Certainly an intriquing story.18/9/12Hughes Drilling (ASX: HDX)...

Certainly an intriquing story.

18/9/12

Hughes Drilling (ASX: HDX) has secured a rolling 12 month contract for an initial three years to provide blast hole production drilling services at Anglo American’s Foxleigh Coal Mine in Queensland’s Bowen Basin.

A key differentiator for Hughes is its drill blast services are for operating coal mines.

Anglo American is the second largest metallurgical coal exporter in Australia with six mines in Queensland and New South Wales, and around 32 million tonnes per annum of saleable coal per year.

Acquired by Anglo American in 2007, the Foxleigh Mine produces around 2.5 million tonnes per annum of pulverised coal injection coal for the steelmaking industry. The mine’s production capacity is 3.3 million tonnes per annum of product coal.

Hughes will begin mobilisation of two new Reichdrill blast-hole (production) rigs to the project late in the December quarter of 2012, with onsite operations of the first rig set to begin in January 2013.

The project is expected to generate revenue for Hughes over an initial three years through a rolling 12 month contract.

The services are production drilling, that is, they are part of the mine production process and not part of any exploration activity.

So far, for the 2013 financial year, Hughes has taken delivery of or has outstanding contract backed orders for six new blast hole rigs, taking its blast hole fleet size to 33 rigs.

The company’s blast hole rig fleet is almost entirely Reichdrill rigs – a business decision that contributes to Hughes’ high relative productivity, effficiency and low cost maintenance.


Strong competitive position

A core differentiator of Hughes is that it provides rigs to coal mine developers and production drillers, compared to supplying the exploration drilling segment which is more prone to cycles and earnings volatility.

This strategic approach has resulted in the company realising net earnings of $8.5 million on revenues of $39.2 million for the year to 30 June 2012.

The company has generated strong cash flows and profits from the first full year of the reverse merger with the cleaned-up shell of Every Day Mine Services Limited.

The net profit of $8.5 million and return on equity of 34.1% reflect the company’s strong competitive position.

Hughes expects ongoing revenue and earnings growth, primarily driven by rigs purchased part way through the 2012 financial year working full years in fiscal 2013 and beyond; further expansion of the blast hole rig fleet as contracts are won; and Express Hydraulics progressively expanding sales of drilling sector agency lines.

The company is the largest provider of blast hole drilling services to Australian coal mine operators that are currently mining coal for export markets.

It services blue chip, long term clients including Peabody Coal, BHP Mitsui Coal, Downer EDI Mining and Leighton Mining.

Hughes operates through three profit centres that include blast hole drilling services for open pit coal mines, coal resource delineation drilling services along with the sale of drilling equipment and parts through agency and distribution agreements.

Blast hole drilling services and work programs within coal pits are ongoing and continuous, and constitute over 75% of revenues, and are in a high growth phase that is driven by new contracts from existing mines, mine expansion and development of new mines.


Analysis

This latest contract win further builds on Hughes’ strong competitive position in the blast hole drilling services for established coal mines. This is a key differentiator as Hughes' business model is away from supplying blast holes services to the riskier coal exploration market.

Hughes is the largest provider of blast hole drilling services to Australian coal mine operators that are currently mining coal.

There is likely to be further upside for 2012-13 not yet factored into Hughes’ market valuation, based on the recent profit result and step up in momentum from the Every Day Mine Services merger.

Profit before tax for 2012-13 is likely to be between 41% and 48% higher as the blast hole rig fleet is expected to grow by 11 to 13 rigs.

Despite the recent increase in valuation, current share price of Hughes Drilling affords investors an opportunity to invest in a significantly undervalued mining services company and acquire a portion of a business at a discount to its intrinsic underlying value. We can see significant upside in valuation of Hughes Drilling over the next 12 to 18 months