Swick Mining Services (SWK.AX) – Merger Arbitrage and Spin-Off – 18%+ Upside

Current Price: A$0.335

Offer Price: A$0.356 + A$0.04 estimated for the spin-off

Upside: 18%+

Expiration Date: late January 2022

Scheme presentation

This idea was shared by Duncan.

 

Consolidation in the Australian metals drilling industry.

Drilling services provider DDH1 is acquiring its smaller peer Swick Mining Services in an all-stock transaction at 0.297 DDH per each SWK share. Spread stands at 6%, however, before the merger SWK will spin off it’s core scanning technology business (Orexplore) into a separate ASX listing and will distribute shares to SWK shareholders. The value of the spin-off is uncertain, but simply valuing it at the to-be-injected cash levels adds a further A$0.04 per SWK share – that’s an incremental 12%+ upside. Risk of termination seems low and both transactions are due to be completed by the end of January 2022. Regulatory conditions shouldn’t be an issue and shareholder approval is likely to be received given strong strategic rationale and support from the founder/managing director (owns 12%). Downside to the pre-announcement price is 19%.

Hedging availability for DDH on IB is limited – local Australian brokers might have higher borrow inventory. However, given a stable DDH share price since IPO, large spread and mining industry tailwinds, unhedged positions are feasible too. The next best thing after hedging DDH directly could be shorting Australian resources ETFs such as MVR and QRE – DDH is a fairly new stock but has correlated pretty closely with the ETFs since its IPO in March.

Regulatory approvals should not be an issue. A$115m merger is likely to receive ASIC (competition watchdog) consent. FIRB (foreign investment regulator) approval is also required, which is weird and probably related to the changes in the FIRB regime made in Jan’21 – this seems more like a formality, as DDH is an Australian company, based in Perth, which operates since 2006.

A separate shareholder meeting for Orexplore demerger will be held in December and the company will be spun-off into a separate ASX listing soon after that. Scheme (merger) meeting will be held in January. The scheme is conditioned on the demerger. Management is finalizing the required documentation (related to the spin) and is expected to log it with the regulators in November.

Right after the merger announcement, there was an interesting purchase of SWK shares from Westoz Funds Management – the fund acquired 2.1m shares at A$0.33/share price raising its total stake to 14.1m or 5% of SWK. Westoz manages two listed investment firms – WIC (A$167m net assets) and OZG (A$96m net assets). Total position size is at 5% of OZG’s NAV (the latest purchase was sized at an additional 1% of NAV) – a vote of confidence in merger transaction success. I expect OZG to support the transaction.

Other major shareholders (aside OZG and the founder) are Perennial Value Management with 12.4%, Castle Point Funds Management with 9.2%, and Circle 5 Management with 8.3%. No shareholders have voiced any concerns so far.

Aside from the potential transaction termination (unlikely), one risk worth noting is that the new Orexplore listing might be small and illiquid making it difficult to cash out after the transaction closes.

 

Strategic Rationale

The benefits of the combination are strong as the services of both companies are highly complementary and will provide cross-selling opportunities between DDH’s surface drilling services and SWK’s underground drilling – some clients have multiple mine sites including surface and underground. Swick engineering division’s manufacturing and maintenance capabilities will lower DDH1 CAPEX (A$43m in FY21) due to possibilities to service more rigs internally. Additionally, DDH expects A$2-A$5m pre-tax synergies from overheads and other costs (combined SG&A was A$42m in FY21) and 10%-15% accretion to EPS.

Both drillers operate largely in Western Australia, but Swick’s acquisition will add a sizeable international division to DDH with a possibility for an international expansion in the future.

In the recent IPO, DDH presented a growth strategy, which includes pursuing strategic acquisitions. Overall, it seems that SWK is a perfect fit for that. As stated by SWK’s managing director/founder:

There is a strong commercial logic in combining the DDH1 and Swick businesses and being able to offer our customers a complete range of high quality and innovative mineral drilling services from the discovery phase, through to mining and completion.

The acquisition also comes amidst the Australian resources industry boom, which caused a surge of mining/resources IPOs this year (including DDH), rising M&A activity, and the general increase of investments in the Australian mining sector. There is also a longer-term tailwind from ESG and demand for cleaner/battery metals.

The combined company will have a strong balance sheet with net cash at A$1m and will pursue inclusion in the ASX300 index.

 

Valuation of the drilling business

DDH is buying SWK business for around A$0.35/share or 3.9x FY21 EBITDA (EV A$115m). In comparison:

• A similar-sized Australian peer (mixed surface/underground) MSV.AX trades at 3.1x FY21 EBITDA, but it has a higher leverage and slightly lower EBITDA margins compared to SWK.
• A larger peer BLY.AX trades at 11.4x TTM (ending June’21) EBITDA, however, this one is a bit tricky/probably is not a good comparison, and is irrationally priced. BLY’s balance sheet is extremely leveraged (US$910m debt vs $200m+ market cap) and in the short term, lenders will likely convert their debt to equity, which will result in huge dilution.
• DDH completed the IPO at 5.3x estimated FY21 EBITDA and now trades at 5.2x. However, DDH is a noticeably better performer, with more aggressive management, much higher growth, and margins. SWK revenues went from A$120m in FY17 to A$150m in FY21, whereas DDH’s grew at 22% CAGR (partly from M&A, but the company is continuing to actively increase its fleet). EBITDA margins are 19% vs 25%.

 

Spin-off – Orexplore

Orexplore develops a fast and accurate technology for core scanning. It includes GeoCore X10 scanning machine and analysis software Insight. Management positions this as a disruptive technology, which doesn’t just scan for the composition of the rock, but visualizes the internal structure of the sample without damaging the drill core. It provides the ability to analyze the sample onsite via a mobile lab.

Honestly, SWK has been rather silent about this technology earlier and the available information is limited. Management promised to provide more details in the Scheme Booklet in November.

What we know so far:

• Orexplore was launched in 2018 and since then SWK has been getting it ready for commercialization. Orexplore has been mostly running trials with tens clients, some of which have entered into commercialization agreements (e.g. St. Barbara in FY20 for A$0.7m) and utilize the services. However, nearly no revenues except for grants were recorded in FY21.
• The division burns around A$5-$6m in cash per year (investments into development and other costs, including upcoming spin), but the product is expected to enter the market in early 2022.
• According to E&Y audit report, SWK has A$9.2m assets “comprising property plant and equipment and intangible assets relating to the development of the Orexplore mineral analysis technology CGU.” I expect these assets to be included in the spin-off.
• SWK will seed fund Orexplore with A$12m prior to the spin.
• There is a chat on Australian investor forum saying that SWK has invested a total of A$50m in Orexplore so far (excluding the to-be-jected A$12m seed funding), however, I haven’t been able to verify this figure in the filings.
• As one of the reasons for the spin-off SWK claims that “Orexplore’s progress and achievements have been somewhat lost in the mix of Swick’s drilling activities and, arguably, have not got the attention to drive its valuation”.

My insights into the attractiveness of the technology are clearly very limited. But based on the points above, I think it’s probably conservative enough to value it at to-be-injected cash levels (A$12m), which would translate into A$0.04 per SWK share.

 

Shareholder approval

SWK drilling business is getting sold at a reasonable, but clearly not a super attractive valuation. Nevertheless, I think the offer coupled with the upside from the spin-off will convince shareholders to approve the merger. The total consideration is at a 10-years-high price and I think many long-term SWK shareholders, especially the larger ones are dissatisfied with the current management given the lackluster revenue growth and share price performance. A shift to a more aggressive management should be a convincing argument. On top of that, the resources/drilling industry is currently booming and there’s a shortage of labor/equipment and rigs. If the tailwinds are going to persist, having exposure to the industry through a larger/faster-growing/better-performing company sounds like a good deal, especially if this merger will push the combined company into ASX300 index.

 

Swick

Swick is an underground diamond core mineral drilling company. The company drills only for metal industries (mostly gold, copper, nickel). It provides deep hole exploration target drilling, underground grade control, directional drilling, and other services to mining operators. On top of that, it also has an engineering division (build and sells mobility rigs) and a Mineral Tech division (Orexplorer), which develops a core scanning technology.

Drilling services is a cyclical business, but the contracts are rather long-term. Clients include major industry players like Northern Star Resouces, Barrick, and BHP. The company has 72 rigs. Most of the revenues are generated in Australia (77%, 44% of the total is in Western Australia) and 23% in the U.S. and Europe.

The engineering division is relatively young and only started generating profit last FY after selling 4 rigs to external customers. The company expects to sell 8-12 rigs in FY22. SWK is currently developing an electric rig, which is expected to reduce power consumption by 50%. The final design is scheduled for the end of FY22 (mid calendar ’22) and construction will begin shortly after that. Aside from that the company also is also working on remote control drilling system to operate rigs remotely through video-linked controls.

 

DDH

DDH IPO’ed in March at A$1.10/share. The largest single shareholder was Oaktree, which reduced the stake from 50% to 22% in the IPO.

DDH provides surface drilling services with a fleet of 100 rigs only in Australia (80% in WA). The company operates under 3 brands – DDH1 Drilling (deep complex diamond drilling), Ranger Drilling (acquired in 2019) – reverse circulation, focus on iron ore, and Strike Drilling (acquired in 2018) – air-core and reverse circulation drilling (focuses on early mine activity). Clients include Newcrest, Rio Tinto, BHP, etc.

The combined companies will look like this: