Consensus community valuation
This is where it gets spicy. The nature of the beast means a DCF is next to useless. One option is to look back the last two financial years and take the average FCF of $30 million and put a multiple on it - let's be really conservative and say 6x. That would give an implied market cap of $180 million and share price of $0.84. That's 140% upside from here. Full disclosure: I don't think FY25 will be as favourable as FY23 or FY24, but FY26 is prospective.
Incidentally, $180 million is also roughly the replacement value of its fleet. But let's not go there. Let's instead use what management says in the market value of the fleet, which is $120 million. If we calculate Net Tangible Assets off that I get an NTA of $122 million. That implies a share price of $0.57. Still a respectable 63% upside.
What about compared to listed peers? I don't like EBITDA as a heuristic for capital intensive businesses, but it's still widely used. Per below it suggests Mitchell may be undervalued by 100%, with an implied share price of $0.70.
EBITDA multiples are even more widely used in acquisitions, so what might that tell us?
I'm going to exclude Rado on the basis that it looks like an outlier. The rig multiple on this deal is lower than Mitchell paid for the distressed assets in 2014 and 2015.
On that basis the EBITDA multiple implies a valuation for Mitchell of $0.75. The rig multiple is significantly higher, suggesting a deal value closer to $200 million and an implied share price of $0.93. However, I acknowledge this is a less reliable indicator with muddy causation and I won't use this in the basis of the valuation.
In the absence of a better measure I'm going to average four of the measures above to approximate the valuation.
On that basis it's fracking cheap!
I've been drilling into the Mitchell Services story of late. It's not a company that has struck much support on Strawman but has garnered a bit of a following among international microcap investors. The thing that really stands out is that the window for getting outsized returns in this type of industry is narrow. It's not an industry that allows for just in time PP&E, so you've got to have a decent fleet of drills throughout the cycle. In fact, by far the best time to buy is when the industry is on its knees and you can score inventory for cents on the dollar, which means potentially buying and then mothballing drills for years at a time.
Then as the cycle starts to turn you have to spend money refurbishing existing fleets and/or buying additional kit, either of which means obtaining funding by borrowing or raising and diluting shareholders. Then you have to hope you get a decent share of the tender pipeline to justify all this spending. Then you spend another quarter or two ramping up, recruiting and training, getting kit to site and commissioning equipment to commence drilling. Then you have to hope you get paid, which is not a given and though more likely from tier 1 participants, they generally demand longer payment terms. Then, and only then, do you get the chance to hit paydirt. Long term shareholders spend most of the time getting shafted!
The good news is that Mitchell Services appears to have pretty solid management that have seen several mining cycles, may just have started to hit the sweet spot of the cycle (at least with regards to the commodities to which it is exposed), and it may be that majors are acting more rationally than in previous cycles, which augers well for a more stable and persistent period of success. Let's dig deep…
History
Like many fault line stories, the history of MSV starts in Queensland. But like ends of a banana it begins in two places, Drill Torque and Mitchell Drilling. Mitchell Drilling traces its genesis all the way back to 1969. It grew steadily in private hands until its 30-rig operation was sold to AJ Lucas in 2008 for a cool $150 million (it's probably worth pointing out here that MSV is currently a circa 100 rig operation with a market cap of $75 million). AJ Lucas was and still is one of the biggest players in the drilling market and included a five-year non-compete clause in the deal.
Meanwhile, Drill Torque broke ground with a single rig in 1992 and by 2011 had grown to a similar 30-rig operation when it IPO'd in 2011. The next couple of years were challenging, with a mining downturn being compounded with some management missteps. However, in late 2013 their luck was due to change. Nathan Mitchell - having served out the non-complete clause - was keen to chisel out a new niche in the industry and had a plan to ore-chestrate a turnaround for Drill Torque.
A deal was struck whereby Mitchell Services would effectively undertake a reverse acquisition of Drill Torque, existing management would stand aside and Mitchell Drilling would be re-spun as Mitchell Services (ASX:MSV). It is enlightening how Nathan Mitchell thinks when he wrote the following in the FY14 Annual Report:
"A cyclical market presents opportunity; this is why I decided to re-enter the Australian marketplace after the expiry of a five-year non-compete period. As the market was at a low point I believed it was the right time to invest."
Growth and acquisitions
Nathan Mitchell quickly began to implement his turnaround plan. His focus was to add capacity, build diversity of resource, drill type and geographic exposures, and build up the company's resilience by focusing on Tier 1 miners who were more likely to continue investment throughout the cycle.
To build capacity he chose to use the mining downturn to his advantage and undertook two significant asset purchases from competitors who had gone into receivership. This allowed him to more than double his fleet and while he couldn't hope to utilise the fleet in the short to medium term, the opportunity to use a crisis to his advantage was too tempting.
Later he acquired the assets and operations of east coast-competitors Radco Drilling and Deepcore Drilling. This added additional capacity, specialist services and, in the case of the latter, regional and resource diversity. In all its acquisitions there has been a focus on ensuring the majority of the assets are tier 1 ready.
The strategy is reflected in the numbers. In FY14, the year of the reverse takeover, Mitchell Services generated $15 million in revenue. It has grown this at a CAGR of 32% to $237 million in FY24. In 2014 it was overwhelmingly Queensland-based. Other east coast states now make up half of all business. In 2014 it was a coal driller. Coking coal is still a significant contributor but gold is now the biggest driver, with copper and other elements making sizable contributions. It's share of tier 1 clients in FY14 was 37%. They now represent 80-90% of all revenue. Finally, in FY14 underground drilling represented a claustrophobic 8% of Mitchell's revenue. It's now circa. 50/50 surface to underground drilling.
Capital management
What has changed a lot less since 2014 is the share price. In fact, it's been range bound for almost that entire period. Why is that? Management of MSV appears to be debt averse. In some of the acquisitions discussed above they've used it to an extent, but when they do, they are at pains to pay it down and their go-to is usually a capital raise. I would confess a similar predilection. However, the impact of that has been significant dilution up until recently. I'll leave it to the reader to decide whether the end justifies the means but will point out that although dilution has been undeniably heavy, it has fuelled growth of both revenue and more recently cash (not earnings - we'll get to that). Also, I'd point to the last two years of the graph below. Is it a temporary blip or has there been a lasting change?
In terms of allocation, it can take a while to make fair judgement but 10 years should be ample. The messaging is good with management consistently using ROIC as a key metric in recent years and this has been trending up. There are other indications. For instance, in 2022 the company sold two rigs that it had acquired as distressed assets in 2014. The rigs were acquired for a combined price of $400k. After eight years of use they were sold for $2.5 million and would have required $1.8 million to re-service had they been kept.
In 2022, after eight years of investment, dilution and growth, the company pivoted. Its ongoing focus would be cash generation and shareholder return, and it would do so by sweating its existing rigs. Shareholder return would include dividends, share buybacks and debt paydown. Since the pivot its ability to generate cash has been impressive. In FY23 and FY24 it generated a combined $60 million in Free Cash Flow (operating cash minus capex). It used this to retire debt (from circa $40 million to now negligible), pay dividends and buy back stock (combined circa $18 million). With debt now all but gone the Company has added a fourth pillar to its capital management strategy being 'growth'. It has indicated that this will be debt-funded and, with a soft $15 million ceiling on new debt, should be easily manageable.
Competition
After a decade of industry-wide consolidation Mitchell Services is left as the biggest operator on the East Coast of Australia. AJ Lucas - who bought the original Mitchell Drilling in 2008 - is the next biggest competitor. Perenti - who is the biggest operator in Western Australia - also has a presence on the East Coast, but is not of the scale as the other two.
Management say that it is very difficult to come in as a new player (funding, relationships etc.) and that is increasingly true if you're prospecting for tier 1 operators. To some extent this can be seen in daily rig rates, which have grown ahead of inflation.
10 years of screwing around
Obviously, the market doesn't have a bullish view on the Company with the share price basically where it was 10 years ago. There are a few things going on methinks. First, it doesn't screen well on an earnings basis. For instance, in the past two years when FCF has been $60 million, combined NPAT has been a meagre $17 million. Lower growth capex requirements are part of the answer. Instant asset writeoff policy has also meant new capex depreciation has been accelerated, while existing capex continues to depreciate, causing a P&L double-whammy (also tax benefits). Also amortisation of customer contracts (non-cash) from the more recent acquisitions also contributed. These have now been fully amortised.
Second, operational rigs have been in decline over the past year, and to a lesser degree over the past two years. To an extent management has been able to make this up via general rates and a greater proportion of higher-margin specialised work. However, it is not a trend we would want to see continue. Management has flagged the decline is due to temporary client-side dynamics and they haven't been losing contracts. In fact, they recently gained three new contracts, representing about ten rigs. However, these will add short term costs to scale up and won't contribute revenue until 2H FY25.
Third, it's caught up in the general malaise/uncertainty of the current mining cycle. Mitchell has no exposure to lithium or nickel, but equally they acknowledge the current elevated gold price hasn't resulted in a rush to accelerate exploration. The benefit to them of an exploration surge would be muted anyway given their focus on tier 1 producers, but the mind of the market isn't always open at depth.
Conclusion
Normally jumping into a company that has a flatlining share price and unchanged management would be something to avoid. It is just hubris to think you can predict the imminent rerate of a company that has stubbornly avoided doing so up to this point. However, the valuation is more than interesting and increasingly so. It is becoming something the market cannot forever ignore. That alone would not be enough but just as importantly, the capital management activities that are being undertaken mean you are being paid handsomely to stay while the market makes up its mind.
Arguably it's not as exciting as Kylie Minogue's hit single Spinning Around but at the very least I think it's worth a look.
[It's a small position for now as I want to see 1H results and probably Q3/Q4 as well.]