Mitchell Services (MSV)

Here you go shareholders...take back your cash...

This post was inspired by someone whose work I’ve recently found on Substack. He’s called Jacob Rowe and he introduced me to Mitchell Services through a writeup here. Personally, I’m not quite so bullish, but I do think it’s a pretty unique situation that’s worth sharing. An aggressive growth strategy being replaced by increasing shareholder distributions - what’s not to like!?

Mitchell Services is the largest drilling services company in Eastern Australia. It owns around 90 drilling rigs, which are used for extracting gold (~50% sales), metallurgical coal (~40% sales) and base metals (~10% sales).

At this point, I’m sure you’ll be tempted (as I was) to dismiss the entire drilling industry as highly cyclical and far too capital intensive. In most cases, I’d agree. There’s no escaping the boom and bust endeavours of many small drilling companies. These rely on a few rigs and operate at the higher end of the commodities cost curve. When prices are strong they can earn a fortune. But when the cycle turns, they are the first to lose business and will struggle during a downturn.

At the other end of the quality spectrum are the largest drilling companies. These partner with the biggest miners and operate at the lowest end of the cost curve. Downturns reduce activity but these drillers often stay busy and profitable throughout the cycle.

Mitchell Services is a fascinating case because it has quickly transitioned from a small speculative business with a few rigs to become one of the largest and most diversified drilling services companies in Australia. When Mitchell Services was created in 2014, it operated an average of 8 rigs. By 2024, this number had grown to 73.

Alongside this rapid growth in the number of drilling rigs was an improvement in business quality. Over time, these rigs have become more specialised and customer switching costs have strengthened.

When starting a drilling business, Underground Minerals is an obvious choice. This uses the smallest, simplest, and cheapest rigs, meaning barriers to entry are low and competition is high. Instead of following this path, Mitchell Services expanded into Surface Minerals by acquiring two competitors in 2014 and 2015. Surface Minerals use bigger, heavier rigs, which are more expensive and complex to operate. Competitors are fewer, contracts are generally longer, and the rigs are better linked to the operations of the mine.

Here's some idea of the size difference:

In 2018, Mitchell Services bought Radco Technologies, a provider of Underground-In-Seam drilling. This highly specialised service involves draining hazardous gases from a coal mine. It’s a niche part of the industry and a duopoly, with only one other business in Australia (AJ Lucus) providing this service at scale.

Mitchell Services also expanded into large diameter drilling (used for power or air), geotechnical drilling (for evaluating the soil, rock, and ground water), and more recently decarbonisation (for reducing emissions).

This focus on more specialised rigs has helped drive a steady increase in the Sales per Average Operating Rig.

A second improvement has been within the customer base. In 2014, only 37% of customers were Tier 1 mining companies (think Glencore, Newmont, Anglo American, South 32). Today, this figure is over 90% and almost all sales are earned at productive sites, as apposed to the more speculative greenfield projects.

On average, customer contracts last around 3 years. Cancellations are rare, but the terms are far from watertight, allowing amendments (or even cancellations) at short notice. Interestingly, a daily rate is earned throughout the contract, no matter the conditions. If the mine stops operating due to inclement weather, a lower standby charge is still paid.

Moving onto management team, there’s clearly an owner-operator mindset. Nathan Mitchell is both the Executive Chair and the largest shareholder, owning ~20% of all shares outstanding. Scott Tumbridge (who was CEO of the recently acquired Deepcore Drilling) is the second largest shareholder. He sits as a Non-Exec and owns ~8% of all shares outstanding.

The executive team, led by the CEO Andrew Elf, have been together for over a decade and, on balance, their capital allocation looks pretty good. Of the four businesses acquired, three were bought out of administration at a fraction of the equipment’s replacement value. Further growth came in 2021 from the purchase of 12 new surface rigs. The timing of which coincided with Covid era stimulus that allowed for the creation of a large Deferred Tax Asset.

On the financing side, the benefits are less obvious. Multiple equity raises (at similar prices to today) have consistently diluted shareholders. Despite growing sales (even on a per share basis) the company’s share price has languished for years.

Normally, I’d be put off by this type of growth strategy, especially given the material dilution. However, in 2022 the management team changed tack. Acquisitions were halted and capital expenditure was cut in half. This led to incredible Free Cash Flow generation, which was initially used to pay down debt, and more recently, to increase returns to shareholders. Share buy-backs have been growing and the dividend yield currently sits at ~10%.

Thankfully, these distributions look set to continue. Management have ruled-out further equity raises and continue to focus on maintaining the current drilling fleet. Capital expenditure has increased from a low point in FY 2023, but the guidance is relatively stable going forwards.

With a share price of 40 cents per share, the current market capitalisation is ~A$85 million. Net Debt is now immaterial and in the year to 30th June 2024, Mitchell Services produced an Operating Profit of ~A$13 million and Free Cash Flow of A$26 million. Using either metric gives us a low valuation, especially given the improving quality and the increasing distributions.

The main risk here is obvious. Operating Profit and Free Cash Flow always look strongest at the top of a cycle, making it the prime time for investors to get burned. Maybe I’m using peak earnings, or maybe we’re at the start of a new commodities supercycle. I’m not convinced anyone truly knows.

What is clear to me, is the improving business model and the willingness of management to accept when growth opportunities are limited and return cash to shareholders. Together, these elements are rare, and help de-risk this investment over the longer term.

In the meantime, the number of operating rigs is trending downwards and there’s good chance quarterly results may disappoint. Yet, with strong commodities markets, almost no debt, and the continuing capital return program, I’m happy to hold. Content that the future of Mitchell Services will be much brighter than the past, especially for its shareholders!

Disclaimer. This article is for informational purposes only, and should not be seen as investment advice. Please do your own research before investing in any company mentioned.