Description

Recommendation

Buy 12/10% senior secured notes due ’22.  The bond trades in the mid 90s and offers a double-digit current yield and could provide mid-teens equity-like returns over the life of the bond.  While I’m recommending the SSNs for the purposes of this write-up, I like all of the secured instruments in the capital structure. There are subtle differences in the various issues that I’ll discuss later but they all offer rich yields and I believe they are covered even if you assume marginal improvement from current trough levels in the fundamentals of the business and industry.  Assuming $65mm of EBITDA for FY18, the SSNs can be created at a multiple of 7.9x which wouldn’t seem all that interesting to most people.  However, normalized EBITDA is well in excess of this amount (more on this later) and the closer we get to that level, this bond should trade materially higher in price.  Furthermore, the SSNs have an unusual call/redemption schedule that provides holders additional upside the longer this bond stays outstanding – for example, if the bond is redeemed at the contractual maturity date, par value is 124.4, which works out to nearly five additional points per year.

Buy 1.5% subordinated PIK notes due ’22.  If you can find the bonds, this is a tiny issue and should essentially be treated as a proxy for the equity.  At 8.2x my FY18 EBITDA estimate, this bond probably doesn’t have much intrinsic value today but at closer to normalized EBITDA levels in a couple of years, the bond could trade in the mid to high 80s, at say a 7.0% YTM.

Buy common stock.  Sized properly, I believe the equity is a fantastic speculation if one believes in a mining sector recovery and that the Company can get above $125mm in EBITDA within the next 2 to 3 years.  While I don’t think most investors are skilled enough to project longer-term cash flows for a business like this, it’s worth noting that BLY generated in excess of $125mm in annual EBITDA during the period FY08 – 13.  This time period included several years where EBITDA came in above $300mm and even reached $400mm in FY12.  I’m certainly not suggesting we get (or do not get) anywhere near those levels again but merely pointing out the explosive upside optionality inherent in buying this levered equity.

The loans, bonds and equity are all closely held by the plan sponsors at the moment and transacting in them may require a bit of effort but liquidity should inevitably improve once there’s more sell-side coverage of the Company and also as the plan sponsors look to reduce their exposure to the name.  This overhang may impact trading prices in the near-term but should not impact the longer term potential upside should the mining recovery thesis play out.

Situation Overview

BLY operates in a highly cyclical industry where its business prospects are at the mercy of commodity prices and drilling expenditures of mining companies.  After enjoying several years of strong operating performance thanks to a robust mining drilling environment, BLY hit a wall in 2014 after commodity prices crashed and came within months of tripping its bank covenants.  This allowed Centerbridge Partners to step in and take control of the Company in early 2015 in an out-of-court restructuring with a $300mm cash infusion.  Unfortunately, the business never recovered and got even worse over the next two years prompting the need for an even bigger restructuring. 

In September 2017, after a hotly contested court supervised plan process, BLY successfully restructured its balance sheet, which resulted in reduced debt, improved liquidity and extension of maturities.  The plan sponsors included Centerbridge, Ares Management and Ascribe Investments.  The principal on the $284mm 7% notes due 2021 issue was reduced by ~$196mm in exchange for significant equity in the restructured business. Additionally, interest on all new restructured debt instruments may be paid-in-kind at the Company’s election until December 2018 (and in some cases, till maturity) and maturities on all the restructured debt were extended to December 2022.

With the balance sheet now restructured, BLY is very nicely positioned for a potential recovery in the mining services sector.   

Company Overview

Established in 1890 and headquartered in Utah, BLY is a global integrated provider of drilling services, drilling equipment and performance tooling for mining and mineral drilling companies.  It also has a substantial presence in aftermarket parts and service, energy, mine de-watering, oil sands exploration, production drilling, and down-hole instrumentation.  The integrated business model of providing both drilling services and drilling products globally gives BLY the ability to integrate knowledge gained from both divisions into the development of new products, and improve its drilling service offerings.

The Company operates in Asia Pacific, North America, Europe, the Middle East and Africa, and Latin America.  North America accounts for 46% of their current revenues, followed by Asia Pacific with 21%, EMEA with 18%, and Latin America with 15%. 

Global Drilling Services

The Global Drilling Services division provides drilling services to mining and energy companies, water utilities, geotechnical engineering firms, government agencies and other mining companies in approximately 22 countries.  The Company has over 700 drilling rigs available globally, making BLY the single largest provider of rigs to the mining and resources industries.

The division, which accounts for 68% of the Company’s total revenues for FY17, primarily offers drilling services for commodities such as gold, copper, and nickel, as well as for the exploration and development of non-conventional energy sources such as shale oil, oil sands, coal, coal seam gas and geothermal energy. 

Drilling Services operates in the greenfield, production and development stage of the mining cycle, with the development and production stages generating the majority of revenue.  BLY specializes in a range of drilling services technology, including surface and underground diamond core drilling, underground percussive drilling, sonic drilling, surface rotary drilling, surface geotechnical drilling, and surface and underground reverse circulation drilling.  

Approximately 87% of Global Drilling Services’ revenue for FY17 was derived from major mining companies, with the majority of these customers servicing the copper and gold industries.   Major customers include BHP Billiton, Goldcorp, Barrick Gold, Randgold, Goldcorp, Newmont and Rio Tinto.  No single customer contributes more than 10% of the Company’s revenue.

Global Products

The Products division designs, manufactures and sells a range of drilling equipment and performance tooling, including wireline core extraction systems, drilling rigs, diamond drill bits and drill rods for mine development, mine production and environmental and infrastructure drilling. The Company’s customer base includes companies in the environmental, mining, resources, infrastructure, and energy industries. Its coring tools include conventional diamond drill and advanced wireline coring systems used in minerals drilling.  The division predominantly sells exploration tooling and production tooling to drilling services contractors and mining companies.

Overall, the Products division accounted for 32% of the Company's total revenues during FY17. The division still carries significant inventory levels, which were built up during the last cycle on the expectation that the good times in the mining industry would continue. The subsequent market contraction led to a reduction in orders causing a surplus of inventory. While inventory has decreased, levels still remain high and so there should be sufficient inventory in place to fill most customer demand in FY18 and therefore purchase activities at production facilities are relatively low.

Exploration Budgets

After a brutally painful four-year period for the exploration sector, things may finally be on the up and up.  Global spending on the search for nonferrous metals rose to an estimated $8.4bn in 2017, compared with $7.3bn in 2016, representing the first annual increase in exploration spending after four consecutive years of declining investment in the search for nonferrous metals.  To put the improvement in perspective, the 2017 spending number is still 60% lower than the record high number from 2012, which may suggest that there is still room for improvement in the coming quarters and years.

Exploration activity was strengthening throughout 2017 thanks to improved equity markets for mining companies which allowed companies to launch or resume drilling programs, including many that were dormant during the last several years.  In Q4 2017, there was a sharp increase in reported drill results and capital raising for mining companies closed the year on a high note.  While exploration for gold was the focus for many miners, activity for base metals also rebounded in the second half of 2017.

Another positive sign for the sector is the renewed interest in grassroots exploration.  During most of the last decade, the number and value of annual initial resource announcements has trended downward.  A year does not make a trend but the situation may be improving. The portion of exploration budgets attributed to initial resources grew by 16% in 2017, compared with the 14% growth in the global budget.  Furthermore, industry experts and governments are starting to acknowledge the need to revive investment in the grassroots exploration that can lead to new resources. Australia and Chile, for example, are encouraging grassroots exploration by its junior companies through tax breaks and government programs.

With the generally positive trend in metals prices extending into early 2018, some sector research firms expect the global exploration budget for 2018 to increase by 15 – 20% year over year with more emphasis on early-stage efforts. Potential headwinds, however, to this forecast include ongoing instability in global and national politics, and emerging market volatility, that could have a negative impact not just on exploration budgets but on the mining sector in general.

Summary Financials

BLY’s recent P&L is both ugly and messy.  During the last five years, the Company has burned $220mm in cash on account of operating losses and massive restructuring and recapitalization costs.  This cash burn was financed by continuous debt and equity capital raises. 

However, market conditions in 2017 saw a modest improvement as most of the world’s mining companies increased exploration and capital expenditures. During FY17, drill rig utilization ended the year at 43%, up from 32% at the end of the previous year.  Comparatively, utilization was approximately 55 – 65% at the top of the last cycle.  Rig utilization improvement has not yet translated into increased pricing conditions for products and services as there is still oversupply of rigs in the industry.

The Products business has historically been a leading indicator of activity in the Drilling Services business, so the improved demand in the Products segment, particularly in the second half of FY17, is a positive sign for FY18 prospects. Backlog increased 73% to $26mm from $15mm at year-end FY16.

For FY18, I’m assuming another year of 15% growth in the top line and some improvement in the margins on account of cost cutting measures implemented during the restructuring process to get to $65mm in EBITDA.  The business doesn’t need a big increase in capital expenditure spend (net of excess equipment sales) and so there should be ~$52mm in unlevered free cash flow for the year.  While for presentation purposes, I’m including total interest (PIK and cash) in the table above, cash interest will be less than $6mm for FY18 and so there should be at least $45mm in cash build for the year before any increase in working capital spending.

To put the volatility of BLY’s fundamentals in perspective, below is a chart of the Company’s EBITDA during the FY08 – FY14 period.  Smart folks can debate whether or not this was a 'once in a lifetime' type time period for mining exploration and that companies like BLY may never come close to enjoying that level of profitability again.  I think that argument is certainly plausible but the bigger takeaway for me is that the current level of profitability for BLY is at the lower end of historical levels and that we are more likely to see an improvement in the coming years rather than a major decline.

Capitalization

Post restructuring, BLY has $646mm in total debt (inclusive of $86mm of accreted interest), cash of $44mm and availability under the ABL of $20mm.  The market cap, based on 27bn (yes, billion!) fully diluted shares outstanding, is $208mm.  Note that the interest rates below are for FY18 only and in some cases, they will be lower during FY19 and beyond.  Furthermore, the interest expense reflected below may be either cash interest or PIK interest, depending on the issue. 

Some key terms of the capital structure are as follows:

Senior secured notes.  Second lien on the working capital assets of the Term Loan B and SSN guarantors that are not ABL or Backstop ABL guarantors, a third lien on the working capital assets of the Term Loan B and SSN issuer and the other Term Loan B and SSN guarantors that are also ABL or Backstop ABL guarantors, and a first lien on substantially all of the other tangible and intangible assets of the Term Loan B and SSN issuer and other guarantors, including equipment, intellectual property, the capital stock of subsidiaries and certain owned real property (excluding assets of BLY IP, Inc.).  Change of control put at 101.  Interest rate of 12% PIK until December 2018 and 10% cash pay thereafter.  An unusual call/redemption schedule is as follows:

ABL.  First lien on working capital assets and a third lien on substantially all of the non-working capital assets including equipment, intellectual property and the capital stock of subsidiaries (but excluding real property), and in any case excluding assets of BLY IP, Boart Longyear Suisse Sarl and Boart Longyear S.A.C.  The facility does not include ongoing financial maintenance covenants. Interest rate of 10% PIK until December 2018 and 8% PIK thereafter.

Backstop ABL.  Same security and collateral package as ABL but including any real property pledged as security for the SSNs.  Interest rate of 11% cash pay.

Term loan – tranche A.  First lien on the working capital assets of the guarantors that are not ABL or Backstop ABL guarantors, a second lien on the working capital assets of the Term Loan A issuer and the other Term Loan A guarantors that are also ABL and Backstop ABL guarantors, and a second lien on substantially all of the non-working capital assets of the Term Loan A issuer and guarantors, including equipment, intellectual property, the capital stock of subsidiaries and certain owned real property (excluding assets of BLY IP).  This loan is non-callable for the first 4 years.  Change of control put at 101.  Interest rate of 10% PIK until December 2018 and 8% PIK thereafter.

Term loan – tranche B.  Same security and collateral package as SSNs.  This loan is non-callable for the life of the loan.  Change of control put at 101.  Interest rate of 10% PIK until December 2018 and 8% PIK thereafter.

1.5% subordinated PIK notes.  Interest rate of 1.5% PIK through maturity.

Equity and warrants.  As of year-end, there were 26.3bn shares outstanding and 731mm in the money warrants outstanding.  I’ve assumed a fully diluted share count of 27bn and to be conservative ignored the $5mm that may be raised when the warrants are exercised.  

Valuation and Recovery Thoughts

I believe BLY is a 6.0 – 7.0x EBITDA business given where I think we are in the cycle (closer to the bottom than top).  The tricky part is figuring out what normalized EBITDA will be for a business like this.  Even management is not comfortable making a forecast.  Below are some projections that they produced as part of the restructuring process – the wide ranges are eye popping but understandable given the nature of the industry: 

I’m comfortable using $75mm at the low end for normalized EBITDA but less confident in my high end assumption of $125mm even though this is still a significant discount to the average from the most recent cycle.  Based on that range, I value BLY at $500 – 925mm.  The low end is consistent with the $550 – 650mm expert valuation prepared by KPMG during the restructuring process.  However, I think KPMG was overly conservative on the high end – seems strange to me to have only a $100mm delta between the high and low estimate for something as volatile as BLY.  

The SSNs (and the other credit issues) generally make out well in these scenarios, as downside is manageable even in my low case.  As you might expect, the unsecured notes would be worthless in my low case but would make out well in the other scenarios.  As for the equity, you need the high case to pan out in order to make money but frankly, you’d only buy it today to bet that there’s a realistic chance that BLY can exceed even the high case, which is why I’ve included what I call the 'homerun' case.

Note that the waterfall below is rather simplistic in the sense that I’ve ignored cash build, any PIK interest accretion on the loans and bonds, and any potential redemption premium on the SSNs. 

Finally, it’s worth mentioning that the management incentive plan was structured as a private equity based long-term incentive plan that incentivizes senior management to increase the Company’s value over time.  Only one-third of the MIP payout is based on time vesting.  The remaining two-thirds is based on increases in the enterprise value of the Company.  Specifically, there are two performance vesting criteria – one set at $900mm TEV, representing a third of the MIP and the other set at $1.1bn TEV, representing the final third of the MIP.  In order for management to get paid on the performance portion of the MIP, the Company’s EBITDA would have to improve significantly to $125 – 175mm levels within the next few years. 

Catalyst

- pick up of sellside coverage in Australia and perhaps even the US

- additional liquidity in the securities as the sponsors reduce exposure