Description

ION Geophysical Corporation

Investment Memorandum

Investment Highlights

• ION Geophysical Corporation (“ION”) is an seismic exploration service provider to the oil and gas industry

• ION has $175mn in one tranche of secured bonds trading in the mid-60s, which are an attractive investment

• Investment merits

• Attractive equity-like return with a very low probability of non-payment

• Low probability of non-payment due to $100mn+ available cash

• Significant asset backing by a highly profitable and valuable Software division generating ~$20mn in EBIT

• Inherently cyclical business going through a down-cycle

• Main investment risks

• No industry recovery in sight as oil prices are likely to remain low in the foreseeable future, e.g. due to new Iranian production

• Ongoing patent litigation with WesternGeco,.The latest court ruling has reduced WesternGeco’s claiming to a manageable $40mn

• Whilst originally drafted as a debt investment, at today’s share price, the equity offers an attractive risk reward profile with a chance of making 3-4x

• From a sizing perspective, the 2L bonds warrant a sizable position whereas the equity could serve as a return sweetener

Security Highlights

• $175mn 8.125% secured bond to ION due May 15, 2018

• 2nd lien security and guarantee over material subsidiaries

• Implied net enterprise creation value of $50mn through the 2L at market prices, $110mn at face value

• $117mn in cash on balance sheet. $64mn net cash after taking into account finance leases and the WesternGeco claim

• $88mn in market capitalization, implying an enterprise value of $200mn through the equity vs. a conservative sum-of-the-parts valuation of $240-500mn

• Average cash generation between 2008-2014 of $40mn

2L Bond Returns Overview

• If one buys at 65c today and gets repaid at face value at maturity in May 2018, one will make a 29% IRR and 1.8x MoM

• Below is a summary of the expected returns at various bond purchase prices

Investment Framework

• Company: high quality company with leading market positions, albeit small in overall size

• #1 market share in streamer positioning systems and streamer navigation software

• Software division is profitable and profitability has been pretty resilient even in the current downturn

• Favorable long-term outlook as oil & gas companies will need to keep finding more reserves, which is getting harder and thus increases demand for seismic services

• Few alternatives to seismic exploration services

• Good through-the-cycle cash generation of ~$40mn p.a. before acquisitions, which haven’t been particularly value accretive anyways

• The company and the capital structure is too small and illiquid for many larger and sophisticated funds to care

• Macro: inherently cyclical sector that is going through a downturn and is likely to recover at some point as existing reserves shrink due to exploitation

• The oil and gas sector goes through innate cycles and the seismic exploration industry that ION operates in tends to get hit particularly hard

• The current cycle for ION is driven by temporary lack of demand rather than structural oversupply in ION’s part of the supply chain

• Overall, ION’s fortunes are bound to recover because even with oil prices at $50 / BBL, oil & gas companies will need to replenish their reserves at some point as oil production eats away on their existing reserves. The prospect of ION seeing increased demand and increasing revenues even if oil prices were to stay low for a longer period of time makes ION a particularly interesting pick in the notoriously cyclical oil & gas space vis-à-vis straight E&P plays

• Lastly, oil prices are likely to recover within 1-2 years to levels beyond $70. As Nobel laureate Niels Bohr aptly put it, “prediction is difficult, especially if it’s about the future”, but with the world’s largest and lowest cost oil producer Saudi Arabia expected to rack of a government deficit of 20% of GDP and the country with the largest oil reserves Venezuela at the brink of bankruptcy, one would think that the oil price will have revert back to higher levels lest the countries have to make painful adjustments to their living standards.

• Key concerns

• Lack of alignment of interest between management team and shareholders

• Lack of shareholder value creation as free cash has gone to poorly timed acquisitions, e.g. ocean bottom services business

• Has let go of formerly good businesses, such as the land seismic equipment manufacturing division (INOVA)

• Burns cash in the currency down-cycle environment. This has been largely addressed by cuts to the workforce of 50%, but it is to be seen whether this has affected the firm’s long-term prospects

• Increasing customer concentration as Polarcus and Dolphin may not survive the downturn, leaving only 3 large integrated players in the marine seismic space

   

1. Company Overview

• ION is an seismic exploration service provider to the oil and gas industry based in Houston, TX

• ION operates in 4 divisions

• Solutions: helps oil and gas exploration and production companies create maps of subsurface structures to identify hydrocarbon reserves by commissioning seismic surveys and processing seismic data collected. ION may bear part of the cost of the survey in exchange for being able to market the data to third parties later under the “multi-client” model

• Systems: manufacturing of marine seismic equipment

• Software: control software for marine seismic equipment

• Ocean Bottom Services: contractor to create seismic surveys using ocean-bottom cables

• INOVA Geophysical: unprofitable 49% JV manufacturing land seismic equipment

Segment Breakdown

Ownership Overview

• Lack of alignment of interest with shareholders is a concern for the equity story

• Disappointingly, insider ownership isn’t very high with only the chairman holding a significant equity stake

• No significant insider transactions of late

1a. Capital Structure Overview

Leverage through the 2nd lien bonds is not very high and repayment at maturity is very likely. The shares have also become so cheap that one can view them as a 3-year call option (until the maturity of the bonds) on a recovery in seismic activity / the oil price. The company is not facing imminent liquidity issues or covenant pressure.

1b. SotP / Liquidation Analysis

Even using very conservative assumptions, allocating very low single digit multiples to LTM financial figures onto industry leading divisions such as Software and Systems, the 2L bonds are well covered. At today’s share price, ION’s equity also offers a compelling risk / reward investment. If ION manages to ride out the cycle, making 3-4x the capital invested is quite feasible, against some low chance of getting wiped out.

1c. Divisional Overview: Solutions

Business Description

• The Solutions division mainly comprises two parts, one being Multi-Client, the other being Data Processing

• The Data Processing division takes raw seismic data acquired by marine or land seismic acquirers and turns it into intelligible maps to identify pockets of oil (pictured on the bottom right). A profitable, IP-intensive, and asset-light business

• The Multi-Client division helps customers (can be national governments or smaller E&P companies with little experience in seismic exploration) to design, conduct, and partially fund seismic surveys

• National governments may choose Multi-Client companies over pure seismic acquisition companies due their expertise particularly in frontier regions whereas smaller E&P companies will use MC companies like ION to perform a “break-bulk” function, finding multiple E&P companies to fund a larger study in which every client is interested in smaller blocks

• Smaller E&P companies are most prone to aggressively cut exploration spending in a downturn

• The Multi-Client business is risky in a sense that for poorly designed services in the middle of nowhere, technological obsolescence will quickly turn older vintage surveys useless. Historically, ION has obtained very respectable pre-funding rates averaging in excess of 100%. For more analysis on the profitability of the MC division, please refer to the appendix

Financial Overview

Product Description

Processed map of seabed

1d. Divisional Overview: Systems

Business Description

• The Systems division manufactures equipment for the marine seismic industry

• Its products comprise streamers (long strings of sensors that marine acquisition vessels pull behind themselves to record reflected shockwaves), streamer positioning systems (fin systems that control the position of the streamer sensors), ocean bottom cables (essentially streamers on the ocean floor)

• Catering to the marine seismic industry, demand is driven by vessel new-build, increasing streamers per boat, and replacement demand as streamers generally only 6-7 years before natural wear-and-tear warrants their replacement

• Obviously with next to no new vessels being commissioned, demand for streamers has fallen off a cliff, resulting in depressed profitability with negative EBITDA and EBIT margins

• The key competitor for the towed streamer business is Sercel, which is part of the French seismic conglomerate CGG. WesternGeco and PGS also manufacture their own streamers although they are generally not for sale to third parties.

• There are not many other major marine seismic companies with the only other notable Western players Polarcus and Dolphin that don’t have in-house manufacturing capabilities struggling very hard to service their debt obligations.

Financial Overview

Product Description

1e. Divisional Overview: Software

Business Description

• The Software division develops and licenses software to marine seismic companies to control the arrangement and positioning of its streamers when conducting seismic surveys

• ION’s Systems division is the world’s leading producer of streamer positioning systems (controllable fins) and ION’s suite of software helps marine vessels control these fins, which can have a significant impact on the quality of a survey

• Despite the clearly complementary nature of the Systems and Software divisions, ION’s CFO Steven Bate stated that both divisions could exist independently of each other

• This is notion is reinforced by the market share data published by CGG (please refer to the Industry Overview section). Despite CGG’s dominant position in the actual manufacturing of streamers, they are still said to use ION’s streamer positioning equipment and navigation software

• ION’s Software division enjoys extremely high EBIT margins of ~50% and the highly stable total profitability suggests that this is a highly valuable business that by itself is probably worth enough for ION to repay most of its bond debt

Financial Overview

Product Description

Orca Software for Towed Streamer Operations

1f. Group Cash Flow Analysis

Below is the adjusted EBITDA and the adjustments required to arrive at unlevered free cash flow of ION, which excludes acquisition expenditure, working capital movements, and cash interest payments. Over the past 7 years, ION managed to generate ~$40mn in unlevered cash flow per year.

2. Macro

2a. ION Valuation & Brent Price Development

ION’s EV has moved in tandem with the falling oil prices, but ION has fallen more and its movements have been more volatile than oil price movements. This is in line with the market view that seismic exploration industry is more volatile than the cyclical oil and gas industry.

2b. Brent Price Development

The oil and gas industry is a cyclical industry prone to price drops of more than 50% from previous peaks. Pure E&P companies are more exposed to the actual oil price levels whereas its suppliers, albeit their business is similarly if not more volatile, are insulated from the actual oil price levels but not insulated from the large oil price swings.

2c. Increasing Production Decline Rates Favors ION

Recent oil field discoveries tend to have higher decline rates than older fields. This is widely attributed to the fact that the highest quality and lowest cost fields have already been tapped and newer fields are all incrementally worse. Higher decline rates mean that E&P companies need to step up the rate at which new oil fields are found and exploited, which helps exploration companies like ION.

3. Industry Overview

3a. Oil Field Services: Positioning of the Seismic Industry

Seismic services are typically engaged in the very beginning of the oil production cycle. Exploration spending is prone to cutbacks by when oil prices fall, although oil majors keep looking for oil with little regard to prevailing oil price levels.

3b. Oil Finding Costs

The cost of finding oil has increased as the success rates of finding oil have declined, which makes seismic exploration services increasingly indispensable.

3c. Seismic Industry Activity Levels

Over time, seismic surveys have become an increasingly important part of exploration programs.

3d. Exploration Capex and Oil Reserves

Despite growth in exploration spending, oil majors have barely managed to maintain their oil reserve levels. As reserves decline, oil companies will have to keep looking for new reserves.

3e. The Seismic Services Industry: Competitive Landscape

The seismic industry is relatively concentrated with three big integrated players PGS, WesternGeco (part of Schlumberger), and CGG as well as a range of smaller companies that occupy different niches along the supply chain.

3f. Marine Seismic Exploration Industry Concentration

The marine seismic exploration industry in particular is highly concentrated between the top 3 players controlling ~70% of the global streamer capacity. However, because barriers to entry are low, competition is fierce as recent entrants created to overcapacity in the market, which is hurting sales in ION’s Systems segment right now.

3g. Seismic Equipment Market Share Data

ION is the undisputed leader in the navigation software and streamer positioning segment of the marine equipment market. ION’s INOVA division is presumably the leading manufacturer of vibrators for the land equipment market, but margins are said to be very slim for physical equipment and higher in the more technology intensive segments of geophones and cable systems dominated by Sercel and Geospace.

Note that the chart below shows the seismic equipment market shares of CGG. ION occupies #1 in Navigation and Streamer Positioning of the marine equipment markets.

4. Valuation

4a. Trading Comps Multiples

Data library businesses trade at ~1x+ book value and other seismic companies trade north of 1.2x LTM revenue.

4b. ION Historical Market Cap / EV

ION is trading at a low valuation relative to past trading levels. Its market capitalization and enterprise value have reached lows last seen in the depths of the financial crisis in 2009.

4c. ION Bond Trading Levels

ION’s bond yields have climbed and bond prices have dropped into distressed levels, currently around a ~27% yield-to-worst and a clean price around 65c.

5. Appendix

5a. Benchmarking: Multi-Client Efficiency Analysis

The best way to assess the quality of the MC business is evaluating the total revenues earned vs. the total capex spent on the library. As one can see below, ION’s Revenue / MC Capex generally is ~2x, quite comparable to what the leading multi-client peer TGS has been clocking, although ION’s 2013 and 2014 vintages haven’t been doing as well as TGS’s.

ION

TGS Revenue / MC Capex

5b. Historical Divisional Financials

It is worth noting that the Software division has managed to generate at least $20mn in EBIT every year over the past 7 years and that the Solutions division has always managed to generate enough cash flow to cover the multi-client capital expenditures.

5c. Historical Income Statements

ION has taken a relatively conservative approach towards fully provisioning for the WesternGeco litigation in 2013, which has required it to unwind the provision thereafter. Furthermore, it has taken a large write-down of its multi-client library in 2014Q4

5d. Historical Cash Flow Statements

ION’s ability to generate cash is more obvious in the cash flow statement that adjusts for the non-cash litigation provision movements as well as the impairment of the data library.

5e. Historical Balance Sheets

ION’s balance sheet shows its strong cash position, although this could partially be driven by a reduction in account receivables.

5f. 2nd Lien Bond Documentation Analysis

Key Terms

• Maturity: May 15, 2018

• Interest Rate: 8.125%, payable semi-annually in arrears

• Interest Payment Dates: May 15 and November 15

• Principal Value: $175mn,

• Issuer: ION Geophysical Corporation

• Security and guarantees

• Guaranteed on a joint and several basis by the material domestic subsidiaries GX Technology Corporation, ION Exploration Products (U.S.A.), Inc. and I/O Marine Systems, Inc., which represented ~22.6% of consolidated assets and 61.5% of consolidated revenues as of December 31, 2013 (NB: it is unclear whether these figures are taking into account the financials of subsidiaries of guarantors too)

• Guarantees are secured by a second lien floating charge over substantially all property of the guarantors

• Financial maintenance covenants: none

• Early redemption

• CoC requires repurchase of 2L bonds at 101%

• Call dates: May 15, 2015 (104), 2016 (102), 2017 (100)

• Governing law: New York

• Minimum transfer: $2,000 minimum and increments of $1,000

Other Terms

• Permitted debt of the greater of $175mn or 20% of consolidated net total assets, but less than $275mn in total

• No finance leases exceeding $25mn

• No preferred stock, additional debt, or acquired debt unless PF FCCR ratio is above 2.0x

• Restricted payment baskets

• No dividends and share repurchases or acquisitions subject to a standard builder basket from April 1, 2013 (most definitely a binding constraint right now so it isn’t an issue)

• However, note that junior debt could get repaid first with proceeds from an asset sale

• Events of Default:

• Payment defaults under the bond,

• Cross payment default under other indebtedness, or acceleration of indebtedness exceeding $20mn

• Need 25% of 2L amounts outstanding to declare a default

• Voting

• Need 1/3 stake in 2L notes to block release of collateral

• Only holders of first priority indebtedness have the ability to cause enforcement proceedings whereas 2L bondholders cannot until the first lien debt has been repaid

5g. Structure Chart

The bonds are guaranteed on a joint and several basis by domestic subsidiaries (within the dotted box) which represented ~22.6% of consolidated assets and 61.5% of consolidated revenues as of December 31, 2013. Note that it is unclear whether these figures are taking into account the financials of subsidiaries of guarantors too.

5h. Sources

• Company materials: CGG, ION, TGS

• Broker research: ABG Sundal Collier, Barclays, Citigroup, Credit Suisse

• Market data: Bloomberg, Capital IQ

Catalyst

1. Potential bond buyback by ION or takeover by other large oil services companies (from the seismic peers, PGS or TGS are more likely as CGG is struggling itself and this is probably too small for Schlumberger to make a difference)

2. Maturity of the bond in May 2018