Description

Summary: At approximately C$4.50, CMG represents an opportunity for material price appreciation with little downside risk. The Company’s reservoir simulation software boasts a 20 year track-record and is the #3 player in its industry with market share of approximately 15%. Furthermore, the reservoir simulation software industry should continue to grow for the foreseeable future as the need for non conventional oil extraction grows.


Several factors make CMG an attractive opportunity:

• Consistent growth and profitability. CMG’s sales have grown at a 9% CAGR since 2000, it has been profitable for 20 consecutive quarters and its business model generates substantial free cash flow.

• Strong balance sheet. Its balance sheet is debt free and boasts an impressive cash position (C$1.64/share).

• Attractive acquisition candidate. Given the technical nature of reservoir simulation software, larger oilfield services companies who have chosen to enter this market (e.g., Schlumberger and Halliburton) have done so through acquisitions of independent companies. CMG is the only independent provider with significant market share.

• Modest valuation. CMG trades at:
- 11x FY 2006 EPS and 8x FY 2006 adjusted EPS (excludes cash and interest income)
- 9% FY 2006 levered FCF yield
- FY 2006 enterprise value/EBITDA of 4x

• Price target of C$6.20, a more than 35% premium to its current price. To arrive at this price, we are assuming modest growth, constant margins and a 17.5x FY 2006 P/E multiple:
- FY 2006 sales of C$14.25mm (9% sales growth in FY 2004 and FY 2005).
- 65% GP and 30% EBITDA margins (consistent with historical performance).
- FY 2006 EPS of C$0.35 (8mm fully diluted shares).
- With no direct comps, we looked to other business software providers. These companies are trading at a wide range of forward earnings: 15.0x-50.0x. We chose 17.5x, a multiple at the low end of this range.
- 8.0mm fully diluted shares outstanding


Company Description

• History: In 1978, Canadian universities and several oil and gas companies created CMG (then a non-profit foundation) to develop reservoir simulation software. CMG later shed its non-profit roots to access the additional capital it required for expansion and became a for-profit company via an IPO in March 1997. Since its IPO, CMG has expanded through organic growth and its business model has remained virtually unchanged.

• Concept: CMG provides its customers (oil and gas producers) with two services: (1) reservoir simulation software (approximately 75% of total sales) and (2) consulting services (approximately 25% of total sales). CMG’s software products allow producers to create 3-dimensional models depicting geological formations of oil reserves. Simulation becomes important after conventional recovery (the low-hanging fruit) is complete and producers turn to non-conventional recovery to extract the remaining oil. Management views the Company’s consulting services as a compliment to software, its core business. While consulting generates approximately 25% of total sales, CMG does not aggressively market this business to customers because doing so would create conflicts with the third party consultants who purchase CMG software for their own use and, more importantly, refer customers to CMG.

• Competitive landscape: Several companies offer reservoir simulation software. Three products dominate the market: Eclipse (made by a division of Schlumberger), CMG’s software suite and VIP (made by Landmark, a division of Halliburton). They possess approximately 65%, 15% and 15% of the reservoir simulation software market, respectively. Several other companies of varying sizes also offer similar products, but do not command the market share of any of the three companies mentioned above. Note that Eclipse and VIP are sold within a larger suite of oilfield services, a potential advantage when competing with pure-play providers like CMG.

• Target market: CMG targets oil and gas producers of all sizes. Their products are particularly valuable to customers who operate in areas that require non-conventional recovery (e.g., Canada and Venezuela). We estimate the market to be approximately C$65 million per year in sales.


Investment Thesis

• Strong business model has generated sales, earnings, ROE and cash flow growth: CMG has grown its business by providing technically sound software to its customers. Used by over 200 companies representing 1,500 users, the software is particularly adept modeling the more complex aspects of non-conventional extraction (for example, channel checks indicate that CMG dominates thermal processes simulation, a niche representing approximately 5% of all non-conventional extraction).
- Sales have grown at a 9% CAGR from FY 2000-2004.
- Gross profit and EBITDA margins have grown from 50% to 70% and 5% to 30% from FY 2000 to FY 2004, respectively.
- ROE has been consistently north of 20% during this time period.

• Demand for reservoir simulation software should increase for the foreseeable future: As the world continues to extract readily-available oil via conventional methods, producers will need to turn to non-conventional recovery to complete extraction from a given reservoir. In non-conventional recovery, reservoir simulation software becomes critical.

• Great balance sheet: CMG has no debt and C$13.1 million of cash (C$1.64/share). This cushion offers significant downside protection. Furthermore, the Company’s strong free cash flow generation and modest capital needs should keep the balance sheet strong for the foreseeable future.

• Modest valuation: We believe that CMG does not trade a price that adequately reflects its past performance and future prospects.
- FY 2006 P/E of 11x
- FY 2006 adjusted P/E of 8x (excludes cash and interest income)
- 9% FY 2006 levered FCF yield
- FY 2006 enterprise value/EBITDA of 4x

• Experienced, competent management team: Management has extensive industry experience and has been employed by CMG for several years. Ken Dedeluk, President and CEO, joined the company in 1998 and has been in his current role since August 2000. His predecessor, Frank Meyer, is the current Chairman of the Board. Janet Taylor, CMG’s CFO, has also held her position for several years.


Risks

• Modest share count and unorthodox structure create a relatively illiquid market for CMG shares: With 8.0 million fully diluted shares outstanding and an average of 6,250 trades per day during the last three months, CMG’s liquidity is a concern. This small float is compounded by an unorthodox share structure. A remnant of the Company’s non-profit past, the CMG Reservoir Simulation Foundation holds 2.9 million non-voting shares, representing approximately 36% of all shares outstanding. These non-voting shares can be converted to voting shares by the Foundation one for one at any time. The Foundation is owned by for-profit oil and gas producers. Management has indicated that the Foundation’s owners will not step in the way of an acquisition.

• Competes against much larger competitors: Schlumberger’s Eclipse and Landmark’s (Halliburton) VIP are components of much larger oilfield solutions. These larger competitors have strong relationships with several different people within a given oil producer. Reservoir simulation software purchases typically involve multiple decision makers, including the engineers who use the product, the information technology groups that integrate the product with existing systems and the finance groups that control purchasing from a corporate level.
- The above risk is mitigated by the influence that engineers have over purchases. Their technical specifications typically drive the sales process. Most producers also use multiple simulators for a variety of reasons (e.g., user preference).

• Large average sale size and a long sales cycle create lumpy, unpredictable results from quarter to quarter: A seat, or single version of CMG’s software, has a list price of approximately $50,000. While several factors typically reduce this price (e.g., competitive bids, volume discounts), the size of a single sale relative to CMG’s total sales for a given period results in somewhat lumpy and unpredictable results. The Company may be more likely to report uneven quarterly results and balance sheet items move somewhat unpredictably. Its most recent quarter is a good example of this phenomenon.

• Management may not use cash reserves prudently: Management has indicated that it plans to use its cash reserves for an acquisition, but has not found the proper target. Management is looking for an oil services IT provider in need of cash for growth. While such an acquisition may lead to a stronger company, it introduces a great deal of risk, particularly when one considers management’s lack of experience in M&A. We would be much happier to see these reserves returned to shareholders via a one-time dividend, but management does not appear to be interested in doing so.

• CMG’s share price may decline if oil prices fall: Over the past three years, CMG’s share price has loosely mirrored that of the price of oil. If demand for oil fell materially, CMG’s share price could reflect this change. Management does not believe, however, that demand for their software is correlated with the price of oil unless it drops below $20/barrell.


Potential Catalysts

• CMG is a strong acquisition candidate: Given the technical nature of reservoir simulation software, larger oilfield services companies who have chosen to enter this market (e.g., Schlumberger and Halliburton) have done so through acquisitions of independent companies. CMG is the only independent provider with significant market share.

• Cash position could be transferred to shareholders via a one-time dividend: Although management has indicated its desire to use cash for acquisitions, few opportunities have arisen. Management could choose instead to dividend the C$1.64/share of cash to shareholders.

• Conversion of non-voting shares to voting would improve liquidity and increase the chance of a sale: The Foundation can exchange its non-voting shares for voting shares on a one-for-one basis at any time.

• Additional analyst coverage could increase investor awareness.

Catalyst

• Strong acquisition candidate
• Special dividend to shareholders
• Conversion of non-voting Foundation shares to voting
• Analyst coverage