Description

DISCLOSURE: We and our affiliates are long OYO Geospace (OYOG) and may long additional shares or sell some or all of our shares, at any time. We have no obligation to inform anybody of any changes in our views of OYOG. This is not a recommendation to buy or sell shares.


We believe OYO Geospace (OYOG) will experience a dramatic increase in business over the next 30-90 days as it wins contracts for their RCS technology and a turnaround in the base business that will drive earnings from ~ .80 EPS today to ~ $3.50 under favorable assumptions in 2006 yielding a stock price north of $50. We believe the majority of positive news that will drive the stock price will surface within the next 30 to 90 days and represents a very attractive risk reward for catalyst driven investors who are willing to value the near term growth. In addition, the multiple investors are willing to give OYO could expand greatly on the news of a few major contracts, and could easily push the stock price past $60 in that scenario over the near term.

OYO sells five lines of products primarily to the offshore seismic industry including: geophones/hydrophones, borehole readers, thermal printers & reservoir characterization systems (RCS). Each line is experiencing an improvement to one degree or another and will be explained below but we have focused most of our research on the reservoir monitoring systems, as they will be the largest value drivers.

The gross margins given by the company (not disclosed in filings) on each line is as follows:

Generic geophone/hydrophones ~25%
Borehole readers ~65%
RCS ~65%
Deep water cables ~35%


The seismic industry is fairly simple and has been covered numerous times on VIC. Essentially, seismic is a form of oil/gas exploration that uses sound/pressure waves to locate hydrocarbon structures beneath the earth’s surface. As oil prices have soared so has the interest in seismic exploration. Seismic exploration should remain fairly robust at any oil price above $40 per barrel, so it is less dependent on the direction of oil prices as in the general need to discover/use reserves more efficiently.


Current Business:

We believe the current business earns around 80 cents EPS today and offers multiple opportunities for significant improvement.

2005E breakdown (millions):
Generic seismic 60
Borehole 10
RCS 0
Deep water cable 1.5
Thermal imaging 13.5
Total sales 85

CGS 59.5
SGA 14
R&D 5
EBIT 6.5
Other .25
EBT 6.75
Taxes 2.15
Income 4.6
EPS .80
Shares 5.685


Future Business:

The Reservoir Characterization System (RCS) business is the most exciting part of the story and we have focused most of our research efforts here. RCS in basic form is an armored seismic shooting cable that sits on the seabed floor and closely monitors the movement of oil over time through repeated seismic surveys. RCS’ value proposition to the end user is that it allows more reserves to be recovered from the oil field by helping better pinpoint where to drill, or where to avoid. The substitute for an RCS system is hiring a seismic contractor to come each month to the oil field and shoot surveys. Aside from being much less precise and being less detailed, the substitute method becomes expensive very quickly, as the per-survey cost of RCS is considerably lower. Essentially, RCS is a tool that aids in more efficient oil recovery over time.

The target market for RCS are long-lived fields- at least 8 years of recoverable reserves at current extraction rates- & total recoverable reserves of over 750m barrels. It has been available for many years but our research proves that it has finally hit a tipping point.

History:
RCS is not a bet on a concept technology, but rather a tried and proven tool. The first and only installation to date is BP’s Valhall field in the North Sea during 2003, where 120km of OYO cable was placed covering 2/3rds of the field (Shell also has a very small OYO RCS system at their Mars Field in the Gulf). There’s an enormous amount of research available but public statements and conversations with experts show that it will help BP extract an additional 60m barrels of reserves with an RCS equipment cap ex of around 22m. Even at normalized oil prices, it has proven to be an excellent ROI for BP, and other oil majors are taking interest.

Tipping point:
It has taken oil companies a few years of testing and evaluation to determine the true value of RCS, as the very nature of the technology is to add value over time, not immediately. Multiple conversations with Seismic Operations personnel make us believe the tipping point is at hand.

Competitive Advantage/Competitors:
Though there are large competitors in the seismic equipment business such as Schlumberge, WesternGeco/Sercel, & Input Output, experts in the field told us that OYO has the competitive advantage for the time being because they have the only tried and proven technology in the space. It is not even apparent that competitors have systems ready today to deliver for contracts or if they’re simply promising delivery by the contract date. While it is conservative to assume future business shifts to the competition, multiple sources expressed high preference for OYO equipment and confidence in their ability to win upcoming contracts. The deep off-shore environment where these systems are installed are very harsh & corrosive, hence the cable’s armor. With a ~20m investment per system per field, major oil & gas companies are telling us that a track record goes a long way for OYO. Furthermore, BP has had flawless success from the equipment at Valhall. Although, once this market takes off, we do not expect OYO to remain the leader indefinitely.

Future RCS contracts:
We believe there are at least 3 contracts in the market place today and bidding has closed for around half of them, so announcements should come very soon. In addition, we have heard there are other fields that are nearing the bidding process as we speak, with Shell and BP being the main participants for both current and contemplated contracts. Multiple conversations with a variety of industry experts leads us to believe there is roughly 200km of RCS cable contracts where OYO is the preferred manufacturer. It should also be noted that with BP’s success at Valhall they are strongly biased towards OYO equipment. Although, timing is difficult and most fields will be built in stages, it seems that the 200km in opportunities should be awarded during 2006. Assuming a $180 ASP per KM of OYO cable, this represents sales of about 36m. On top of off-shore opportunities with the major oil companies, there are two land RCS contracts that stand a good chance of going to OYO in early 2006, valued at around 10m in sales- though we have not researched this opportunity well so we will value it separately. OYO has the manufacturing capacity today to build RCS at 4 to 5x the size of Valhall per year, or roughly 500KM of cable. We have presented multiple scenarios to better understand the risk/reward.

Incremental RCS @ 2006
KM offshore cable: 40km 75km 125km 200km
Sales 7.2 13.5 22.5 36
GM 4.68 8.78 14.63 23.4
SGA .75 .75 1 1
R&D .5 .5 .5 .5
EBIT 3.43 7.53 13.13 21.9
Taxes 1.2 2.63 4.59 7.67
Income 2.23 4.89 8.53 14.24

Incremental EPS off shore
.40 .85 1.50 2.50

Incremental EPS land
.65



The geophones/hydrophones are fairly generic and are used for basic seismic data gathering. It has been experiencing an upturn since a recent bottom in 2003. Early feedback from seismic contractors is showing 2006 could be 10-20% more volume than 2005 and 2007 sounds like it will be at least flat- although too early to pin down.

Incremental Generic Seismic @ 2006
Sales 10
GM 2.5
SGA .72
EBIT 1.78
Taxes .62
Income 1.16
Incremental EPS .20



Borehole readers are small devices that sit down in a borehole and provide extremely detailed seismic data of the concentrated area about the borehole. It is used to track and separate water movement from oil movement in the well, as pressurized water injection has become a preferred method of extracting additional oil from fields of declining production. Overall, it is gaining more traction with customers.

Incremental Borehole @ 2006
Sales 2
GM 1.3
SGA .28
EBIT 1.02
Taxes .295
Income .66
Incremental EPS .11


The thermal imaging business makes printer & printing supplies for seismic graphs and other related activities. After a few years of R&D, management believes they can vastly improve this business and will be able to remove 1m in warranty expenses beginning in 2007. OYO also believes it will have the expertise to produce printing supplies in house that they used to purchase from Agfa, sacrificing healthy margins. By 2007 OYO believes they will be able to supply 100% of their customers printing supply needs internally. Today, ~10m in sales in this division are printing paper/supplies, with 5m being produced internally for approx. 0.41 per square foot and are sold for 1.15 square foot. The other 5m in sales are sourced from Agfa for ~0.90 and sold for 1.15 sq/ft. Management also thinks they’ll be able to take share away from Agfa in this market once they have comparable quality, but we have not given any credit for that scenario.

Thermal Imaging @ 2007

Incremental
GM 2-3
Tax .7-1.05
Income 1.3-1.95
Incremental EPS .22-.34



Deep water cables is a very small portion of the business today @ roughly 1m in revenue for 2005 but management predicts customers will begin buying more from OYO at 3m in 2006 and 5m in 2007. Current industry supply comes from France and is expensive to ship (each cable orders typically run close to at least 100k feet) so OYO should have the cost advantage to the customer’s door.

Incremental Deep water cable @ 2006
Sales 3-5
Incremental EPS .03-.05


Management:
We have met management and believe they are honest, dedicated, and talented enough to steer the business well over the next few years. Gary Owens, CEO, has over 35 years experience and used to head Input/Output (IO) until he left in 1997. He wasn’t in retirement for more than six weeks before he was approached to run OYO Geospace. With some of his top engineering talent from IO joining him at OYO, he has fought hard for multiple years to demonstrate the value of RCS technology and other OYO innovations. A few quick searches on the web should locate numerous articles that quote his efforts over the years. Furthermore, management and the majority of employees are incentivized through a special bonus program based on meeting certain levels of business over the next two years. We think interests are aligned well with investors.


Summary:
All in, we believe OYO represents a compelling catalyst driven investment with a favorable near term risk reward. Although, we do not recommend buying this business based on the stability or visibility of long term cash flows, we think the next year or two will offer significant share price appreciation that could reach $50 to $60 per share.


Total 2006:

Pessimistic Scenario Favorable scenario

Current business 0.8 0.80
RCS 0.40 2.5
Land RCS 0 0.6
Incremental Seismic 0.20 0.20
Borehole 0.11 0.11
Deep water 0.03 0.05
Total EPS 1.54 3.46
Multiple 12x 15x
Share price $18.5 $52


*Thermal EPS (07’) 0.1 0.28
*Not included in 06’ analysis, but likely deserves some appreciation of future value. Mgmt. said they might spin this off after they turn around but wouldn't sell for anything less than 20-25m before improvements.


2007 and Beyond:
I’m a fairly conservative investor so I’ve possibly painted projections for OYO that could be drastically undershooting the company’s potential. Although I’m creeping out of my skin here, let me lay out what I like to call a “Jim Cramer bull case.” The Valhall field at 22m dollars and 120km of cable (and only 2/3rds field coverage) over a 1 year period represented an incremental $1.50 in EPS to OYO. We’ve done an extensive amount of work here and believe there are many more oil fields where this makes sense today (management will loosely guide you to 50 such fields) and it is only a matter of time/more installations before these fields get an RCS like system. In a world of shrinking reserves and more than 25 years since the last great oil field discovery, a technology that greatly improves the reserve extraction for existing oil fields should have significant value. Even if you assume only half of what management guides to and you assume a longer term value per field of only 22m for 100% coverage- this would still result in $38 equivalent OYOG EPS up for grabs based on the current target market. In addition, there are many multiples more, smaller fields where this technology would make sense once it hits a mass market adoption phase and geologists learn how to extract more value from it.


Risks:
-Competition takes some of the RCS market away from OYO in the long haul and put pressure on margins. Management does not debate this scenario and it is not a concern today.
-Sparse Ocean Bed Cable Concept (OBC). A theory headed by shell geologists that suggests laying RCS cable at 1/3rd the current spacing parameters (1/3rd the capital cost) and still having a seismic survey that yields results suitable for reservoir tracking over time. I attended a presentation on this topic with numerous geologists and the key question was if Sparse OBC data was concrete enough to make drilling decisions based solely on the survey. The majority felt it was not and Shell had not made any drilling decision based solely on their Sparse OBC shots. Today’s information on Sparse OBC does not seem robust enough to make it a threat. Also, the KM reduction could be offset by the target market increasing, assuming the cost of RCS per field would come down, but this would be a longer term phenomenon.

Catalyst

-Earnings release Tuesday December 20th. With bids closed, contract announcements could come as early as tomorrow, either land or offshore RCS.
-New RCS contract announcements over next 30 to 90 days.