Feature: Foraco International
History
The company was founded in France in 1961, designing small geophysical drilling rigs primarily for water drilling efforts in West Africa. It changed ownership several times, including at one point being a wholly owned subsidiary of a predecessor company of Total SA before Daniel Simoncini (CEO) and J.P. Charmensat (CFO) acquired 100% of it in 1997.
The management team built up the company from $16 million to $50 million in revenue in 2006, mostly through acquisitions in water drilling in Africa and greater expansion into mining. In July 2006, the company hired Tim Bremner as SVP of North America to expand and build the business in a new region.
In 2007 the company went public on the TSX to help fund this expansion. At the time the company had 100 rigs and 50% of its revenue came from water drilling and 50% from mining. 68% of its revenue was from Africa with the remainder split between Europe and Asia Pacific.
Over the next five years, the company grew aggressively through acquisitions and regional expansion, culminating in large acquisitions in Brazil and Australia in what was to be the peak of the market in 2012. At this stage, Foraco was operating 308 drill rigs in twenty-three countries with over 3000 employees. Being in a cyclical industry with too much debt at the wrong time can be very painful if not lead to bankruptcy.
Fortunately, Foraco was able to negotiate with their lenders to give them more time. As the funding for junior mining companies dried up, drilling work in the mining sector contracted significantly, and pricing in areas like Australia was weak with low industry utilization.
During this period, the company streamlined operations cut costs, and stayed EBITDA positive – but was not able to reduce the debt burden.
Foraco Deleveraging Through Time
There are only two other companies of size that can effectively compete for work with the major mining companies – Major Drilling and Boart Longyear. Major Drilling has approximately 600 rigs and similar capabilities as Foraco. It is a public company with a strong balance sheet. They have been a disciplined competitor looking to compete on service – not on price – which has led to pricing stability in the market since the recovery from the cyclical lows in 2016.
Boart Longyear is a larger diversified company with its largest segment being drilling services. They are more vertically integrated selling drilling rigs and their components as well as a technology solution focused on geological data. With approximately 620 rigs, its drilling services division is about the same size as Major Drilling. Boart Longyear was over-leveraged coming out of the cyclical downturn and was investing more in their equipment and technology divisions. They needed to recapitalize their balance sheet in 2021 to reduce their heavy debt burden.
These competitors have a similar margin structure as Foraco, suggesting that at 300 rigs Foraco is capturing the scale economies available to its larger peers. We expect the competitive dynamic to continue to be disciplined as there is lots of work to go around. Despite the recent growth, rig count across the three players has been stable over the last 5 years suggesting that all players are focused on better utilization and passing along cost inflation through better pricing.
Investment Case
Our investment thesis is based on three main tenets;
The quality of Foraco’s business model is not well understood,
Foraco’s growth prospects are strong and have embedded optionality, and
Its valuation in the market is extremely mispriced.
Quality Business Model
Foraco has made dramatic improvements to its business over the last three years, fixing its balance sheet, realigning the fleet to focus on more stable and growing geographies, and increasing its utilization. Since Foraco was over-leveraged from 2013-2020, it had too much debt to appeal to investors – it simply fell off the radar. Investors could gain exposure to mining services through Major Drilling, a less leveraged, larger, and more liquid competitor. But Foraco has improved, and it is now stronger and better positioned than it has been at any time in its history.
Foraco differentiates itself based on quality service (our channel checks confirmed this) and they provide technical expertise in highly specialized areas, like drilling to solve water management issues within the mine site. Management has focused more on specialized work over the years (water management, long hole drilling) which is more resilient given there are fewer competitors.
On November 8th, 2023, Foraco announced that it refinanced its debt, reducing its borrowing cost by nearly 50%, signaling its return to commercial banking relationships. It will now have more money to allocate to growth. For the first time in over a decade, Foraco’s cost of capital is lower than its return on invested capital (ROIC) – a positive trend that we anticipate has a multi-year runway ahead of it.
Foraco’s ROIC Progression
The industry changed after the low point in 2016, the majors are more willing to sign 3–5-year contracts to ensure rig availability for development and production work instead of risking timelines trying to save 10-15% on drilling. This willingness to contract and placing an emphasis on service timelines is good for pricing and utilization, something that is not well understood by investors today.
We also believe that the industry will remain more disciplined as the larger players will be reluctant to add more capacity without contract commitments and will focus on increased utilization for growth. Industry utilization rates are between 45-60% and have been in this range for years. This should bode well for the industry, but particularly for Foraco as it is the most mis-understood of the group.
Foraco’s Primary Customers
Loyal customers: 70% of revenue consists of renewals of contracts that have been in place for more than 10 years.
Foraco Segment Exposure - September 30, 2023
Growth Prospects
Over the last 10 years, Foraco has had to exclusively focus on debt repayment. Only now, going into 2024 can it look to selectively put growth capital to work. Tim Bremner who was hired as SVP of North America in 2006 was appointed CEO in March 2023 with Mr. Simoncini and Mr. Charmensat remaining on the board. Tim Bremner built the North American business (mostly organically) from nothing in 2006 to US$120M+ in revenue a year (TTM ending September 30, 2023) – now 33% of the business.
We expect Mr. Bremner will expand into the U.S. market, increase exposure to battery metals mining across the Americas, and continue to win work in the water space like the US$74M 5-year water drilling contract for Rio Tinto in Australia announced in April.
We believe that there is likely to be increased demand for base metals as part of the energy transition and that this will lead to increased demand for drilling services. But you don’t need to believe in outsized growth in demand for this to be meaningful for Foraco, even a measured mid-single-digit steady growth in demand drives a lot of value for the company.
We believe that there is optionality that you are not paying for today. This includes seeing strong double-digit demand for mining services and a sharp increase in demand for water drilling services (a higher margin area of expertise for Foraco).
A step change in utilization (currently at 58%) could lead to much stronger margins and a higher ROIC. We expect gradual progress in building into the U.S. market – but that could move faster with a small acquisition and dedicated regional expansion.
Compelling Valuation
When we first started researching Foraco in September it was trading around 2.1x 2024 EV/EBITDA and 2.7x 2024 P/E, while Major Drilling was trading at 3.7x 2024 EV/EBITDA and 8.4x 2024 P/E. We believe that Major Drilling should trade at a premium to Foraco, it is larger, its shares are more liquid, and it has a larger following by institutional investors and analysts – with 5 covering analysts.
Our intrinsic value model, using a mid-single-digit growth rate for the next few years before paring back growth in the outer years, and using modest margin assumptions gave us a $4.25 share price. That was showing a huge upside to the $1.80 share price at the time. This is a cyclical industry, and we did not explicitly factor in a downturn in our model, which is why we wanted to be conservative with our growth numbers. We also estimated that at $1.80, shares were trading at a 23% (pre-growth capex) free cash flow (FCF) yield on our 2024 estimates.
We saw very little downside and considerable upside, even if our intrinsic value turned out to be optimistic. We believe the path to value realization will occur through multiple phases. The first is awareness, only one analyst covers the company, as the company is small and has been easy to ignore for a long time given its over-leveraged history. We believe that as the company continues to deliver strong results like it has been doing, investors will wake up to this and begin to revalue the stock. This has already started to happen in early 2024.
We also see a path of shareholder returns, with a possible dividend announcement and management actively buying back shares. These actions could also turn investors on to the company. We also believe that the entire industry is trading at a depressed level and that this is not warranted given the more favourable competitive dynamics and trajectory for growth in drilling services.
Early evidence that investors are beginning to recognize this value was seen with the December 27th announcement of the takeover of Boart Longyear by U.S. private equity firm, American Industrial Partners. The takeout value represented a 5.4x trailing 12-month EBITDA valuation. While Boart Longyear is a larger and more diversified business than Foraco, using that same multiple would value Foraco at over $5.00/share. We believe $4.00 is a fair price for Foraco based on triangulating our intrinsic value model, our FCF yield analysis, and using a 5.5x 2025E EV/EBIT multiple. We could revise this higher if Foraco delivers on any of its higher growth opportunities.
Foraco fits within our investment process because its quality and growth are under-appreciated. Both its business and industry dynamics have changed for the better, laying the groundwork for a multi-year growth trajectory.