Long Civeo (CVEO)

Underfollowed spin-off with REIT conversion potential

Thesis Review

Civeo (CVEO) is an underfollowed recent spin-off with the potential to materially re-rate after pursuing a REIT conversion. CVEO operates using a "pick and shovel" business model by providing workforce accommodations (also known as "man camps") for oil and mining workers in remote areas. The company was spun off from Oil States International after Jana Partners, an activist investor, encouraged a separation. The stock began regular way trading on June 2, 2014 and Jana remains involved.

CVEO is a strong free cash flow generator, uses multi-year contracts, and benefits from barriers to entry. The key element of my investment thesis is the re-rating shares would see from a REIT conversion, a change management is considering and for which Jana is pushing. I note that this value driver is within the control of the company, as opposed to market conditions, which are not.

A cyclical trough in earnings and income from new projects represent secondary value drivers. This year will likely mark a bottom in earnings due to the impact of depressed coal prices on the company's Australia segment. The company is renegotiating contracts with some customers and management expects earnings to bottom in the middle of 2014. As a result, shares could see some near-term volatility as investors begin to better understand this dynamic. I believe this volatility represents an opportunity to be tactical, particularly around earnings, in building a position. The positive overhang of a REIT conversion should provide a floor for the share price. In addition, starting in 2H14 the company's new McClelland Lake lodge in Canada is coming online with 1,561 rooms, and management notes that it has several other potential growth projects contingent on signing customer contracts.

Assuming a REIT conversion and a modest recovery in EBITDA in 2015, I believe CVEO could be worth ~$39 per share, which represents ~50% upside from the current share price of $26.

Please see below for important disclosures.

Business Description

As mentioned above, CVEO provides permanent and temporary workforce accommodations for oil and mining workers in remote areas of Canada, Australia, and the US. The company develops, owns, and operates the housing facilities, meaning the company not only owns the physical plant but also provides associated catering, facilities management, and logistics services. Many of their facilities really look more like hotels than trailer parks, with restaurants, lounges, and gyms.

CVEO has over 12,900 rooms in Canada (63% of 2013 EBITDA), over 9,000 rooms in Australia (33% of 2013 EBITDA), and over 750 rooms in the US (4% of 2013 EBITDA).  Their facilities fall into two main categories: villages/lodges (77% of 2013 revenue) and mobile/open camps (23% of 2013 revenue). Villages and lodges are more permanent structures with multi-year take or pay contracts (typically 1-3 years). Mobile and open camps are smaller more temporary facilities that can be quickly deployed on short term contracts (typically 6-18 months), usually to support transient drilling, pipeline, or seismic work.

Using lodges and villages, CVEO currently serves oil sands projects in Western Canada (both mining and in-situ), metallurgical coal mining in Australia's Bowen Basin, coal mining in Australia's Gunnedah Basin, and gold, iron ore, and LNG mines and projects in Australia. Open and mobile camps serve a range of unconventional oil & gas projects in the US and Canada, including in the Bakken (US and Canadian), West Texas, the Rockies, and British Columbia.

I view CVEO as having more of a "pick and shovel" model. Direct commodity price exposure is limited. Take-or-pay contracts with customers provide some insulation from market swings, and greenfield projects are backed by contracted revenue before construction begins. Over the medium to long term, commodity prices will dictate employment levels at their customers, but this dynamic is a lower hurdle than for the miners themselves.

Why this Opportunity Exists?

Underfollowed

As a recent spin-off, Civeo is likely off the radar for many investors. The company has not filed a 10-K yet (it does have a Form 10 available) and only just filed its first 10-Q. In addition, the company currently lists only three sell-side analysts covering the stock, none at bulge bracket banks.

Few Natural Comps

Civeo's only direct C-Corp workforce accommodation comps are Canadian listed and not widely known in the US. In the US, workforce accommodations in remote regions are an emerging asset class, primarily in the Bakken, but such investments remain largely confined to the private market. There are no US workforce accommodation REITs of which I am aware. If Civeo were to convert to a REIT, the closest albeit imperfect comps would be other alternative REITs and REIT candidates such as prison and billboard companies.

Commodity Concerns

Civeo's primary customers are in the coal industry in Australia and the oil & gas business in Canada (oil sands). Stocks associated with coal these days are under pressure given weak prices, and I believe Civeo is not an exception despite the fact that it is not a producer and its franchise is much more durable than that of a commodity price taker.

REIT Conversion and Re-Rating

REIT Conversion

The key element of my investment thesis is the potential for CVEO to pursue a REIT conversion. Non-traditional REIT candidates such as billboard (CBSO, LAMR), prison (CXW, GEO), and document management (IRM) companies are increasingly opting to become REITs due to the tax advantages and potential for multiple expansion. Several such conversions have already occurred. Management has indicated that CVEO's Board will consider a REIT election after spin-off. However, Management has also stated that they are interested in continuing to grow the company, which becoming a REIT may make more difficult. Given the continued involvement of Jana (who is pushing for a REIT conversion), the compelling logic of a conversion, and the success of other non-traditional REIT conversions, I believe CVEO will eventually opt to become a REIT.

Multiple Expansion

I believe the company could see ~3 or more turns of EBITDA multiple expansion to ~13x if the company made a REIT election. CVEO currently trades at ~8x 2013 EBITDA and ~10x 2014 (trough) EBITDA, while non-traditional REITs and conversion candidates like prisons and billboards trade at ~12-13x. According to Jana, Bakken workforce housing is currently being sold at 12-14x EBITDA.  In comparison, workforce accommodation peers (Canadian listed Black Diamond and Horizon North) trade at ~7-10x. Catering and building services companies, another possible comp, trade at ~8-10x. Lodging C-Corps trade at ~13-14x, lodging REITs at ~15x, and manufactured housing REITs at ~16-17x. I do not think that CVEO can reach the valuations of lower multiple REITs like lodging and manufactured housing because its tangible assets are in remote regions and have only a single use dependent on commodity companies.

Activist Involvement

Jana Partners remains involved after successfully lobbying for CVEO's spin-off from Oil States International. Jana filed a 13-D for CVEO on June 9 which declares ownership of 11.5% of shares. In the filing, Jana states that it may continue to have discussions with management regarding a potential REIT conversion, capital structure, and other considerations. I believe Jana's continued involvement reinforces the REIT conversion thesis, as I expect them to push for such an outcome.

Room for Higher Leverage

Either as part of a REIT election or even without a conversion, CVEO has room to increase leverage. Presently, the company has net debt of ~1.5x EBITDA. Bringing net debt up to ~2.5-3.0x could be used for either a special dividend or to fund future growth projects. Flexibility to increase borrowing means a REIT conversion would not necessarily hamper growth, which is one of management's concerns, since debt could be used to finance new projects. For reference, prison owners Corrections Corporation of America and Geo Group are ~2.9x and ~4.8x levered respectively. Billboard owners CBS Outdoor and Lamar Advertising are ~3.5x levered. Many traditional REITs run even higher leverage, often ~5-8x. Based on the terms of its credit agreement, CVEO must maintain total debt to EBITDA below 3.5x and EBITDA to interest of greater than 3.0x. Even with these limitations (which could be relieved by a refinancing), there is headroom for more leverage.

Favorable Business Attributes

Strong FCF Generation

I view CVEO as primarily a free cash flow story, not an asset value story as with many REITs. The company generated $337m of operating cash flow in 2013 (down from a peak of $433m in 2012). Capex in 2013 of $292m included significant growth spending, depressing free cash flow. Management pegs maintenance capex at $50-$60m a year, placing true 2013 free cash flow (operating cash flow less maintenance capex) at ~$282m for a ~10% yield. Capex will again be above maintenance levels due to the completion of the McClelland lodge, but this project is already contracted with customers and should be accretive. Earnings will also be lower this year due to challenges in Australia, but as I will explain below, I believe 2014 will mark a trough. When this business is firing on all cylinders with minimal growth spending, it can throw off a lot of cash. Net income understates cash generation power (2013 net income was only $182m), which explains why CVEO may look rich on a P/E basis (a recent WSJ Heard on the Street column highlights the high P/E multiple, which is not relevant in my view). The ~2.0% dividend yield ($0.52/year) has room to rise, which would happen if a REIT conversion were to occur.

Barriers to Entry

Once a company like CVEO has constructed a lodge or village, I believe it is difficult for competitors to take away that business. CVEO is protected by multi-year contracts. Competitors are unlikely to invest the time and money to build a nearby facility to try to lure CVEO's customers away without a similar contract. In addition, the company estimates that site acquisition and permitting takes 1-2 years, while facility construction takes 6-18 months. As a result, competitors cannot nimbly move into CVEO's markets.

Contracts

CVEO uses contracts with customers, ranging from 1-3 years for lodges and villages vs. 6-18 months for open and mobile camps. Contracts are often structured as take-or-pay, meaning customers must pay an "unoccupied rate" even if they are not using a room. Annual escalators reset prices to cover higher labor and supply costs. Contracts can be ended early, but a large termination payment would be required. At the end of the original contract term, CVEO has an advantage because it is easier for customers to renew and competition is long lead time.

Growth Opportunities

CVEO has a well delineated growth pipeline, with 11 sites capable of supporting 15,000 potential rooms already land-banked and fully permitted. The company does not begin construction on a greenfield project until it has secured a multi-year contract with a launch customer. The ability to increase leverage means that growth projects can be funded using debt, an important consideration if CVEO becomes a REIT and must pay 90% of income as a dividend. Management views LNG projects in northwestern British Columbia as an attractive opportunity to expand beyond oil & gas production. Near-term, the McClelland lodge project is coming online in summer 2014 with a three year contract, and will add 1,561 rooms. I estimate that McClelland will add $22-$29m in annual EBITDA. Management has also referred to other potential projects (likely in Canada) that may move ahead if a contract is signed.

Earnings Trough in 2014 and Potential Risks

2014 Earnings Trough

Given the contract pipeline and market conditions, management expects overall results to bottom in 2Q14, with Australian occupancy troughing in 3Q14. Results for 1Q14 were already released, while management has given guidance for 2Q14 of $210-$215m of revenue with EBITDA margins of 33-34%. This guidance was originally given as part of the spin-off and then re-iterated with 1Q14 results on June 17, but the market reacted negatively despite unchanged commentary. I think there may be some more volatility around earning as investors get comfortable with the situation.

One consideration to keep an eye on is contract expirations. The contracts for 27% and 33% of rooms (60% together) are expiring in 2014 and 2015 respectively, with most of the 2014 expirations in Australia. While there is certainly risk here, management bases guidance on their knowledge of their contracts and many of these workers will still need a home, so I'm comfortable that there is a floor in sight.

With a bottom in Australia and the McClelland lodge starting operations, I think ~$375m in EBITDA is achievable in 2015 (vs. small sample size sell-side consensus of ~$360m). EBITDA of ~$375 in 2015 implies a quarterly EBITDA run-rate similar to 1Q14 levels despite 1,561 contracted rooms added, and remains well below 2013 EBITDA of $427m. Below I outline my assumptions. As you can see, there is a great deal of upside from current profitability as conditions in Australia normalize, and I believe the world needs the commodities that CVEO's clients produce.

FX Exposure

The vast majority of CVEO's revenue is non-USD denominated, with 68% in Canada and 25% in Australia in 2013. The good news is that costs are also CAD and AUD denominated, so there is less cash flow risk. But investors are still susceptible to translation risk since the majority of profits are in CAD and AUD. The AUD has actually proven surprisingly strong recently (rallying off a low in February of ~$0.87 to ~$0.94 today), and could remain stronger than some think as Japanese savers look for some yield in Australia. Similarly, the CAD has been strengthening recently as well, so these headwinds in the first quarter are now flipping to tailwinds. The bottom line is that there is some currency risk longer term if the CAD and AUD weaken, but this could be imperfectly hedged using forwards, currency ETFs, or an appropriate equity pair if you have access to those strategies.

Metallurgical Coal

CVEO's Australia segment has substantial exposure to metallurgical coal producers, which are currently facing a difficult commodity price environment. A large portion of the negative sentiment around CVEO stems from this exposure. However, I believe the impact on CVEO will be relatively limited and temporary. First, metallurgical coal prices are near their trough in my view, with a large portion of global producers losing money. Second, Australia's Bowen Basin (one of the regions CVEO serves) is the lowest cost in the world, meaning supply here is more likely to survive than in other regions. Third, CVEO's customers are largely top tier large cap miners who are well capitalized to handle weak prices and take a long term view. Fourth, while there have been some workforce reductions in Australia, I believe these cuts will begin to reverse even with a modest price recovery as the impact on productivity becomes apparent.

Oil Sands

The development of Canada's oil sands continues to expand, with the Canadian Association of Petroleum Producers expecting production to rise to 5.2m barrels/day by 2030 from 1.9m barrels/day in 2013. The completion of the Keystone XL or the Northern Gateway pipelines will give oil from the region an easier way to the coast, as would the conversion of the Energy East natural gas pipeline to oil.

There are two main ways to produce oil from oil sand. Mining uses trucks and shovels to remove the sand for processing, while in-situ extraction uses steam to heat the sand and remove the oil. A recent WSJ Heard on the Street column pointed out that much of the growth in oil sands output will involve in-situ methods (eventually about 80% of production), which are less labor intensive than mining. Whereas open-pit mines typically employ 800-4,000 workers, in-situ plants need only 40-150 workers.

While I agree that in-situ will be the primary extraction technique, I do not think that this fact poses any problems for CVEO. The growth pipeline for both mining and in-situ projects is quite deep (see http://tinyurl.com/mswqhot for a non-exhaustive list and http://osip.alberta.ca/map/ for a useful map). The Petroleum Human Resources Council of Canada expects the direct oil sands operations workforce to grow to 41,880 by 2023 from 26,550 today, an increase of 15,330. There will also be significant construction during this period as projects are developed, requiring additional workers. Some in-situ projects will require up to ~3,700 construction workers over 1-3 years of work, although 300-750 is more typical.

Valuation

As discussed above, I value CVEO at 13x EBITDA, in-line with other alternative REIT and REIT conversion candidates. On my 2015 EBITDA estimate of $375m, CVEO would be worth ~$39/share, or ~50% upside from the current share price of $26.

Risks

1) FX translation risk involving AUD and CAD

2) Additional multi-year weakness in metallurgical coal prices

3) Significant fall in oil prices

4) Environmental policies discourage oil sands development

Important Disclaimer

The above text is the view of the author alone and is for informational and educational purposes only. It should not be construed as investment advice or a solicitation to buy or sell securities. The author may hold a position in the securities mentioned, and does not have to provide updates for changes to his view. The author does not warrant his work for correctness or accuracy. Perform your own due diligence before making investment decisions.

Catalysts

1) REIT conversion and increased payout policy

2) Management embrace of higher leverage

3) Stabilization in Australia segment earnings, anticipated in 3Q14

4) New project announcements (likely in Canada)

5) Oil sands pipeline approvals