meters per drill
Revenues per meter = $190
Normalized Revenues = $437.2m
Normalized GM @ 40% = $174.9m in gross profit
Normalized SG&A @ 10% = $43.7m in corporate expense
Normalized Tax Rates @ 30% = $39.4m in taxes owed
Normalized NI = $91.8m
Normalized Maintenance FCF Yield = $91.8m/~$130m or a ~70% maintenance FCF yield
Applying reasonable 10x multiple on 2017 NI, the business is worth $918m which divided by the ~46.5m F/D SO, equals ~19.75/share. At a more rational market multiple of 15x 2017 Owner Earnings, the business is worth $1.37B or ~29.61/share. Not bad given a current share price of ~3.86/share.
Note: Because the company has hit an inflection point within its corporate development that should allow it to internally fund the entirety of its growth capex on a go forward basis we have decided to keep the share count the same. We realize that management has historicallyrecently opportunistically issued shares to fund a fair amount of its fleet growth/acquisitions but the past is not likely prologue in our opinion and why issues shares when there’s no need to (again, internal cash generation should be plenty sufficient to add the rigs necessary to capture 5% of the market. Historically it made sense (all things considered) and given rig count grew at 3x the growth in share count, that growth was still massively value accretive on a per/share basis.
Normalized Earnings Power (Scorched Earth Scenario):
Now that we’ve looked at the some of the more probable outcomes, lets assume that the future turns out to be considerably worse than we imagine and not only does growth cease, but that the mix shift and therefore revenue and gross margin expansion we expect never materialize. As the low cost operator then, we assume that the company starts bidding contracts out at say a 30% gross margin or a level at which its comps will lose money. Lets also assume meters drilled per day are only ~5.5k and purposefully inflate SG&A and depress the price/meter piece of the equation to account for a potentially equally as difficult market environment as the company experienced in ‘09 – all of which we think are incredibly unlikely to happen again but we are attempting to see what this business is worth under a scorched earth scenario so we’ll run with it.
So with YE 2011 rig count at ~130, 5.5k meters/rig, and price/meter at $165 we get normalized revenues of ~$117,975,000. At a 30% gross margin, SG&A at $20m, and a 30% tax rate Energold will earn ~$35.4m in gross profit. Taking that ~$35.4m and subtracting the ~$20m in corporate expense equals ~$15.4m. After adjusting for the 30% tax rate we get ~$10.78m in after tax income or ~12x the current adjusted EV.
Ironically enough then, we think that if one assumes an almost impossibly draconian outcome that implies (1) no growth (2) no market share gains (3) depressed fleet wide utilization and (4) a price per meter drilled less than what was earned fleet wide at the trough of the worst environment in modern memory, then investors are paying something much closer to fair value on an earnings basis or a ~12x multiple on depressed 2011 earnings. Yet our margin of safety under this scenario comes from the fact that we didn’t purchase the company at a significant premium to NAV. Wherever we are in the cycle, a wonderful business run by a phenomenal jockey is worth more than its tangible asset value.
We think the odds of such an outcome coming to fruition are less than 5% and even if it does, the company would in reality still offer downside protection, consistently generate cash and grind out additional share gains (and hence grow) by undercutting less efficient comps, which as it happens would fuel even stronger core earnings once the cycle eventually turns at some point in the future (and preserving/growing Energold’s per/share intrinsic value in the process).
Top and Bottom Line Drivers – Recap:
Company Specific Factors
Rig Count is Increasing – As more low cost, quick payback, high ROIC rigs are built and deployed towards the company’s highest return opportunities, Energold should increasingly benefit from fixed cost utilization as early stage markets gain scale and the higher margins and better utilization rates on incremental revenue start falling towards the bottom line. As rigs are rapidly added, we expect the combination will be explosive, as increased activity should result in more rigs doing higher volumes at better prices, which in turn should drive rapid improvements in revenues and gross margin.
Also, investors should take comfort in the fact that demand for additional rigs should stay extremely strong given industry trends as it provides a relatively visible and significant growth trajectory for Energold to exploit. It’s also nice that Energold is in a great position to meet this large and growing demand given it has the internal cash flow and balance sheet strength to continue to finance above average (high return) fleet growth as long as necessary.
Price/Meter is Increasing – With the shortage of rigs within the industry already evident and the step change in exploratory spending in frontier markets just beginning, pricing power should rapidly accrue to the industry as what is an increasingly tight supply/demand bottleneck only gets worse from here (as incremental rig demand should continue to overwhelm incremental “frontier” capable supply).
With that in mind, we expect both overall rig demand and day rates to continue to move up – and given the company remains pretty much the only game in town – we expect that most of the mineral industry’s increasing exploration spend on frontier drilling should, in one way or the other, accrue primarily to Energold. After all, there isn’t a competitor in sight that has anywhere close to the unique capabilities required to step into this growing gap in order to help “de-bottleneck” the situation.
Rig Utilization Increasing – With large and growing spreads between the ROIC and the cost of capital, gold producers of all sizes should continue to fire up their drill bits as fast as possible. Again, this increase in frontier related exploration spend looks set to continue for quite awhile and will obviously augment the demand for man-portable rigs, in turn driving a growing proportion of Energold’s total fleet towards higher margin markets.
Positive mix shift – a large % of the company’s assets will be redeployed at more attractive rates within the next year as more rigs are added and legacy, lower margin drilling contracts run off. The result is that higher margin frontier contracts should begin to make up an increasingly large portion of the companies total revenues and operating profit over the next couple years. This will slowly transform the cash generating capabilities of the existing fleet in a hugely positive way, and ultimately leading to Energold generating rapidly increasing amounts of owner earnings/share.
Industry Specific Factors
Increasing Commodities Prices (primarily gold) – Given how profitable gold production is around current levels, increasing amounts of capital should continue to flow into the industry. This could cause both volumes and pricing to simultaneously increase dramatically, which in turn would likely result in exponential as opposed to linear EBITDA growth as operating leverage and pricing power magnify FCF growth in relation to revenue growth.
Major/Junior Capex Budgets are Increasing – With both major and junior E&P’s sitting on record cash balances and structural issues being what they are, producers have (unsurprisingly) continued to expand their exploration budgets for the 2011/2012 fiscal year(s). Notably, exploration spending for 2011 is on track to clock in at ~14B and due to issues already covered, will almost certainly go higher from here.
So, what we have here is an innovative, environmentally friendly business with (1) a sustainable, nearly impossible to replicate cost advantage (2) attractive incremental economics (3) very low market share and (4) a tremendously long runway for high return growth in front of them coupled with a growth strategy focused on rapidly expanding in under-served markets with minimal competition, which in turn allows them to quickly entrench as the low cost provider.
This is a business that also happens to be (5) a leader in innovation with an ability to grow rapidly over time from its present small base of revenue and profits and perhaps even more importantly, has a very high probability of earning multiples of what it earns today looking out a few years and (6) is run by a uniquely capable, visionary owner/operator with a long and impressive paper trail of success and huge insider ownership. It also happens to be unsustainably cheap.
We think the combination of the above factors should provide investors with the opportunity to earn 2-10x their money with very little risk of permanent capital loss under any reasonable future scenario we can imagine looking out 3-5+ years. In the incredibly improbable event that a scorched earth scenario happens, its important to keep in mind that even then, the company would likely still prosper in a downturn (at the expense of its weaker comps) and its still cheap to fairly valued (and growing).
The bottom line here then is that Energold appears to be a classic low-risk, high-return fat pitch and in our opinion it’s only a matter of time before the market wake’s up and comes around to our point of view (our guess is sooner rather than later). When it does, we expect the market will quickly award this high quality business with an appropriate (i.e., higher) multiple much more reflective of the quality of this business and its high return, above average growth prospects.
Investor recognition of a great business
Improving operating performance – increasing rig utilization and pricing power begin to demonstrate the company’s latent/true earnings power
Gold/Silver go parabolic
QE3 is announced
Miscellaneous Must Read’s:
CEO Fred Davidson’s recent interview
Adventures in Capitalism Blog Posts
Mining Services Part 1
Mining Services Part 2
Eric Sprott Interview/”Markets at a Glance”
Follow the Money
Energold Company Materials
Financials/Letters to Shareholders