Why our Small Companies Fund sees value in IMDEX

These days, I hear many commentators say it’s hard to find value in the market. But if you look hard enough, it’s still possible to find a gem. One of these is IMDEX (IMD), a global mining-tech company. With a strong management team, an attractive product suite, high returns, and a net cash position, IMDEX could be set for a significant step-up in earnings growth.

At the Montgomery Small Companies Fund, we believe IMDEX is now at an important inflection point in its life cycle with an exciting pipeline of new technologies progressively being commercialised representing an opportunity for transformational growth and material value creation. Based on our assessment, the share price ascribes very little value towards these new products and we like free options, especially when the odds of success appear favourable.

IMDEX is the global leader in subsurface instrumentation solutions for mining exploration and development with sales in 102 countries and a strong presence on around 70 per cent of the world’s mineral drill rigs. The existing product suite includes ‘AMC’ branded drilling fluids and fluid systems which enable clients to drill holes and recover samples required for analysis, as well as ‘REFLEX’ branded subsurface instruments which are used by drillers to accurately measure and control the location of sample recoveries and to measure sample structures. The latest generation of subsurface instruments have in-built connectivity to a proprietary cloud-based platform, IMDEXHUB-IQ, which provides clients with real-time data and workflows, both in the field and remotely, ultimately improving exploration decision making outcomes. The company has a market cap of $550 million and in FY19 generated $28 million of post-tax profit (grew 31 per cent over the prior year).

Founded in 1980 and listed on the ASX in 1987, IMDEX has established a dominant market position within its niche industry segment. We believe the company has a strong and sustainable competitive advantage, underpinned by its technical leadership and strong customer value proposition. IMDEX’s leading-edge technologies essentially help clients drill faster and smarter, increasing productivity rates and lowering operating costs. Productivity is a key focus for drilling contractor clients (such as Boart Longyear and Major Drilling) who operate in a highly competitive and cost-conscious sector. IMDEX’s technical leadership is reflective of its continued investment in research and development and targeted acquisition strategy. The portfolio of patents and intellectual property also act as a firm barrier to any new entrants, further reinforcing IMDEX’s competitive positioning.

Demand is cyclical, strongly leveraged to exploration expenditure levels, mainly in gold and copper. The medium-term outlook for mineral exploration budgets is broadly positive, supported by buoyant commodity prices, depleting reserves, falling grades and a general lack of any major new discoveries. Although certainly not immune to a potential cyclical downturn, IMDEX has historically outpaced cyclical recoveries thanks to its productivity enhancing technologies. New product releases, some of which will expand the company’s reach into new market segments and further along the mining value chain, should provide diversification benefits and make the business more robust.

IMDEX has an attractive business model being relatively capital light and generating high returns. Drilling fluids are consumable products which the company manufactures and directly sells to drilling customers while the company employs a build-to-rent model for the high-tech subsurface instruments. Group gross profit margins are a healthy 65 per cent and the business scales well when demand grows on the largely fixed operating cost base – EBITDA margins are around 22 per cent at present. The economics of the subsurface instruments are especially compelling with a three-month payback period on invested capital.

Management has a successful track record of developing and commercialising technologies and the new product pipeline looks particularly promising. The most progressed instrument, ‘CoreVIBE’, has been confirmed in trials to increase drilling productivity by around 33 per cent over conventional coring and has the potential to become the industry standard for drilling in hard ground. Commercialisation of CoreVIBE commenced in 1Q FY20 with the first instruments hired out at commercial rents to clients operating in Australia and the US. The addressable market for CoreVIBE is large with about 1,800 coring rigs operating in hard ground globally (assuming a monthly rental rate of $10,000, we estimate the CoreVIBE market opportunity to be $216 million).

Another highly prospective instrument in the pipeline is ‘MagHAMMER’, a technology which allows entire drill holes to be completed by a single diamond drill rig, reducing the need for a costly second air powered RC rig. Commercial trials are scheduled for 3Q FY20. The addressable market for the MagHAMMER is also significant with approximately 1,000 rigs identified as initially suitable for the technology ($120 million opportunity assuming $10,000 per tool per month).

IMDEX has also released limited details about two other pipeline products, XTRACTA and BlastDOG, which offer future value creation potential for the company.

CoreVIBE and MagHAMMER together represent a $336 million market opportunity for IMDEX which is material compared to the company’s FY19 revenue base of $244 million. Assuming a 50 per cent product penetration rate (which doesn’t sound crazy considering the core business operates on 70 per cent of global rigs right now) and 25 per cent margins, implies 80 per cent ($42 million) upside potential relative to FY19 EBITDA of $52 million. Management have stated that new drilling technologies are expected to produce ‘material’ revenue from FY21.

With broker estimates currently forecasting just 6-9 per cent annual revenue growth over the next three years, and the core business likely growing mid-single digits, we think the market is attributing little value towards the new technologies. We rate management and back them to execute on the growth strategy. Trading on 7.5x FY21 EBITDA with a net cash balance sheet and material upside to market expectations, we see value on the table and have invested.