Drillcon: An anti-Buffett stock

A small drilling company called Drillcon AB has had my attention the last week or so. I've called it an anti -Buffett stock as it is a capital intensive business, with as far as I can tell no moat, no economic goodwill nor brand. On top of that its performance relies heavily on commodity prices.

First a bit of background. It is a Swedish small cap that whose main activities are diamond core drilling above and below ground, directional core drilling, raise boring and horizontal raise boring. It's operations cover Sweden, Finland and Portugal.


I've not been able to pinpoint exactly how many machines it has but the end of year report 2012 report refers to about 51 being in use in it's three geographical operations (double counting is highly likely as the Swedish arm of the business hires out machines to the Portuguese arm.)

Anyway, since mid-2013 the company has suffered a drop in revenues in Finland due to reduced prospecting activities and lower precious metal prices. The company of course has a high level of CapEx as fixed costs, meaning a relatively small drop in revenues (-8%) caused operating profit and net income to fall off a cliff by over 70%! (Of course this world both ways if these lost sales are recovered, profits will bounce back.)

Interestingly I think this has resulted in a situation where the company looks expensive in respect to its earning power and cash flow, yet looks cheap relative to its assets. For instance, all rolling P/E, EV/EBIT and EV/EBITDA ratios look relatively high and are significantly higher than end of 2012, despite the 26% drop in stock price. 

In contrast to its income the share price is trading just above it's book and tangible book value of 3,07sek. The vast majority of the companies equity is made up of its tangible assets (i.e. drilling machines) and it has little debt.

P/B & P/TB 1.02
Current ratio 1.64
Total debt/Equity 29%

An investor buying this companies stock is effectively buying its drilling machines at book value, nice, but unfortunately overpaying the current income stream (such is the case with these type of situtations). This leaves an interesting dichotomy about which is more important in determining the company's fair value. 

A deeper look in the notes shows that Drillcon's machine purchases total about twice the current tangible book value, the difference has been depreciated away over the years. This begs the question, what is the real market value of these assets and what would be their value in the event of a liquidation? I assume the latter would be significantly lower as the company would be a forced seller and the market for drilling machines wouldn't being very liquid.

Clearly Drillcon is in a cyclical industry and mining is in a depressed state at the moment. The key is knowing whether Drillcon specifically is in a permanent decline and whether it will get it's profits back. What I've been trying to decide is whether the current price gives a sufficient margin of safety to protect from this potential negative outcome.

No doubt the share price could fall significantly below tangible book, especially if the company continues to loose sales and profits. In actual fact the share price could fall at a constant P/TB ratio as the value of its assets are depreciated away and the company can no longer afford new CapEx. The company would then be worth more dead than alive.

It should be mentioned at this point that both the Swedish and Portuguese businesses are still growing (albeit slowly). Plus investment company Traction increased its stake in the company back in the summer by making an offer to share holders at a share price of 2,90sek. This may put a short to medium term support level.

Looking forward if the Finnish operation claws back some sales and manages to generate zero EBITDA, instead of a loss so far seen in 2013, then EV/EBIT becomes 5 (about the same as 2012). I would like see a bit more pessimism and a better margin of safety to get me interested.

I expect a correction in the market soon (yes timing the market is not a good idea!) and combined with the possibility of poor report in February could present an opportunity as this stock goes lower.

It looks like Mr Market may deliver with another 2.2% loss yesterday. This is despite Catapillar's better than expected EPS numbers which pushed up related mining companies.