Boart Longyear living on the edge In the June half last year, it notched up earnings before interest, tax, depreciation and amortisation of $US208million. For the present December half, analysts are predicting Boart will make EBITDA of $US35million to $US40million. Earnings have toppled off a cliff. Just as they did the last time they got into trouble, management has swung the axe at the cost base with relish, stripping the number of employees from 11,400 mid-last year to 6300 mid-last month. It's a swift response though eerily redolent of what happened three years ago. Boart has been chock with debt since it floated in April 2007, just a couple of months before the credit crunch. Its market cap then was $2.87billion. Its market cap now is $221million. Its debts surpass $US600million, before the likelihood of some large tax liabilities to the Canadian government. The story of Boart is a morality play in how not to manage a company. It is true that other drilling services players are suffering. Rivals are close to breaching their banking covenants too, but none with the inevitability of Boart. The No.2 in the sector, Major Drilling, saw its revenues plunge from $US237million in the first quarter of 2013 to $US108million in the last quarter, while EBITDA dropped from $US60million to $US20million. Same trajectory as Boart - the difference is Major has a better balance sheet. It is net cash. Boart's glory days came soon after its sharemarket float, as it raced up to $2.70 a share in October 2007. But this is a volatile business. Its record revenues of $US1.9billion in 2008 halved in the ensuing 12 months to a little under $US980million. EBITDA tumbled by nearly 70 per cent from its peak of $US356million. Such is life in the drilling services business and a key reason the big miners are happy to outsource their drilling operations to third parties. Their impressive margins and profits in the good times turn on a dime. More than any drilling services business, during the upturn in the cycle, Boart put its foot to the floor, accelerating both capital expenditure and inventory to fill demand - particularly during the biggest mining boom in history, the China super cycle. Before its IPO Boart held a whopping $US1.275billion in long-term debt and $US696million in the aftermath. In late 2008 and early 2009 it faced the unenviable prospect of having to refinance $US585million of its credit facilities by April 2010. Amid the uncertainty and the general market malaise, Boart's shares changed hands as low as 7¢, a fall of 96 per cent from their issue price less than two years earlier. Gaming instincts When credit markets reopened from the crisis in the first half of 2009 and the sharemarket edged up from its lows, it was ""game on"" again for Boart, which pulled off a jumbo recapitalisation at 27¢ a share. It might have been an 85 per cent discount to the float price but it was alive. For shareholders though, prosperity was fleeting. Boart for a short time enjoyed a pristine balance sheet after its recapitalisation. Shares on issue trebled and net debt fell 94 per cent to just $US48million in December 2009. It was time to roll the dice. Gearing up again into the 2010 upswing in mining, fired by a resilient Chinese economy and its demand for resources, revenues rose year on year by 51 per cent in 2010 and then another 37 per cent in 2011. Again, the company put its foot flat to the floor, both with respect to its capex and its inventory. The 2011 and 2012 years saw record revenues surpassing $US2billion. EBITDA notched up its record of $US356million in 2011 and Boart was on track to deliver more than $US400million in EBITDA for 2012 after a $US207million result in the first half. At one point, guidance for 2012 stood at a heady $US460million. And so they doubled up in the debt markets. Boart raised $US300million in 10 year unsecured notes in a placement managed by JP Morgan in April 2011. It also made good use of its banking syndicate revolver facility (a revolver is like a cheap credit card when times are good) which geared up from $US67million after the 2009 recapitalisation to $US183million in 2010 and $US308million at December 2012. Just like in 2007 they were off to the races again. The problem this time was that, unlike the global financial crisis, which was a credit event, the downturn in the greatest mining boom in history is patently cyclical. Dark side of the boom Things started to cool in the mining sector in the back end of 2012. Only the most prospective and advanced projects were kept on as miners pulled the pin on a host of new exploration projects. Just as they did in 2009, Boart Longyear's revenues are on track to halve from the record levels of 2012. But this time, the gross profit margin has been hammered. In 2009, the company's gross margin fell to 23 per cent from the 31 per cent the previous year. In the second half of 2012 Boart's gross margin fell to 21.9 per cent from 28.4 per cent in the previous half. Since then it has collapsed further to 18.7 per cent for the recent first half result. Meanwhile, drill rig utilisation, a key indicator of top line sales, fell from 70 per cent in 2012 to roughly 50 per cent. Boart makes good money at 70 per cent. With half its rigs lying idle however, EBITDA starts to evaporate, depending on how fast management strips the costs out. O'Brien and his team are doing just that, slashing the workforce to near the levels at which it bottomed in June 2009. No other sector-leading business has been so volatile in so many metrics, from staff to leverage to earnings. None so aggressive to respond, either. Survival is at stake. In its products business (which makes up a third of revenues and earnings in the good times) the product backlog has shrunk from $US62million at June 2012 to $US20million last month. It had bottomed at $US18million at the nadir in 2009. In inventories - as in leverage and capex - it is also back to the future for Boart. But the future holds two looming threats; one, the state of the gross margin and, two, a tricky tax situation in Canada. At a record low of 18.7 per cent for the six months to June 2013 things are not bright on the profitability front. Mind you, as sector leader, this company has traditionally run skinnier margins than its peers. Still, Boart remains a bet on the mining services market recovering - and that future is uncertain. Although volumes fell sharply in the first half, pricing is yet to take a meaningful hit. Management has signalled this in its most recent half-year presentation. While rig utilisation keeps declining, all drilling services companies must be tempted to cut prices. Customers enjoy a lot of choice these days. Last week's quarterly results from Boart's Canadian rival Major Drilling are slightly foreboding. Major said lower demand had increased competitive pressures in the industry, a condition which would persist into next year. Until now, the drilling services providers have been able to lift productivity (and reduce costs) to sustain their profits. From now on though, any further reductions in pricing may be difficult to offset by productivity gains. Meanwhile, the banks have moved to improve their security. On July 1, Boart told the ASX it had successfully amended several key terms of its bank debt facility to ""enhance the company's ability to withstand further contraction of its markets"." They revised the gross debt to EBITDA leverage covenant on the facility from 3.5 times to 4.75 times. The quid pro quo for this relief was the banks taking security over a suite of Boart's assets and a higher interest rate. There was also some mention of security which might have to be lodged relating to tax assessments. Eight weeks had made a world of difference. By the time of Boart's first-half results release and presentation on August 26, management was conceding drill rig utilisation rates had pulled back to 50 per cent. Moreover, there would be a $US315million restructuring and impairment charge. The analysts pulled back their forecasts again, even as this once ""big cap"" had well and truly turned small cap. Further, it admitted it needed to put the hat around once again. Without a short-term refinancing, come December 2013 and June 2014 it was likely that it would be in breach of its recently renegotiated banking covenants (relating to gross debt to EBITDA). The other wildcard for Boart shareholders on their five-year roller-coaster trip is Boart's fracas with the Canadian tax authorities. It flagged in its June results that it had provided security of $C11million to the Canada Revenue Agency. Further, on August 24 post-balance date it lodged a further $C24million in security. This $C35million security pertained to the tax years 2005 to 2006. It was required under Canadian law to be lodged and remain in place until a dispute relating to transfer pricing was resolved. Boart may be responsible for principal amounts deemed to be owed, penalties and interest. It may also be able to claw back tax overpaid in other jurisdictions. Extrapolating however, there is significant risk that Boart will be hit with further demands. It also disclosed in its half year report that should the CRA deliver assessments to the company for 2007 to 2009, it would be required to lodge a further $C50million in security. The company also noted in the fine print that the CRA had expressed its intention to audit the 2010 through to 2012 year. These were some of Boart's most profitable years so it could be that security even greater than the $C50million required for 2007 to 2009 may need to be lodged for 2010 to 2012 - although this is surmising. As if things could not get any hairier with the Canadian taxman, the security lodgment represents only 50 per cent of the disputed principal amounts so if Boart were to be unsuccessful in its claims the final amount - including interest and penalties - may be materially larger than the sums lodged to date. How has Boart funded the lodgement of this security to the CRA? In view of its dire liquidity position ($US34million cash at June 30) it has issued some kind of derivate to fix the bill. And Boart's lenders include the security amounts in their leverage covenant ratios, namely its gross debt to EBITDA, and any revisions would also need to be included. Tapping the market Last week Boart announced its intention to tap the sophisticated US 144A debt market to refinance its $US305million senior secured debt. The deal was due to close ??yesterday but the indications are that there has been some pushback from US institutions. Commitments were initially due ??yesterday but the small unsecured piece of the strip structure was a problem. A tweaking of the offering to make it more palatable is not an easy fix. Should JPMorgan attempt to restructure the deal to offer a single $US300million tranche of first lien secured notes, it risks alienating lien incurrence covenants relating to the $US300million notes (priced at 7 per cent) issued by the company in March 2011 when times were rosier. Boart cannot simply cut the size of the deal to $US260million as it then risks alienating Bank of America Merrill Lynch backed senior revolver lenders who had been anticipating a full paydown as compensation for amending their leverage covenant ratios twice in a few months. What the pushback suggests is that Boart is at its limits having to restructure the deal after trying to tap the most liquid and sophisticated market in the world at a time of unprecedented cheap money flow. To reintroduce our first analogy, its mates are losing their patience and, even if Boart throws in the car keys as security, that might not be enough. An equity raising might be in the works. The problem for Boart is that even if this deal gets away, its capital structure is geared more than any traditional leveraged buyout in the US market and an equity investment would hardly be suited for the faint hearted. Looking at price talk for the debt deal coming out of the US banking press, Boart's EBITDA to interest coverage ratio could fall as low as 1.67 times assuming that the current projected half $US40million in EBITDA is repeated in the first half of next year. Traditional US LBO deals usually max out at 2 times. These numbers do not take into account any interest payable (and most likely being capitalised at a robust rate) on the financing of the Canadian tax issues now and into the future. Another way to look at the situation is that when a banker is orchestrating a leveraged buyout - say an Allco bidding for a Qantas - the rule of thumb is to gear up no more than 8 times gross debt to EBITDA or an EBITDA to interest coverage ratio of no less than 2 times. Interestingly, the US 144A market is not discussing pro forma total leverage to EBITDA taking into account the security ($C50million to extreme case $C135million) that Boart may have to stump up for the Canadian taxman. If one assumes these amounts which the BofA Merrill Lynch backed senior revolver lenders did take into account in their covenants, the total leverage to EBITDA blows out even further. Compounding the problem is that, at a current equity value of $US200million, traditional institutions just don't have to be there, while retail investors already caught in this value trap might constitute an extravagant marketing challenge. When the pricing on the latest debt deal becomes apparent next week, a clearer picture of Boart's future will emerge. Right now, it remains a roll of the dice.