Layne Christensen is a leading global solutions provider to the natural resources industry with roots dating back to the late 19^th century.  While better known for its presence within the Water Infrastructure market, where it carries the moniker of “world’s leading groundwater services company”, it is our belief that LAYN’s oft-overlooked Mineral Exploration division alone is worth more than the entire enterprise value of the Company, despite accounting for less than 25% of consolidated revenues.  A confluence of factors, including inefficient joint venture accounting mandated by GAAP (hidden asset value), the lack of material sell side analyst coverage, recent management changes, the below-trend operating performance of the Company’s better known Water Infrastructure division, and a pending FCPA investigation have caused the stock to languish near its 52-week low and has created the opportunity to acquire a portfolio of market leading businesses for a significant discount to its sum of the parts value.  Using rather conservative assumptions, we believe an investment in LAYN offers 100+% upside potential all the while trading near tangible book value and at a discount to today’s liquidation value.  Needless to say, we believe the risk/reward is heavily skewed in our favor.

 

($, MM)		Sum of the Parts
Division/Method		Bear		Base		Bull
Mineral Exploration & Affiliates
TTM EBIT:	$72.10	$433		$649		$865
Mutliple of EBIT		6x		9x		12x
Water Infrastructure
TTM EBIT:	$40.50	$243		$365		$486
Mutliple of EBIT		6x		9x		12x
Energy
FY11 PV-10	$31.30	$0		$16		$25
% Disc to PV-10		100%		50%		20%
Sum of the Parts:		$676		$1,029		$1,376
Less: Corporate Overhead
TTM Corporate O/H	$25.00	$150		$225		$300
Multiple of TTM Corp O/H		6x		9x		12x
Enterprise Value:		$526		$804		$1,076
Less Net Debt:		$24		$24		$24
Less Potential FCPA Fine		$55		$25		$5
Fair Market Value of Equity:		$447		$755		$1,047
FD Shares Out:		19.76		19.76		19.76
Value/share:		$22.60		$38.21		$52.99
Upside Potential %		2%		72%		138%

 

Mineral Exploration Division (~23% of TTM Revenue):

“…Demand for drilling services continues to increase and customers remain anxious to secure rigs and crews.”

Major Drilling, Inc. CEO Francis McGuire, 3/5/12 

Layne Christensen is the world’s third largest provider of drilling rig services to the global mineral exploration industry.  Since 1895, mining companies have hired LAYN to perform both exploratory and definitional drilling in order to extract samples and/or define the size of an ore body before investing heavily in development.  The Company’s rigs are used primarily by major gold and copper explorers & producers; these commodities account for nearly 70% of the Company’s divisional drilling activity (Gold = 50%, Copper = 20%) Major customers include all the usual suspects, i.e. Barrick, BHP, Freeport, Rio Tinto, Newmont, etc. 

The market for mineral exploration has never been stronger, as global non-ferrous exploration spend in 2011 of $18.2B handily eclipsed the previous high water mark set in 2008 of $14.4B.  Current prices for both copper and gold are substantially higher than global average cash production costs of $0.90/lbs and $600/oz, respectively.  In fact, current prices of these commodities are more than double the 90th percentile (most expensive) cash production cost curve, leading market prognosticators such as the Metals Economics Group and CIBC to predict 2012 non-ferrous mineral exploration spend growth of at least 10%.  As a point of illustration, the following is list of major explorers and their announced 2012 exploratory budget percentage growth:

• Barrick Gold +34%
• BHP/Billiton +15%
• Freeport-McMoran +24%
• Rio Tinto +36%
• Newmont + 19% 

Rising metals pricing, increasing capital availability and declining reserve replacement ratios industry wide have created an extremely tight market for the mineral rig drilling industry.  On the supply side of the equation, rig utilization rates are at or near effective full utilization (~80-85%) for the three largest mineral drilling rig companies in the world; Boart Longyear (ticker: BLY AU), Major Drilling (ticker: MDI CN), and Layne Christensen’s Mineral Exploration subsidiaries.  The primary constraint to rig supply growth remains the lack of skilled labor, which every management team operating in the space has echoed for the last several quarters.  We view this as a significant positive given that previous bull markets in mineral exploration were met with excessive rig supply growth, making the inevitable slowdown in the cycle all the more painful.  Given the dynamic of today’s market, we expect pricing increases of 15-20% in 2012. 

In order to evaluate LAYN’s Mineral Exploration division, you must incorporate the results of both its “Wholly Owned Division” as well as its proportional ownership in its Latin American Affiliates, which is carried under the name “Investments in Affiliates” on LAYN’s balance sheet using the equity method of accounting.  LAYN’s Wholly Owned Mineral Exploration division consists of 185 rigs operating primarily in the western U.S., Alaska, Mexico, Australia and Africa.  The Company’s Investments in Affiliates business owns a total of 250 mineral exploration rigs, of which LAYN owns ~46%.  LAYN’s Affiliates business operates exclusively in Central and South America, with leading market positions in Chile & Peru, alongside their presence in Panama, Columbia, Uruguay, and Brazil.  There is no debt at the JV level that is recourse to LAYN.  

Using publicly traded pure play peers as a guide, we believe that LAYN’s Wholly Owned Mineral Exploration group and proportional ownership of its Latin American Affiliates more than justifies today’s current stock price, creating the opportunity to own the remaining businesses for free.  LAYN’s two most significant competitors are listed below:

 

Company	Mkt Share	Ticker	Mkt Cap ($MM)	EV ($MM)	TTM EBIT	Owned Rigs	EV/TTM EBIT	EV/Rig ($MM)
Boart Longyear	#1	BLY AU	$1,326	$1,336	$103	700	13.0x	$1.91
Major Drilling	#2	MDI CN	$1,899	$2,166	$246	1184	8.8x	$1.83
Average:							10.9x	$1.9

 

LAYN’s wholly owned Mineral Exploration division’s TTM EBIT (excluding Affiliate income) is $38.8MM.  LAYN’s proportional interest in its Affiliates TTM EBIT amounts to an additional $33.3MM (which equates to a JV Carrying Value/TTM EBIT of 2.5X!).  Using a discounted 10x multiple to LAYN’s collective Mineral Exploration TTM EBIT of $72.1MM equates to a fair market value of $721MM.  LAYN’s wholly owned and proportional affiliate rig ownership count is 300.  Ascribing the peer group average of ~$2MM/rig, LAYN’s Mineral Exploration fair market value would equate to $600MM (LAYN is a more efficient operator by almost every metric vs. its peers).  LAYN’s total Enterprise Value at the time of this writing is $460MM.

Water Infrastructure Division (~75% of TTM Revenue):

Layne Christensen is a leading turnkey solutions provider to the water industry, offering a comprehensive suite of services including water well drilling, aquifer sourcing, pipeline installation, cured-in-place-pipe (i.e. trenchless installation/repair), and the design, construction, and maintenance of wastewater systems and water treatment facilities.  The Water Infrastructure Division is segmented into four distinct groups, including (1) Water Resources, (2) Innerliner, (3) Heavy Civil, and (4) Geoconstruction. 

It wasn’t long ago that water scarcity, deteriorating water quality, dilapidated pipeline infrastructure, shifting demographics and booming migratory population trends to water scarce regions of the U.S. were dominating the media headlines and creating a compelling investment pitch…that is before the investment community learned that the water industry is by no means immune to the trends in the broader economy.  While the long term drivers underpinning the growth of this industry remain intact due to the non-discretionary nature of many water related capital expenditures, the closet cyclicality of the industry caught many investors by surprise.   LAYN’s reputation, brand awareness (founded 1892), and diversification across product lines enabled the Company to weather the proverbial storm and operate profitably throughout the downturn and its history.  However, on 3/22/12, LAYN issued a press release stating that overly aggressive project bidding and poor cost estimation within its Heavy Construction division (treatment plants & wastewater systems) forced the Company to write down unprofitable projects priced in 2010 and 2011 (under prior management) and take a non-cash $70-$80MM impairment charge.  This segment accounts for about 50% of the Water Infrastructure Division’s revenues.  The aggressive bidding was due to the fierce competition within its Heavy Construction division by commercial contractors willing to work for seemingly nothing which, under normal economic conditions, would not bid on large municipal bonded jobs.  The well publicized troubles facing the municipal sector, which accounts for ~2/3^rd’s of LAYN’s Water Infrastructure Division revenues, has further depressed this division’s recent performance, with municipal bond issuance down 22% in 2011 vs. its 5 year average.

We spoke at length with management following the press release on 3/22/12 and feel more confident than ever in LAYN’s upside potential and muted downside from these levels.  New CEO Rene Robichaud (more on him later) officially took the reins on 2/1/12 and stated that he personally reviewed hundreds of projects within LAYN’s Heavy Civil Construction business in an effort to rid the Company of unprofitable work.  Sacrificing short term pain for long term gain is never easy.  Rene decided to effectively take the “big bath” in Heavy Civil, which will dampen overall Water Infrastructure margins  in 2012 but set the stage for “normalized” profitability in calendar 2013 as legacy, zero margin projects roll through the backlog this year.  From management’s perspective, the hard part is over.  The remaining 50% of this division is generating record revenues and profitability. 

While 2012 will be a challenging year for LAYN’s Water Infrastructure Division, the medium term outlook remains bright.  Both the EPA and State Revolving Funds have over $6B in infrastructure funding that must be pushed through the queue this year.  There is near-universal agreement by industry players that the current rate of sewer rehab investment is below the pace required to maintain, let alone improve, North American wastewater infrastructure.  LAYN’s cured-in-place-pipe segment is running at full capacity, and pricing remains stable.  There are signs that North American residential housing may be recovering, which bodes well for new water well drilling.  Furthermore, management sees a huge opportunity to capitalize on the Company’s expertise in both water management and mineral drilling by becoming the “go-to” water solutions provider to the unconventional natural gas exploration and production industry.  Within this recently created Water Technology group, LAYN will help solve the toughest water issues facing the E&P industry, including sourcing water from drought stricken areas, water transportation, managing produced water, flowback, recycling, treatment, and disposal, among others.  Given the highly fragmented nature of the competitive landscape today, LAYN believes that within 5 years they can generate as much as $200MM in additional revenue at 30-40% EBITDA margins.  They are in active dialogue with players in the Marcellus, Eagle Ford, and Bakken shales today about how they can become the industry’s outsourced water asset managers. 

The following table presents the Water Infrastructure Division’s recent historical operating performance:

FYE 1/31
Water Infrastructure Division		TTM		FY11		FY10		FY09		FY08		FY07
Revenue		$840,734		$788,397		$698,506		$766,957		$639,584		$531,916
PF EBIT:		$40,491		$46,321		$33,017		$48,399		$41,369		$35,000
PF EBITDA:		$69,748		$75,893		$58,320		$72,140		$63,347		$52,691
PF EBIT Margin		4.8%		5.9%		4.7%		6.3%		6.5%		6.6%
Water Infrastructure Division				FY06		FY05		FY04		FY03		FY02
Revenue				$320,996		$198,475		$169,631		$167,080		$172,806
PF EBIT:				$28,255		$23,311		$18,927		$24,524		$27,474
PF EBITDA:				$38,859		$28,643		$23,470		$29,263		$32,561
PF EBIT Margin				8.8%		11.7%		11.2%		14.7%		15.9%

The division’s five and ten year average EBIT margins are 6.0% and 9.2%, respectively.  We believe that LAYN’s inevitable emergence from the recent cyclical trough provides an opportunity for significant earnings growth in the future.  The Company’s Water Infrastructure Division EBIT margins in calendar 2012 (FY13) will likely remain challenged, but we expect the division to return to more normalized operating performance in calendar 2013. 

Energy Division (~2% of TTM Revenue):

Layne Christensen owns 270k net acres of primarily unconventional natural gas properties within the Cherokee Basin of southeastern Kansas.  As of 1/31/11, LAYN operated 642 net producing wells which produced 4.5Bcfe during FY11. The majority of LAYN’s production is dry natural gas extracted from methane found in coal deposits.  From FY07-FY10, LAYN generated average annual EBIT of $13.1MM (excluding asset impairments) from its upstream energy portfolio, a product of higher historical natural gas pricing and some fortuitous hedging.  On a TTM basis, this division has generated $1.7MM of EBIT and accounts for only a sliver of LAYN’s consolidated revenue.  While still marginally cashflow positive at $2.50/mcfe gas, management has decided that upstream natural gas development will no longer be an area of emphasis for LAYN, and will therefore not commit any additional growth capital into this division.  As of 1/31/11 (last reserve update) LAYN’s energy division had a pre-tax PV-10 value of $31.3MM.  The Company is currently exploring strategic alternatives for this division.

Valuation:

At the time of this writing, LAYN trades for ~$22.25/share, has 19.8MM shares outstanding, $24MM of net debt and a fully diluted market cap and enterprise value of $440MM and $464MM, respectively.  The Company’s reported TTM EBIT of $39.2MM includes $2.4MM of one-time severance costs associated with the retirement of the Company’s former CEO and the firing of its Mineral Exploration Division President.  Additionally, reported TTM EBIT includes non-recurring legal and professional fees of $4.2MM.  Adding back these non-recurring items, LAYN’s pro forma TTM EBIT is $45.9MM.  Note that LAYN’s reported EBIT does not include operating income generated from its Mineral Exploration Joint Venture (i.e. Investment in Affiliates).  LAYN’s 46% ownership interest in its Joint Venture’s consolidated EBIT of $72.8MM equates to an additional $33.3MM of operating income net to LAYN, bringing the Company’s consolidated pro forma TTM EBIT inclusive of JV’s to $79.2MM.  Note: LAYN carries its “Equity in Earnings of Affiliates” below the operating income line, partially masking the Company’s cheapness under traditional EV/EBIT or EV/EBITDA screens.  LAYN’s TTM D&A was $59.7MM.  Inclusive of its $13.2MM net proportionate share of D&A within its Joint Ventures, LAYN’s consolidated pro forma TTM EBITDA is $152.1MM, which equates to an EV/EBITDA multiple of 3.05X. 

We view our base case sum-of-the-parts analysis as rather conservative. Keep in mind that we are purely talking about trailing numbers in our analysis, despite the fact that the Company’s Mineral Exploration pricing is expected to increase 10-15% in calendar year 2012, its Water Infrastructure division is significantly under earning, and the emergence of its promising Water Technology group could potentially add as much as $80MM in EBITDA in four to five years.  Moreover, the existence of publicly traded pure play competitors that are comparable to LAYN’s Mineral Exploration division trading for premiums to our base case valuation methodology helps underscore our view that the Company is trading well below intrinsic value.  While the Water Infrastructure Division will be challenged in calendar 2012 (FY13) for the reasons mentioned above, LAYN’s TTM Water Infrastructure EBIT margin of 4.8% is still below the Company’s normalized 6.0% divisional EBIT margin, which management believes to be achievable within twelve to twenty four months. 

In addition to hosting significant upside potential, LAYN has considerable downside protection in the form of stated tangible book value of $20.59/share, which equates to a P/TBV of 1.08X.  Moreover, we believe that LAYN’s “Investment in Affiliates” (Joint Ventures) carrying value of $84.4MM as of 10/31/11 significantly understates the fair market value of this division, given that the carrying value relative to its TTM EBIT net to LAYN is 2.5x.  Replacing the Investment in Affiliates carrying value with a more realistic fair market value of $333MM (10x TTM EBIT) equates to an adjusted tangible net asset value per share of $33.18/share (P/Adj. net asset value of 0.67x).  In short, we believe the Company could conceivably liquidate for much more than its current stock price.

Management:

After 18 years as CEO of LAYN, Andy Schmitt stepped down from this post on 1/31/12.  LAYN’s new CEO, Rene Robichaud, is no stranger to the Company, as he served as a director since ’09.  A Harvard graduate, Rene’s prior work experience includes a 15-year history in investment banking, culminating in his role as a managing director and co-head of the Global Metals & Mining Group of Salomon Smith Barney. He stepped down in ’99 to serve as COO, and eventually CEO, of NS Group.  NS Group was a publicly traded manufacturer of oil country tubular goods and pipelines, which Rene helped grow from a $150MM market cap business to a $1.5B enterprise value at the time they sold to steel manufacturer IPSCO on 12/4/06.  Under Rene’s watch, the share price of NS Group increased tenfold.  This article exemplifies Rene’s managerial style: http://www.bizjournals.com/cincinnati/blog/2011/07/robichaud-rebuilt-culture-at-ns-group.html

We believe that Rene will prove to be a far superior CEO than his predecessor.  In his own words, he sees LAYN as a “tremendous, unexplored asset that has been undermanaged.”  We couldn’t agree more.  Rene is conscious of the significant discount that LAYN is being valued at relative to its intrinsic value, and has a proven track record of enhancing shareholder value.  He recently created a business strategy coined “OneLayne” in order to enhance the collaboration between the Water/Mineral/Energy Divisions.  He believes there are incredible opportunities for Mineral Exploration to help Water Infrastructure, and vice-versa, and has made LAYN’s newly created Water Technology group a top priority and a working model for his new mantra.  He stated to us that he will prove to investors that the Company can do more together than apart, or else they’ll have to rethink their “holding company” strategy. 

FCPA Overhang:

The biggest overhang on LAYN’s stock has been the Company’s Foreign Corrupt Practices Act (FCPA) potential violation that was self-reported to the SEC and DoJ in September of 2010.  According to the Company, internal questions were raised about the legality of certain payments made by the Company to agents interacting with government officials in Africa related to LAYN’s Mineral Exploration division.  The potential violations are related to the payment of certain taxes and the importation of equipment, made over a considerable period of time.  While at first read this disclosure seemed a bit alarming to us, after our review of other historical FCPA settlements and extensive dialogue with management we believe that the ultimate outcome of this investigation will prove to be rather insignificant and is already more than reflected in the current stock price.

First off, the CFO of LAYN has signaled to us that his expectation of any fine levied upon LAYN will be substantially less than $50MM, if any.  The Company self-reported the issue and has been extremely aggressive and transparent with the FCPA.  They have already fired the worldwide Mineral Exploration division president as well as several managers operating in Africa, have hired both a compliance firm and internal legal counsel to investigate the issue, and have trained hundreds of employees on best practices when operating within the corrupt West African business culture.  Moreover, LAYN’s CEO Rene Robichaud, as well as COO Jeff Reynolds, personally purchased $900k and $825k worth of LAYN stock around today’s levels in September of 2011, nearly a year after the Company self-reported the issue.  Had Rene been concerned about the outcome of the FCPA’s findings, or had he thought the Company to be morally corrupt, he would have never taken the CEO post or come out of pocket to buy shares. 

We have reviewed several FCPA settlements in an effort to further enhance our ability to bracket LAYN’s potential liability.  For perspective sake, up until the KBR/Halliburton FCPA settlement reached in 2009 (in which they were accused of bribing officials for over $6B worth of contracts in Africa!), the largest fine ever levied against a U.S. based Company was $44MM against Baker Hughes in ’07.  The other largest FCPA fines ever levied against U.S. companies include Willbros ($32MM in ’08), Chevron ($30MM in ’07) and Titan Corp ($29MM in ’05).  In Willbros case, the fine amounted to ~8% of the $387MM worth of illicit contracts they “won” over a ten year period.  LAYN’s revenue generated from Africa within its Mineral Exploration division from FY01 through FY10 was $523MM.  LAYN’s average EBIT margin over this time period within this division was 10.3%, which equates to $53.9MM worth of EBIT earned since FY01.  Applying the same % fine that Willbros received to 100% of the revenue LAYN generated over this ten year period would equate to a potential fine of $41.8MM.  If 100% of the EBIT (not net income) was deemed to be illicitly won, which we believe is not the case, then the total amount of profit disgorgement would be $53.9MM.  We believe this outcome to be the worst case scenario, given that LAYN is one of the few being investigated that actually self-reported the incident to the DoJ.  Based on our analysis and the comments from LAYN’s CFO, we feel comfortable that should a fine arise, that it will be substantially less than $50MM.  We expect this issue to be resolved in 2012 and to serve as a catalyst to the equity given the prolonged overhang. 

Concluding Points:

We rarely find well managed companies with leading market share in their respective industries and attractive long term growth opportunities that trade at tangible book value and 3x trailing EBITDA.  Several factors have colluded to disguise the cheapness of LAYN, many of which we believe to be overblown and short sighted.  With over 100% upside potential and minimal risk of permanent capital impairment in our view, we believe LAYN to be a compelling long.

 

 

 

 

 

 

Market's recognition of LAYN's degree of undervalution

FCPA investigation finality

New management

Turnaround in Water Division