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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