Boart Longyear – drilling itself out of a hole?

Boart Longyear – drilling itself out of a hole?

Boart Longyear (ASX: BLY) owns the world’s largest fleet of drilling equipment, and in doing so has amassed considerable debt. The downturn in the mining sector brought the company perilously close to breaching its debt covenants, and while management was able to refinance the debt earlier this week, we are unconvinced that this has given the company a lot of breathing space.

For those unfamiliar with the company, Boart Longyear is a mining services company that provides drill rigs to mineral explorers. The industry is highly cyclical and requires operators to manage substantial capital – two factors that are not conducive to burdensome debt. BLY management rapidly increased its assets with debt funding as the mining sector boomed. This strategy produced considerable profits with utilisation rates at around 70 per cent. However, in the space of a year, the utilisation rate has fallen to 50 per cent, resulting in a loss of $60 million for the half year to June 2013, along with the impairment of one quarter of the asset base. And while demand for rigs fell considerably, the debt still remained.

At 30 June, Boart Longyear had $598 million of borrowings on the balance sheet as well as current tax payable of $104M. The debt comprised $300 million in senior notes, with a 7 per cent interest rate and maturing in 2021. The majority of the balancing $298M of debt was for repayment by 2016. The interest on this loan was a premium of 250 basis points on the 30 day London Interbank Offered Rate (LIBOR) – or just under 3 per cent.

The directors projected that the company may breach the agreed leverage covenant by 31 December 2013. Management opted for a refinancing of the debt rather than an equity raising – this would have been a bitter pill for shareholders to swallow having already watched the share price fall by over 75 per cent in the calendar year to date.

The refinancing agreement required the issuance of $300 million in new senior secured notes, which will mature in 2018. This has allowed the company to reduce the limit of the 2016 credit facility to $140 million – but this debt hasn’t come cheap. The new debt was issued with a coupon of 10 per cent, a considerable premium to the 3 per cent rate on the existing credit facility. Along with the existing $300 million notes that mature in 2021, the company will be required to pay over $50 million per year in interest.

It is difficult to see how the company will be able to service this debt. In the six months to June, the company generated cash flows from operations of $16.2 million – and this barely covered the interest expense during the period of $16.1 million.

While the company has embarked on a program to reduce costs and improve operational efficiencies, underlying conditions are deteriorating, with rig utilisation at 45 per cent in September. The aim of reducing debt will likely be hampered by the significantly higher interest expense and poor economic environment.

Excess debt can be hazardous to a company like Boart Longyear, which has operational leverage, especially when things go wrong. While management has managed to find some breathing space in the near term, we at Montgomery Investment Management remain unconvinced that the company can generate value to its shareholders – and drill itself out of a hole.