Description

At current levels, ION Geophysical (“IO") equity trades for ~2.4x 2018E EBITDA and closer to ~1.7x when factoring in $320 million of NOLs conservatively valued at $60 million (compared to ~4.5x long-term average) and the equity offers a 20% - 25% FCF yield on 2018E estimate (and mid-30% in 2019E and this assumes IO is a 25% tax payer), allowing the business to rapidly deleverage to under 0.5x over the next twelve months. IO is an under-appreciated asset-light energy services business operating in some of the best industry segments poised for an exponential recovery as capex budgets improve from multi-decade lows.  IO generated over $160 million of EBITDA per annum btwn 2010-2014 (and this was before the development of its OBS technology which has the potential to add $20 - $25 million) and had a market cap that ranged from $450 million to $1.3 billion.  Following the oil downturn, the company was slow to right-size its cost structure and the business posted negative EBITDA in 2015 and saw its market cap crumble to under $100 million.  Since then, management has taken multiple steps to improve the business (shifting strategy toward asset-light differentiated biz and removing >$100 million of costs) and it is now clicking on all cylinders with a multi-year recovery ahead.  YTD EBITDA (first three quarters) is up 35% over prior year with momentum accelerating (Q3 EBITDA of $27 million compares to Q2 of $17 million, management expects to maintain this level going forward).  Faced with relatively easy comps, the business is set to outperform. While equity stakeholders have begun to take notice, this still has the potential to double in twelve months assuming a 4x EBITDA multiple on a conservative $90 million EBITDA estimate for 2018 and should the business return to historical levels of profitability, which is more likely even in a lower for longer oil environment as over $100 million of fixed costs have been removed, it would support a stock price of $40-$50 / share versus under $14.5 / share at present.

IO debt was previously written up by huqiu in late 2015 and todd1123 earlier this year. The debt, though difficult to source, is still attractive given 1) 9.175% coupon, 2) >10% CY, 3) very attractive call protection features (first call date is 12/15/19 at 105.5, so high probability of trading >105), 4) rapid deleverage profile w/ net debt / EBITDA at ~0.5x by YE 18E and 5) possibility of M&A upside.  With KPIs inflecting, the equity however is now the superior risk-reward with ~100% upside potential from current levels over the next 12 months and possibility of >200% over a 2-year timeframe. While the equity has responded favorably following last week’s Q3 results, IO equity is still (i) under-followed: 1 analyst covers who lags the market, (ii) un-loved: historical overhang around debt maturities + litigation have kept demand sidelined but these risks have recently been put to bed, (iii) mis-understood: IO has significant momentum within its data solutions (data surveys and processing) and is positioned well to outperform regardless of oil end-mkt volatility given long-term projects underway.  IO’s 2 other business segments are “options” on an oil market recovery and have significant upside optionality as evidenced by the Company’s >$200 million of EBITDA in 2012 before factoring in the recent OBS segment which would have taken that figure up by $20 million.  The “option” segments are operating in bottom-of-cycle conditions and even if these segments were only to produce an additional $10 million of EBITDA (versus >$105 million in 2010 – 2014 timeframe PF for the recent addition of OBS … and compares to relatively negligible contributions today), it would allow for >25% upside to the stock so a powerful call option upon an oil-recovery (but not underwriting), (iv) under-valued: IO equity trades at ~1.5x 19E EBITDA (factoring in the NOLs) and a mid-30% FCF yield assuming a full tax-payer.  At cycle lows, the business is still valued on 2017E at a lower multiple than its historical average of 4.5x so there’s an ability to win from both the multiple and earnings power trajectory. Factoring in FCF generation over the next 15-months, net debt will be less than $40 million by YE 18E which implies a PF TEV of ~$150 million (factoring in NOLs), for a business that will be generating ~$125 million of EBITDA in 2019E and >$75 million of FCF per annum as a full tax-payer. Looking out 12-months, its not difficult to pencil in a $30 / share FV and $40 - $50 / share (~200% upside) over the next 2-years.

The current capital structure and implied multiples are below:

 As IO has been written up on 2 occasions in the past, the purpose of this memo is to summarize 1) Q3 results and why significant, 2) provide a valuation construct and 3) roadmap for how this might play out (events ahead)

Q3 results / current valuation: Q3 2017 results (EBITDA >50% above expectations), the outlook for Q4 2017E (also >50% above expectations) and general commentary (sustainability of growth and outperformance) were all favorable and supportive of a multi-year tailwind for its core data library / processing segment. As we’ve confirmed w/ consultants, IO has uniquely positioned themselves in attractive geographies (Brazil, Mexico, Argentina, Panama), w/ strong customers (Exxon and Shell most notably) and a differentiated and cost-advantaged strategy (they shoot both new data that historically returns $2.5 - $4 per each dollar invested in addition to the $ received from customers upfront … but also have been focused on re-processing old data that’s much more cost efficient and has proven to be lucrative w/ returns of $7 - $10 on each $ invested). Looking out over the next few years, IO has data that is well positioned within 60 auctions and has a proven track-record of executing on the pipeline. Overall, we believe the data library results are sustainable and will be the key driver to the biz

As it relates to the Systems / Software and OBS segments, mgmt is still upbeat on the future and believes there will be a multi-year recovery in these segments (currently operating in trough conditions for Systems / Software and generating negative FCF for OBS). The performance of these 2 segments was negatively impacted by the unprecedented fall-off in E&P spending … and the future trajectory of the recovery will be driven the coiled-spring in capex that’s more a matter of when not if. As noted above, we have ascribed little benefit from these “option” segments (PF for OBS segment which started in 2015, these 2 segments averaged more than >$105 million of EBITDA during 2010 – 2015 assuming $25 million is feasible in OBS once they win projects … we are assuming these 2 segments contribute no more than $40 million in our mid-case valuation). Every $10 million of additional upside from these segments is >25% upside to the equity.

Valuation construct (up / down / base): Our mid-case EBITDA is $125 million which implies an equity value of ~$44 / share (versus ~14.55 current) or ~200% upside using YE 18E net debt balance of $43 million. The FCF generation of >$65 million in 2019E is powerful as it’s the equivalent of >$5.50 / share of value creation (on $14.50 / share current share price)

Roadmap for the future / how this plays out: Given its modest leverage profile (~80MM YE 17E dropping to ~40MM by YE 18E), we believe IO could be viewed as an interesting acquisition candidate. Looking out 18-months, the market is implying ~$150MM of value for IO (factoring in NOLs) which compares to a historical peak value of $1Bln in the last oil up-cycle. Given the ongoing momentum in the business + optionality of its Systems / Software and OBS segments, we think a $400 - $600MM (low versus high) value is reasonable (and this assumes a 10-year historical multiple of 4.5x on the business and low-teens FCF yield on an under-leveraged balance sheet as the biz should have net cash by mid-2019E by our estimates or ~1.5 years away). Notably, the management team has been radio-silent on communications during the downturn (focused on the $90 - $100MM of cost saves + not much good news to share to the market during the oil market fall-off). As the business is inflecting and has sustainable l-term drivers, management appears to be more open to communications. We anticipate an Investor Day in early 2018 as well as roadshow appearances in 1H 2018 and greater transparency on the situation should be a positive regarding improved technical, greater sell-side coverage, etc.

Catalyst

Biz performance, Investor Day in early 2018 as well as roadshows in 1h 2018, possibility of M&A given inflection in performance + inexpensive multiple