In Part I, I made the case for mining services companies and in particular for those that are focused on greenfield projects. Now, I want to talk about my two favorite companies, Aeroquest (AQL: Canada) and Energold (EGD: Canada). To summarize what I wrote in Part I, the mining industry is not spending enough to replace annual depletion, much less grow production. The majority of the world's metal comes from a few key elephant deposits that are now in decline. The majors only want to mine elephants, and those will have to be 'discovered.' Just witness a few of the billion dollar production decisions made in the past year on properties that are dismal at best. The majors need to find better mineral assets. This will take a major increase in exploration expenditures. With cash flow now increasing with higher metal prices and investors once again willing to invest in junior exploration, I think we are on the cusp of just such an increase in exploration expenditures. Aeroquest and Energold should be very significant beneficiaries.

If you want to discover a sizable new orebody, you have three choices; you can look deep, look someplace remote or go to a country that others have avoided because of politics. Let's talk about looking deep first. Aeroquest uses aerially mounted proprietary geophysical equipment to analyze differences in magnetism and density of host rock and mineralized rock. The computer printout looks like a Rorschach test that trained geophysicists then analyze to help mining companies plan drill campaigns. Throughout history, the vast majority of the world's mines were discovered because the orebody outcropped at some point and a geologist chipped off a sample of it and sent it to the lab. The problem is that for hundreds of years, geologists have been combing the world looking for interesting rocks. The majority have now been found. This means that the current generation of geologists need to look under overburden to see what exists a few hundred meters down.

In the past, companies would just stick holes all over the place in geologically promising regions. This is terribly expensive and often doesn't yield much in the way of results. Using Aeroquest's technology, you can create a much more prospective drill program that only targets 'anomaly' zones where the mineralization ought to be. To the company's credit, they've been responsible for dozens of significant discoveries over the past few years in everything from gold to diamonds to uranium and hydrocarbons. The technology is particularly useful for scanning a large area to see the extent of an ore body or the positioning of that ore body. Not only can the technology be used to find interesting anomalies, but it can be used simply to save money on a drill campaign. Using their proprietary helicopter systems, Aeroquest can zero in on a smaller area and give a very detailed picture of the underlying geology. I've spoken with geologists who've used the technology when tracing out a vein system. Rather than sinking holes where they think the vein is, and often missing, they can directly target the vein for better drill intercepts and fewer missed holes. This saves fortunes -- especially for junior miners who are perennially tight on cash.

The other exciting application for the technology is at existing mine-sites. The adage is that the best place to look for a mine, is next to an existing mine. That's the way geology works. A mine is just a hole next to a very expensive chemical plant. When the mine begins to run out of ore, the economies of scale of a large chemical plant start to deteriorate rapidly. Eventually, you have a worthless stranded asset that has a replacement cost of a few hundred million dollars at a minimum. This creates an incredible incentive to look for more ore nearby. In today's environment, many of the world's largest mines are in decline. They're going to start frantically looking for nearby ore. The quickest and cheapest way to pinpoint where to look is using Aeroquest's technology. This should create quite a tailwind for the company for years to come.

Left picture is a helicopter-borne Frequency Domain Electronic System. Middle picture is early off-time response showing nickel sulphide zones and power line corridors on FNX Mining's Victoria Property in Sudbury, Ontario. Right picture is an AeroTEM magnetic intensity grid with EM profiles and EM anomalies

AeroTem Em profiles and flight path on top of gridded total field magnetics. Labels and outlines indicate known showings and zones of mineralization

Over the last few years, the company has expanded aggressively both organically and through acquisitions. It grew from about $25m run rate revenue in 2007 to $55m in 2008 and it was projected to grow to about $90 million in 2009. Clearly that did not happen as the demand for all exploration collapsed this year. As demand has come back, the focus of that demand is not greenfield work -- at least yet. Anecdotally, I hear that this is changing rapidly and 2010/2011 should see a good deal of renewed demand. In 2008, the company had about $9 million in cash flow. It might take another year or so, for demand to return to that level -- but as long as metal prices stay elevated, it's not a question of if it happens, but when. Using a conservative multiple on 2008 cash flow would value the company at a few dollars a share, compared with the current quote of sixty cents. You would then have all the upside going forward when greenfield exploration really picks up. When looking at downside protection, the company has no debt and trades for a hair over book value. Most of the book value is made up of cash and receivables. The company lost a good deal of money in the past two quarters as it had to rapidly downsize when demand collapsed. However, they seem to have right-sized things to the point where they should be essentially break even at current trough levels of revenue. Finally, in the past year, a number of insiders have bought a decent amount of stock at current prices.

While Aeroquest allows a geologist to look deeper, Energold really focuses on drilling in remote locations. There are about 7,000 drill rigs in the world and the vast majority of them are truck mounted. This means that to do a drill program, a road needs to be built to each drill location and then a drilling site needs to be cleared, leveled and prepared. This works well in theory, in reality, most mines are in the mountains and in rough terrain. Building roads is expensive, time consuming and often leaves a long term environmental footprint. This is where Energold comes in. They use 'man-portable' rigs where all components can be carried manually or by donkey to the drill pad where the rig is re-assembled. This gives the company a very significant cost advantage over the competition. Even more importantly, it allows Energold to drill in places where no one else can, either because the drill site is too steep or because it's impossible to build a road to bring in a truck mounted rig. Between the cost advantage of nearly 1000 basis points and the ability to drill almost anywhere, Energold really has a pretty thick moat around what is normally something of a commodity business.

Left picture is an Energold team transporting a motor. Right picture is the rig set up.

Everywhere you turn, people want to talk about 'green' products. Let's face it, mining isn't exactly green. The producers have left a century long legacy of environmental calamity. This reputation makes it difficult for the big guys to get permits. What good is an asset if you cannot mine it? If you've ever traveled around mining country, you see dirt roads and drill sites all over the mountainsides. It's ugly and it leads to landslides. In dry regions like Nevada, it can take a century or more for vegetation to cover up the scars. It's easy for anti-mining activists to point to these as proof of bad environmental stewardship. This is the reason that the big guys are increasingly trying to use man-portable equipment for drilling. It doesn't leave a footprint and shows communities that the mining company is serious about the environment. It also lets communities get 'involved' in the process and experience the economic benefits of mining. A truck mounted drill team usually involves a half dozen gringos bushwhacking through a region. A man portable team involves dozens of locals moving supplies around. This creates immediate high paying jobs. If people are well paid, and it doesn't look like you're harming the environment, it's unlikely that you will face local opposition to your mining project. That fact is worth a lot of money to the mining companies that have figured it out so far. I think this gives the company some untapped pricing power on top of their lower cost structure.

Having a massive competitive edge has allowed the company to earn very impressive returns on capital and rapidly grow the business. In Q1/2006, the company had 24 rigs. The company currently has 78 rigs and they intend to begin growing again when business recovers a bit more. If metal prices stay elevated, in five years, they could have 250 or more rigs.

Typical truck mounted core drill that most companies use

Drilling was never hit as hard as aerial geophysics because a good deal of total demand is on a recurring basis at mine sites. Still, the industry dropped from over 100% capacity utilization in Q2/2008 to around 25% utilization at the trough in the spring of 2009. Energold fared better than the competition and picked up business quicker than everyone else when things turned as they were able to underprice everyone else because of their cost advantages. Drilling is a business where you can cut back rapidly as demand disappears. This helped Energold remain essentially break even, excluding some bad debt expense -- even when the industry collapsed. They are once again profitable and their drill fleet is at around 75% utilization. As demand picks up, they should be back to full utilization by early next year.

There isn't much downside risk to the shares as the company has no debt, is profitable and cash, receivables and investments come to nearly a dollar a share. Total tangible book is nearly two dollars a share. 2009 will end on a strong note, but the fireworks should start in 2010. If they get all rigs turning by early next year, it should earn somewhere between 25 and 35 cents a share, however I think this is a conservative range. If they get any pricing power on a pickup in demand, they can clearly earn a whole lot more. Looking out a few years, I think you can create some quite attractive scenarios.

At 250 rigs, I think they can earn around $1.50 a share. 250 rigs may sound like a lot, but they tripled the rig count in the last 3 years. Why can't they triple it again in the next 5 years? As they add rigs, they should also get some pretty good synergies as there are some sizable fixed costs to operating in any particular country and you have to pay for those if you have two rigs or twenty rigs in that country.

In conclusion, I think these are the two best run companies in the mining services universe. They were growing exponentially until demand collapsed last fall. I think that when demand returns, these two will grow just as rapidly. They both trade at prices that leave minimal downside and sizable upside if metal prices stay at current levels. Mining is clearly in a strong bull market. In most mining investments, there is little in the way of earnings and you are gambling on geology, politics and metallurgy. Here, you are just betting that mining companies are going to be forced to spend on exploration -- they really have no choice. I think there could be some explosive growth in the next few years and these two are my favorite ways to capitalize on that theme.

On a side note, institutional investors who are unfamiliar with mining will eventually be 'forced' to own some mining companies. Unable to interpret geology, they may simply buy the service companies as you can build spreadsheets and analyze revenue and earnings trends. The high returns on capital make these two ideal for that.

For disclosure purposes, my partnership is a sizable holder of each company.

Categories: Current Investments
Positions: EGD.v
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