Capital Drilling - A Mixed Bag

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Capital Drilling (LSE:CAPD) is an LSE listed company which specialises in a variety of drilling tasks for other companies. Capital Drilling listed on the AIM in 2010 and has seen its share price reach heights of ~110p and lows of 16.5p in late 2012. The company currently trades higher at 37.25p. The company as enjoyed a strong recovery in 2013 so far, with the share price up around 50% year-to-date, but the question is whether this is just a temporary spike up or a more solid foundation for long-term growth. With 134m shares in issue, the company is capitalised at ~£50m.


The technical analysis for Capital Drilling does show the the company is currently in a bearish phase as demonstrated by the sharp move down towards late 2012. Whilst there has been a strong recovery, the downward motion still exists with the recent downward trundle following the spike up to above 40p, testament to this. I would expect (excluding news), a short 1-2 day movement up to precede a continued downward trawl towards around 28p. From this level the medium term outlook would be determined with a rise to the upper 30s at this point required to break the downtrend. Further analysis at this point in time would be required to ascertain expected movement considering the volatile nature of the Centamin Egypt debacle (I'll explain this later). Ultimately, from this perspective I would be very surprised if a lower share price did not offer itself up over the coming weeks, especially considering the recent weakness in both small and large mining firms.

However, technical analysis is only one side of the larger picture. It only helps to determine when an entry point would be advisable or not as the case may be. Capital Drilling is a drilling services company with operations across Europe, Asia, Africa and Latin America. The company has a fleet of over 90 relatively new drilling rigs which as suitable for a series of drilling projects including blast hole, diamond and deep-hole drilling. With over 1200 full-time employees Capital Drilling is the 'umbrella company' with smaller businesses within it including Capital Drill & Blast, Well Force International and Cap-Sat Technologies. The immediate question you have to ask with a company like Capital Drilling is whether the business is secure. There are two issues here.

Courtesy of Andreas. on flickr
Firstly, you have to examine the state of the mining sector as a whole. Both major and minor exploration companies listed on the UK markets are clearly feeling the pinch of falling demand (as China's growth has slowed) plus cost-push inflation narrowing profit margins. This effect is also seen overseas with examples of falling share prices of miners seen as far afield as Australia. The result of these obstacles has been deferred investment by companies. The issue here for drilling services companies is that their demand is derived. As some mining projects become less economically viable, demand for services falls. This is a phase being seen at the moment albeit not explicitly at Capital Drilling. This cycle is underpinned by falling metal ore prices, which contrasts against the oil story which is underpinned by historically high oil prices. Arguably though, Capital Drilling is somewhat immune to these effects. The company is specifically focused on supplying services to emerging markets such as Africa, where many projects are still being funded by high income countries such as China. In addition the company has established a strong customer base which should negate the effects of a lack of funding that has constricted progress with many junior mining firms.

The second issue is even more unpredictable. Capital Drilling receives a significant amount (estimated at over 30% by brokers) of its business through fellow London-listed firm Centamin Egypt (LSE:CEY). The problem with this stems from over-reliance on one customer, but more importantly the unstable governmental regime in Egypt that has led to disconcerting activities at Centamin's flagship Sukari Mine. The Sukari confusion started in October 2012 when rumours circulated that Centamin's concession agreement to operate Sukari was annulled. Whilst Centamin argued that the court involved did not have the authority to annul the agreement, Centamin's and consequently Capital Drilling's share prices dropped sharply in tandem. Further to this, it was announced in December that the Egyptian General Petroleum Commission had filed retrospective claims for the payment of $65m from Centamin regarding the supply of diesel fuel to the mine. The impact of this was the temporary suspension of activities due to the diesel fuel being cut-off whilst the matter was resolved. Luckily for shareholders this suspension lasted less than 24 hours. Shortly after this, gold exports resumed. On March 20, the court ruling for Centamin was suspended, during which operations could continue. This clearly is positive for Capital Drilling, but without doubt it will have shaken many investors from their holdings. The risk level has been increased significantly, and the end of the tunnel regarding this matter has not yet been reached. In relation to Centamin's activities, it is worth looking at their outlook.

Centamin does have various legal matters ongoing, each which have potentially significant consequences if they materialise. These include the two as highlighted above, but also a dispute with Chevron regarding fuel subsidies who are demanding a payment of $60m. Whilst the risks with Centamin are inherent, upside does exist as outlined with their 2013 forecasts:

"For the year 2013, we project production of 320,000 ounces at a cash operating cost of US$700 per ounce, at international fuel prices, which will mark the third year of successive growth in output from Sukari, and another step on the way to our long-term target for the project of 450-500,000 ounces per annum from 2015 onwards at an industry-competitive cost of production. The key drivers of production growth this year will be a continued period of elevated head grades from both the open pit and underground mines and increasing the underground ore tonnes mined to 500,000t, as well as commissioning of the Stage 4 plant expansion to double the processing plant's nameplate capacity to 10 million tonnes per annum. "

The completion of these activities including increased production would inevitably help Capital Drilling to further boost revenues and potentially improve underlying profit before tax figures.

The other side of the equation is to look at Capital Drilling's financial state via their full-year results that they released on March 18. Fleet utilisation fell by 7% reflecting the declining outlook for the mining industry although this was offset by the ARPOR (Average rate per operating rig) increasing by a massive 22% to $192,000. This led to revenues also increasing by 22% to $158.9m. On the contrary, this does not detract from the substantial slide in post-tax profits by 20% to $14.1m. With earnings per share of 6.94p, this translates to PE multiple of just 5.36 which is certainly very low, but this is because of the Egyptian uncertainty. At the end of 2012 the group had $9.06m in cash and cash equivalents although long-term (Non-current) liabilities totalled close to $30m. These include the fully drawn-down  $17m term loan facility and $11m of their $30m revolving facility. A smaller portion of short-term liabilities are also present on the balance sheet. The result of this is that there is a fairly healthy $34m in extractable cash through debt facilities if need be. The problems with this is that these loans do carry interest at coupons of around 4-5%, and any significant disruption to revenue streams such as through the Sukari mine being closed for an extensive period of time, would substantially deteriorate the financial position of the company. Perhaps most positively the company is forecasting reductions in CAPEX during 2013 which, assuming an equal level of revenue, would allow a substantial portion of the debt to be repaid.

Ultimately though, aside from raw balance sheet figures, there are other factors that have to be considered. As noted earlier, Capital Drilling has a strong customer base with exposure to 'major mining houses' at 76%. Furthermore, the number of drilling rigs in the fleet continued to rise during 2012 to 93 with an average age of just 4 years. The stated utilisation rates remain in line with past years. Interim CEO Jamie Boyton commented:

"As we commence 2013 we are cautiously optimistic of an improved performance. Despite the weaker demand environment we continue to work with a high quality client list and have maintained robust levels of utilisation which are trending above reported industry levels. The Group's substantial investment in capital equipment over the past two years, with one of the most modern drilling fleets in the industry, positions us well for the periods ahead. With available capacity and a fleet averaging four years in age, we expect a substantial reduction in our capital requirements over the year ahead, positioning the Group well for cash generation during this period."

There is little doubt that an investment in Capital Drilling would signal two things. Firstly you would have to be confident in a successful outcome at Sukari (this would create an upside catalyst) and secondly, you would have to be cautiously optimistic on the state of the mining industry towards the end of 2013. Personally, I believe that an outcome at Sukari is likely to be positive for the company, but I remain sceptical about the mining sector as a whole. The sector has been the second worst performer during January and February with an increase of only a couple of percent, compared to a wider market rally. The question that arises is that, if the sector can only make minimal headway during strong market performances, what will the result be if the markets turn to the downside? Whilst the company does have a strong asset base and has been able to maintain respectable financial figures, the bearish chart position, high levels of debt and material uncertainties within the mining industry perhaps mean that the technically undervalued £50m company still has further to fall before upside can be discussed. Of course though, this is just my take on the situation. Numerous brokers have a much more optimistic outlook with Cannacord and Liberum upgrading their target prices to 68p and 60p respectively in light of the full year results. My current medium-term target price is 30p.

UPDATE (May 2013) - Capital Drilling has reached my medium term target in just over one month. The result is a ~19.5% gain and the share has now been moved from sell to neutral on the 'Review Results' page

9 comments:

  1. Have never heard of CAPD before but looks decent. will wait for a drop off before drilling down further. Mind the pun

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  2. Fascinating little company. Shame it has been adversely affected by Centamin

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  3. Have recommended your site to a friend

    happy easter

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  4. I am a holder of centamin and this entire egyptian calamity is ridiculous. all they are doing is deterring future investment into the country.

    Good article

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  5. Thanks for the write up. Its interesting to get a technical analysis slant on things as ive only ever been a fundamentals investor. Can anyone recommend a decent starter book?

    I'd like to draw out a couple of things about CAPD all from recent RNS's:

    Outlook for 2013: 'We have also received confirmation of drilling activities from clients representing approximately 90% of our forecast revenue for 2013. The balance of confirmations are expected in 1H 2013 as the current tenders conclude and are re-tendered for the year ahead. Furthermore, operations at the Sukari Gold mine in Egypt resumed in late December and are performing to the Group's expectations since the beginning of 2013. Finally, the tendering market remains strong, with significant opportunities in East and West Africa, as well as in Latin America.

    · Increased exposure to majors in the mining sector, representing 73% of revenues in 2012 (2011: 68%) which gives me better confidence in future earnings.
    · $50mn invested in CAPEX over the past two years primarily to fund growth opportunities. '

    So..The company generated cash inflow of $24.1m last year so a reduction in CAPEX will all things being equal lead to an increasing cash pile.

    I hold and continue to do so give the very low P/E, discount to NAV of 69.2 cents and $93.2m net assets providing good downside protection for a company who are well positioned and confident about prospects for 2013. Indeed if Centamin and Egypt gets resolved I'd expect another push upwards.

    Happy hunting, Shaun

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  6. Hi Shaun,

    No problem, Well done on winning the competition. Regarding the technical analysis, it is something you pick up on. Without doubt there will be some books out there - I personally don't have any specific ones though so I'll let someone else answer.

    CAPD does have a decent financial outlook. Revenues are high and rising which is most important, but equally there is this issue of debt. If CAPEX is reduced during 2013 then some of that debt should be able to paid down, rather than the levels increasing. As you note though, the PE multiple very low and does reflect the CEY and external market issues. If the former of these is resolved, you would expect to see a rising share price. The lack of clarity over these timescales and the outcome is probably what is holding it back at the minute.

    Good luck!

    El1te

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  7. CAPD is listed on the main board not AIM

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