Description

We believe Mitcham Industries (Ticker: MIND), a seismic equipment rental company, represents the opportunity for a 2x return over the next six to twelve months.  As well, given the fact the company carries zero net debt and will generate significant free cash flow in the coming years, we see limited risk of permanent loss of capital.  The long term risk/return characteristics of this investment are very compelling.  Highlights are as follows:

Business Characteristics

• Good returns on capita: Mid to high-teens ROIC over the cycle
• The only company of its kind of any scale: Nearest competitor is less than 1/5 its size. MIND is the only player in the space with global scale
• Meaningful barriers to entry: Long term customer relations, global operations, knowledge/skills difficult to replicate

Valuation (cheap on earnings and on hard assets)

• 3.2x trough EBITDA and 1.9x mid-cycle EBITDA. We understand that EBITDA is often of limited use for equipment rental companies. But, given that Capex is coming down meaningfully it becomes another metric to consider (discussed more later)
• ~10.0x trough EBIT and 3.0x mid-cycle EBIT
• 0.7x tangible book. Implies basically zero value to the operations of the business - just a discount to the value of the assets. Also, implies zero value for the profitable ancillary manufacturing business. MIND has added in excess of $35mm to their equipment rental pool in the last two years. At current prices the market cap and enterprise value are roughly $50mm.

A Low Risk Investment

• As mentioned above MIND carriers essentially zero net debt. In reality, they may be running overcapitalized for the type of business in which they operate. But, recent trends in the business and today's challenging environment makes their clean balance sheet look prudent
• MIND will generate significant free cash flow in the coming periods. Rough math suggests that over the next two years MIND will generate one half its market cap (and enterprise value) in FCF

Below, we provide a description of the business and elaborate on each of the investment points discussed above.

Business Description

MIND does two very simple things.  They buy land and marine seismic equipment and rent it to companies searching for oil and gas (we'll call this the 'Rental Business').  They manufacture and sell marine seismic equipment ('SeaMap').

The Rental Business:  Seismic is an important element to understanding subsurface geology and finding/exploiting oil and gas.  Basically, a company uses equipment to shake the earth - dynamite does the trick but they also use vibrator trucks and air guns in marine applications.  Then, they listen to and record the sounds bouncing back off the earth's substructure.  They employ various types of sensors - mostly geophones stuck at intermittent locations into the soil or on streamers behind large ships.  All the sensors are strung together and hooked up to channel boxes which convert the signal to digital.  A different device then records these many signals and saves the data for future analysis.  

MIND rents geophones, channel boxes, processing units (CEUs), air guns, vibrator trucks, and recording trucks.  As well, they rent Vertical Seismic Profile equipment VSP (for seismic recording inside existing well bores).  They also have a host of other equipment but the above categories constitute the majority of what they rent. 

The Company calls this the 'Leasing Business' but it really more akin to rental.  These are short term contracts of two to six months.  Very rarely there are purchase options in the contracts but this is generally not the case. 

The few competitors in the space tend to be specific to certain geographies or plays.  For instance there might be a competitor with a few million dollars of equipment the in West Texas or the Rockies.  MIND is a global player, will ship equipment anywhere in the world, and delivers this through five different distribution centers (U.S., Canada, Australia, Singapore, and Russia).

Who rents seismic equipment and why?  MIND's equipment is primarily rented by companies that offer seismic acquisition services to their E&P customers.  A seismic contractor will own some of his own equipment and employs his own crews.  He will bid on a job and service that job with his equipment and his crews.  Often, he will need to supplement his equipment with rental equipment.  He may not have enough of his own equipment in that specific region (or perhaps not the right type).  MIND rents him the extra equipment and in this case is the marginal provider of seismic equipment.  Alternatively, the work may be taking place in regions where there is little to no existing equipment.  In this case, MIND may be the only provider of equipment to the region.  As well, they play a very important logistical function as they must transport assets to remote locations in third world countries with complicated duties / tariffs / other restrictions (example below). 

Example:  Imagine a contractor gets a job to shoot seismic in a remote region of Peru.  Setting up the shoot and crewing it properly is one thing.  Getting the specialized equipment there is another.  The seismic equipment must be packed for international air transfer, it must be insured for work in a foreign country, tariffs must be paid, bills of lading taken care of, permits filed, etc, etc.  Then, when the shoot is over, the whole process must be reversed with the equipment returning to a distribution center thousands of miles away to be serviced/refurbished and made ready for the next job.  This is the value that MIND often adds beyond just renting the equipment.  In the U.S. and Canada (together are about 30% of rental revenues) MIND is closer to a marginal provider of seismic equipment.  But, in the rest of the world MIND has a meaningful logistical role in providing equipment.  In most cases MIND can fulfill a customers equipment needs within 24 hours.  Having been in the business for almost thirty years MIND has relationships with basically every seismic acquisition company in the world.

SeaMap Business Description (the brief version) 

SeaMap manufactures and sells marine seismic equipment.  Products primarily include GPS and streamer products and gunlink and array accessories.  Basically these are things that are towed behind ships and generate sounds to bounce off the sea floor or tools to listen to those sounds coming back.   

Company Financial Model

We do not have sufficient information to allocate corporate costs to the two divisions and try to determine division level profitability.  So, we need to add the gross profit contribution of each division and then subtract corporate and simply view the business as whole. 

Rental Division Financials and Business Model:  By definition, in a rental company it is the assets that generate revenue and gross profits.  It is important then to look at this relationship over time.  Given a certain level of assets available to rent what level of revenues and gross profits should we expect? 

Over time we can see that in good years, for every dollar of rental equipment on the balance sheet (based on beginning net book value plus ending net book value divided by two), MIND earned in excess 60 cents of gross profit.  Last year, which experienced a very poor winter (important season for earnings), MIND only earned about 40 cents for every dollar of rental equipment on the balance sheet.  Based on this math it seems reasonable to assume that on average over time MIND can earn about 50 cents of gross profit for every dollar of equipment (net book value) on the balance sheet.  The financial history teaches us this and management has also validated this as a good way analyze earnings power.  (It is important to note that we are talking about Gross Profit net of depreciation - not cash contribution from the rental division which is obviously higher.) 

For the next couple of years the average net book value of equipment should be about what the 1/31/09 book value is ($64.3mm) and perhaps a bit lower.  Depreciation should slightly exceed Capex and therefore Net book Value will come down.  For simplicity/conservatism we can assume that the average net book value of rental equipment will be about $60mm.  Using our rule from above, this implies $30mm of mid-cycle gross profit earnings contribution over the next few years. 

Why focus on mid-cycle?  Well, because MIND is about to emerge from a very difficult period for the rental business.  Winter is a critical season for MIND because they do a lot of business in Canada and Russia.  In those countries, for the most part seismic can only be shot in the winter because frost must be in the ground in order for the roads to be hard enough to handle transport of heavy equipment.  In the 4Q two years ago (Nov 07, Dec 07, Jan 08) MIND made $6.1mm of gross profit in the leasing division.  In their most recent 4Q they made only $3.4mm.  The first quarter was even worse in this regard.  Gross profit declined from $8.3mm in the year before to $1.7mm this first quarter (ended April 09).  If we look at this winter as a whole, gross profit declined 65% while the rental pool actually increased by about 20%.  In the all-important winter season MIND's rental division generated $9.3mm less in gross profit than it did the previous winter.  Our best guess is that MIND will recapture a large portion of this lost gross profit next winter. 

Why do we believe this?  Entering this past winter the environment was perhaps the worst it has ever been in terms of companies looking to deploy capital into energy exploration.  A number of conditions were prominent:

1. Worldwide financial crisis - practically all firms, included E&P companies, were paralyzed and capital decisions were postponed 
2. Crude oil prices were at $35 - at that price companies will likely allocate investment dollars to projects in place but not spend aggressively on seismic to prospect for new oil and gas
3. Money was impossible to borrow - A number of the smaller E&P companies in Canada and Russia rely on credit; they could not borrow and therefore could not commission seismic work
4. Credit concerns - Given the decline in credit quality of certain potential clients, MIND deemed them simply too risky rent to (especially in Russia).  They were worried about getting their equipment back if they let it out of the warehouse.  At least in part, they practically just shut down the operation in Russia and decided to wait for this coming winter 

The good news is these conditions are easing and next winter should be much better for MIND.  We may be in world economic doldrums, but not an outright financial crisis like 2008.  Oil prices have rebounded substantially.  Credit has eased and customer credit quality has improved (lower energy prices have served to expose the really weak E&Ps companies).

We think the current quarter will be MIND's last really bad quarter.  On the last call management detailed some significant jobs that MIND hopes they will be a part of.  As well, it is hard for us to imagine that this coming winter could set up as badly as last winter.  With new international work ahead of them and the prospects for a better winter, we think MIND will enter a period in which it can generate 50 cents of gross profit on the net book value of their equipment - again, this implies gross profit contribution of about $30mm.

SeaMap Division Financials and Business Model

• In FY 2008 SeaMap contributed $8mm of gross profit on revenues of $25mm. Gross margins were artificially low as they had some problems with new products. In addition, they were paying royalties on intellectually property in FY 2008. At the end of the year the bought-in the IP and changed the margin profile of the business
• In FY 2009 SeaMap contributed $8mm of gross profit on revenues of $17mm
• In the first quarter of this year SeaMap did about $2.5mm in gross profit. On the last call management discussed the delivery of a ~$11mm orders in the coming three quarters to one large customer. Beyond this large customer there should be another $5 to $8 million of orders from other customers. We model $20mm in revs and a 45% gross margin for the for the entire year.
• Despite the fact that we may see record gross profit in SeaMap this year, on a recurring basis we think $8mm is probably about the right number
• Overall this seems like a decent little business although results can be lumpy from quarter to quarter

Rental Gross Profits + SeaMap Gross Profits - Corporate Expenses = Earnings Power

Corporate G&A has been running about $17.5mm.  Provisions for doubtful accounts spiked last year - but, we just use an average of the last three years at $1.2mm.  Corporate level D&A is about $1.4mm.  Taken together there is roughly $20mm of corporate costs. 

Mid-cycle Rental Business Gross Profit of $30mm + SeaMap average Gross Profit of $8mm - Total Corporate Costs of $20mm = $18mm of Operating Income.  This is the mid-cycle earnings power of MIND 

A reader of this piece might look at the MIND's previous peak EBIT of $17mm in FY 2008 (Jan 2007 - Jan 2008) and say that our 'mid-cycle' EBIT number must be wrong.  But, investors must remember that the $17mm of EBIT was generated on a much lower average equipment base (closer to $40mm average net) versus today when MIND has in excess of $60mm net.  Since their peak EBIT year MIND has spent $37.5mm on new equipment against dispositions of only $3.5mm.  When all this excess equipment gets working earnings power will increase dramatically.  Management has been trying to emphasize this point.  The company is very well positioned geographically and with critical equipment.  An uptick in demand and an improvement in the aforementioned winter challenges will be cause for a meaningful earnings increase.

Quick Thoughts on EBTIDA:  In the rental business Capex, which of course give rise to depreciation, is a real and recurring cost of the business.  This makes EBITDA a pretty useless metric. Anyone can grow/generate EBITDA in a rental business if they simply deploy capital.  The problem is they might be deploying capital in a horribly inefficient way.  That is why we focus on EBIT.  That said, it is worth noting that lease pool depreciation was about $15mm last year.  So if we add this back to EBIT we get to mid-cycle EBITDA of $33mm.   As mentioned earlier, we think the Net Book Value of Rental Equipment will come down some in the coming two years.  We see roughly $25mm in Capex against $30mm in depreciation (see mgt commentary on the calls). 

Per above, over the next two years the company should generate about $36mm in EBIT.  Assuming an average tax rate of 40% and zero net debt (thus no interest expense/income) - that would imply $21.6mm of net income + $5mm in excess cash flow as capex is below depreciation.  This $26.6 increase in cash over the next two year is striking considering MIND has a market cap and enterprise value of roughly $50mm.  That brings us to valuation...

MIND Capitalization and Valuation

FD Shares                    10.35mm

Share Price                  $5.00

Market Cap                 $51.8mm

Cash (4/30/09)            $4.8mm

LTD (4/30/09)             $6.5mm

Net Debt                     $1.7mm           

Enterprise Value           $53.5mm

We see a few different ways to look at valuation:

• EBIT Multiples:  Because of the terrible last two quarters - TTM EBIT is $5.2mm.  Thus, if we think that MIND is at trough earnings then it is trading at ~10x EBIT.  In reality, this current quarter will comp down from same quarter last year - so, we are not at trough numbers yet.  But, on the mid-cycle numbers of about $18mm in EBIT - MIND is only 3.0x EBIT.

• Assets:  Another way to look at valuation is basically to say, you get buy the business for a nice discount to the net book value of the seismic equipment.  Then you get SeaMap for free.  As well, the net book value of the seismic equipment likely understates its economic value - we know this because year after year MIND books gains when they sell their used equipment. 

• One Year Out:  In another exercise, we might simply look out one year and see where we think MIND is likely to stand.  The company should be in a $5 to $10mm net cash position (one year of EBIT plus Capex should be lower than Depreciation).  Earnings power should be restored - not to peak metrics but at least to mid-cycle.  Much of their excess equipment will then be employed.  Investors will rediscover the earnings power.  As MIND approaches $18mm in EBIT this equate to in excess of $10mm in net income and therefore in excess of $1.00 per share in earnings power.  We think a 10x multiple (at least) would be reasonable suggesting a 2x on the stock.  Given the earnings momentum that MIND will be demonstrating we think it is possible that investors could put a much higher multiple on the stock.  Before recent challenges, over a four year period MIND was averaging about $1.00 a share in earnings power (again - with much less equipment).  During this period the stock hovered between $10 and the low twenties suggesting a 10x to 20x multiple.  Given how investors have valued this business in the past, we certainly do not think our $10 price target is aggressive - in fact it may be too low.

 Summary

An investor must be willing to buy this stock a quarter or two before trough earnings.  But, if one can stomach this for a short period, then not long from now historical metrics should catch up with MIND.  This shouldn't be long off since next winter will be meaningfully better than this past winter which had everything going against it.  As the metrics start to improve just a couple of quarters from now - a $10 stock is highly reasonable and perhaps conservative.  On the risk side, the fact the even in these tough times the company is FCF positive and has basically zero net debt should be enough to provide safety.

Finally, we've found management intelligent, committed, non-promotional, and accessible to investors. 

Catalysts

• Announcements of Contracts: On the last call management mentioned that they are involved in bids for some large international contracts. It is worth noting that MIND is often acts as a subcontractor and is part of multiple or potentially all of the potential prime contractors' bids. In other words, MIND may win business regardless of who the prime ultimately is (the extent of their participation will vary). Any announcement should be a positive catalyst and help investors see that the seismic market is not dead
• Analysts Will Need to Raise Estimates: MIND did close to $30mm in EBITDA a few years back with meaningfully less rentable equipment. Despite that fact, Street analysts essentially have MIND earning less than $20mm in EBITDA into perpetuity. In our view EBITDA will quickly start to annualize at well more than $20mm once we get through this tough period. Analysts are likely being overly conservative and estimates will need to move up. (Pure speculation: This sets up as one of those situations in which analysts will have a 'Hold' rating on the stock at $5.00 but in six months will have a 'Buy' rating when the stock is $8.00)

Catalyst