Accounting is backwards looking—as investors, we have to be forward looking. That said, past numbers are usually a good starting point for estimating future earnings. Numbers only tell you part of the story—the reason why the numbers are how they are, is often much more important than the actual numbers. Unless you can understand the moving pieces involved in the final numbers, you cannot possibly understand the business or what future results may look like.
I have written about Energold (EGD: Canada) in the past. It is an operator of environmentally friendly, man-portable drilling rigs that service the mining industry. The company is experiencing remarkable growth in both rig count and numbers of meters drilled. I believe that it is also about to experience even more remarkable growth in earnings—growth that most investors do not understand because they keep focusing on last year’s earnings and not future earnings. Before we dive into what future profits may look like, we need to understand the drivers behind earnings.
To start with, operating drill rigs in dozens of emerging markets is not an easy endeavor. You have corporate costs, you have daily costs per rig in the field and you also have costs per meter drilled. Many of these costs are fixed in nature. Corporate costs do not vary much as employment contracts and rent are static. If you hire crews for your rigs, those costs are also rather stable. The only real variable is how many meters you drill—the more meters drilled, the more bonuses you pay your employees, the more diesel you consume and the more drill bits that get chewed up. You also have to consider how many new rigs are deployed.
When a new rig is built, it gets shipped to its first job site. Then it has to clear customs and get mobilized into the field. This all costs money. Even more expensive is the task of hiring a new drill crew and training them. There is no way to quantify this expense, but it isn’t cheap. If you figure it costs between $150,000 and $200,000 a rig, then when the company adds 30 rigs this year, it will cost between $4.5 million and $6 million to get them crewed up and earning profits. Clearly, this is a sizable line item in the income statement. It is a real expense that you cannot ignore, but when I value a company, I want to know what the earnings are at a steady state—not when the business is growing like kudzu. I realize that I take some accounting liberty in doing this, but I like to take this growth expense out of the earnings numbers to get to what I will call the ‘core earnings.’
Now let’s look at revenues. Revenues drive income—especially in a business like Energold’s, where there are high margins and many fixed costs. When you look at revenues, there is a very easy calculation to use. Meters Drilled X Price Per Meter = Revenues. Unfortunately, this equation is open to a lot of interpretation. How many meters will Energold drill in 2011 and what will they get paid per meter? For meters drilled, I find that if you look at last quarter’s results and annualized them, you are likely off to a good start—in fact you are probably being conservative as Energold will continue to add rigs that operate at very high rates of utilization.
Pricing is the most difficult variable to estimate. Over the past three years, quarterly price per meter has been as high as $194 in 2008 and as low as $144 in 2009. Conference calls and industry contacts are useful guides for where current pricing is and where it is likely to head. Remember that there is a six month lag between contract signings and when that shows up in the income statement. Based on recent talks, I believe that pricing is around $190 now and heading higher. To be conservative, let’s use that number.
Now, we have to put it all together.
|2010 Meters Drilled||346,300|
|2010 Drilling Costs||43,061,923|
|2010 Cost Per Meter Drilled||$124|
|2010 Corporate Expense Before Options||8,179,975|
|Q1/2011 Meters Drilled||125,800|
|Q1/2011 Meters Drilled At An Annual Rate||503,200|
|2011 Estimated Price Per Meter||$190|
|2011 Estimated Margin Per Meter||$66|
|2011 Estimated Gross Margin||33,211,200|
|2011 Estimated Corporate Expense||10,000,000|
|2011 Estimated Pre-Tax Income||22,211,200|
|2011 Estimated Net Income||17,408,400|
|2011 Estimated Earnings Per Share||$0.44|
Remember, that these are estimates and subject to a lot of guess-work. I’m guessing that corporate expense grew by almost a quarter to account for having a similar increase in rigs. I also estimate that recent tax planning efforts finally start bearing fruit and lower the overall tax rate closer to 25%. Keep in mind that the above number is roughly what I expect reported earnings to be—what I really want to know is what standing still earnings look like.
In 2010, Energold grew from 80 to 103 rigs. In 2011, the company intends to grow from 103 to 133 rigs which is a similar growth rate. This is the reason that I feel confident using 2010 expense numbers as a starting point for 2011 numbers as 2010 already accounts for the rig mobilization costs that I spoke about earlier. To get to the ‘core earnings’ number, we have to subtract this growth expense. If we take the low end of this estimate for 2011, $4,500,000 and add it back to income, we have earnings per share increasing to $0.52, after tax.
Keep in mind that when you drill 500,000 meters a year, every dollar change in pricing is worth $500,000 in revenue or almost a penny a share in income. Therefore, revenue per meter is really the driving force behind changes in earnings and the data point that I watch closest. From recent conversations with mining companies in desperate need of drilling rigs, I feel strongly that $190 a meter is a waypoint towards much higher pricing power. I have recently heard people talk about $300 a meter on rush projects, that was unheard of a year ago. Demand for exploration services is finally picking up (which is a story for a different piece).
So what is Energold worth? Today it’s either trading for a high single digit multiple on rapidly growing reported earnings, or a slightly lower rate of earnings on standing still earnings. Pricing is about to accrue to the industry in a pretty remarkable way and it should be pretty clear that Energold will drill a whole lot more than a half million meters this year. Plug 650,000 meters at a $200 price into my model and you’re at $0.75 a share, even before accounting for growth expenses. I’m not saying that this is my estimate for earnings, but I wouldn’t be surprised to see that be the actual number either. Could Energold be trading for less than five times standing still earnings? In Q1, the company grew meters drilled by 131% over the prior year. What is the correct multiple on the industry leader in a rapidly growing business? It has to be worth more than a single digit multiple, right? Get ready for growth and pricing power. There is a reason that Energold is my fund’s largest position.
DISCLOSURE: My investment partnership owns shares of Energold. We may buy or sell shares without further notice. This is not a recommendation to buy or sell shares.