AJ Lucas Group — Positive momentum in drilling services

AJL’s drilling division had a significantly improved FY18 driven by coal mine de-gassing and directional drilling demand from tier 1 clients in Australia. Drilling revenues grew by 70% to A$124m with underlying EBITDA of A$19.7m (+635%), generating an EBITDA margin of 15.9%. This step change in revenues and profitability was driven by several factors: AJL’s rig fleet utilisation was materially higher year-on-year and margins benefitted from the completion of lower margin legacy contracts in the coal seam gas and water markets. Management shifted drilling rigs back to the company’s core competency, mine de-gassing, while allocating under-utilised rigs to the mining exploration and production sector. AJL’s strong customer relationships, track record of delivery, focus on efficiency improvement and safety have helped drive order book growth and make AJL well placed to continue to benefit from a recent up-tick in coal mine activity. We continue to track data on shipped coal tonnage from ports in New South Wales and Queensland as well as mining exploration expenditure/metres drilled, in order to take a view on the sustainability of current drilling activity. Mining exploration expenditure saw material uptick in 2018, while shipped coal tonnage from port data we analysed appears to have stabilised (six-month average) close to historic highs.

We continue to value drilling services based on three-year average underlying EBITDA and an EV/EBITDA multiple based on the company’s ASX listed peers. Given the volatility in both revenues and margins, we use an average of EBITDA for FY17, FY18 and FY19e and apply a valuation multiple of 6x EBITDA which values drilling services at A$54m (Book value of drilling service plant and equipment stands at A$26.6m and receivables at A$27.2m). We see room to increase our valuation as activity levels and margins stabilise and a higher EBITDA multiple is justified. Management currently guides at a similar outturn for FY19e as FY18 based on the group’s order book and coal mining activity levels. Current rig utilisation stands at c 28 rigs out of a fleet of 39 providing scope for top-line growth if activity levels continue to rise.

Cuadrilla (47.45% owned by AJ Lucas) completed drilling the UK’s first ever horizontal shale wells earlier this year. The first of two horizontal wells at Preston New Road (PNR) was completed in April 2018, penetrating the Lower Bowland shale to a depth of 2,300m and extended laterally by 782m. The second well at PNR was completed in July 2018 penetrating the Upper Bowland shale at 2,100m and extended horizontally for 743m. Cuadrilla has consent to hydraulically fracture the first of the two laterals (due imminently) and has submitted an application for consent to fracture the second horizontal.

Under Cuadrilla’s farm-in agreement with Spirit Energy, for Spirit to maintain its 25% interest in the PEDL165 licence it is obliged to fund a further £46.7m (gross) of costs once first gas has been flowing for six months. Our financial forecasts assume a net A$20m contribution to fund ongoing activity at Cuadrilla in FY19 prior to the drawdown of the outstanding Spirit Energy carry.

Edison recently carried out a probabilistic valuation of Cuadrilla’s UK shale acreage; this analysis can be found in our initiation report. Key outputs from our analysis include an estimated 67% chance of commercial success for UK shale based on input distributions for type curve (Anderson Thompson type curve as published by Cuadrilla), well cost (US analogues adjusted for UK), gas price (forward curve), activity rates and a risked valuation of US$2,142/acre.

UK shale unit NPV of risked diluted P50 US$2,142/acre

Exhibit 6 below provides an insight into key valuation sensitivities. IP (initial production) rate, estimated ultimate recovery (EUR), gas price and well cost are key sensitivities. The sensitivity tornado shows the impact on our unrisked P50 UK shale valuation when the top and bottom 10% of our input distributions are used in our valuation. This demonstrates that given the known uncertainty ranges for key inputs the most sensitive factor from a valuation perspective is IP rate with low initial rate scenarios driving negative NPVs. We believe that Cuadrilla’s upcoming appraisal programme at Preston New Road will reduce uncertainty on the IP rate and EUR, providing for a tighter valuation range.

Our analysis also suggests that in generating a positive NPV15, IP rate needs to be at a minimum 5mmscfd and EUR at least 2.3bcf for a 2.5km lateral. We expect initial test rates from the first well at Preston New Road to be greater than those seen at the 2011 Preese Hall-1 vertical exploratory with 3 frac-stages at 400-500mscfd.

Key changes to our valuation from our April 2018 initiation are highlighted below:

A waterfall chart of our update valuation is provided in the Exhibit below.

Our sum of the parts (SOTP) group valuation incorporates a risked P50 commercial success case UK shale valuation, a deduction for UK shale overheads, balance sheet adjustments and valuation of Lucas Drilling Services (LDS). This equates to a group valuation of A$0.93/share, as broken down in Exhibit 8 below.

Following a A$51.2m equity fundraise in February 2018, which included partial conversion of the Kerogen loan facility and a A$11.3m repayment of AJL’s senior loan note, total debt was reduced to A$84m (net debt A$75m) from A$107m at FY17.

Following the end of the reported financial year, AJL reached agreement with OCP Asia to increase the headroom on its senior loan note facility to allow the ability to draw down an additional US$9m and to extend the maturity of the facility to 31 January 2020 (from July 2019). The requirement to reduce the facility principal by US$20m was also deferred to 30 June 2019 (from 30 September 2018). In addition, Kerogen has agreed to extend the term of its loan facility from 31 December 2019 to the earlier of 31 July 2020 or six months from the full repayment of senior loan notes.

Outstanding debt instruments command an 18% interest rate, therefore cost of capital is high relative to the company’s drilling service and E&P peers. We would expect re-financing to deliver a significantly lower cost of debt as drilling service profitability stabilises and in the event of successful gas flows from Cuadrilla. Both senior and subordinated are provided by material, supportive shareholders in AJL.

At the end of FY18 (end June 2018), AJL had A$9.8m of cash and is expected to receive A$25m cash from the sale of engineering and construction (E&C) over the course of FY19. Depending on the timing of E&C, sale cash receipts and cash outflows (capex A$4m on drilling maintenance and A$20m contribution to Cuadrilla) we see a potential need for drawdown on AJL’s OCP debt headroom (US$9m) or an equity raise in the event of UK shale appraisal success. We provide a cash flow bridge below based on our modelled assumptions (which do not include any dividends from Cuadrilla in the event of gas sales).