Preface:  I have been writing reports on VIC for a number of years now, and I would rate this idea (according to my own self rating) the most compelling idea I have written.  PSD has all the indicators of an investment that will work out well:  high free cash flow yield (25% pro forma for a recent acquisition), significant insider buying, uninformed shareholders selling, multiple catalysts, a history of strong takeover interest from multiple parties, good management with excellent capital allocation skills and strong business fundamentals.  Importantly, I believe the idea is also executable in size despite the small market capitalization ($117mm) given the investor transition that is currently happening in the stock.  In terms of valuation, the market cap is $117mm, enterprise value is $163mm and I think free cash flow will be approximately $30mm next year and will grow from there.  The most obvious catalyst is a substantial dividend that will start in the next year, but I have laid out multiple additional catalysts below.  That being said, read on and I look forward to your comments and dialogue on PSD.

Business Overview

Pulse Seismic ("PSD" or the "Company"), based in Calgary, operates in the seismic data industry in Western Canada.  The Company has a market cap of CAD117mm and an EV of CAD163mm (all numbers in CAD in this writeup).  Seismic data refers to mapping of subsurface geological formations in order to support oil and gas exploration and production ("E&P") activities.

Seismic data comes in two forms: 2 dimensional data and 3 dimensional data. 

• 2D data is measure in linear kilometers and will provide an illustration of geological formations on a straight line. 2D data is typically used for large scale prospecting (exploration activity) as opposed to drilling activity.
• 3D data is measured in square kilometers and provides an illustration of geological formations in 3d in order to support actual drilling activity.

PSD owns the second largest library of seismic data in Canada, next to Olympic Seismic, a subsidiary of Seitel.  The Company owns 340,000km of 2D seismic data and 26,400 square km of 3D seismic data.  80% of this data is located in Alberta, with the remainder located in British Columbia, and about 70% of the data is used for natural gas exploration (and the remainder for oil). The business model is to sell licenses for its seismic data to oil and gas companies on a perpetual basis (any given transaction will involve licensing the rights to a very small portion of the overall data library, not the entire library). 

There are a few key points to make about PSDs business model:

• Once you own a seismic data library, there are very few expenses associated with engaging in this business. EBITDA margins are in excess of 50% and incremental EBITDA margins approach 100%.
• Seismic data is essential to E&P activity - if an oil and gas company want to explore or drill in a given area, seismic data is absolutely essential - there is no cost tradeoff or substitute process, you simply have to have the data in order to operate.
• Seismic data is exclusive to an area. If PSD owns seismic data in a given region, they are the only game in town. This is especially true for 3D data, though PSD believes there is about a 20% overlap in their 2D seismic data set with Olympic. Regardless, if you are an oil and gas company with a land lease in a given region, you probably only have one choice in terms of where to buy your data.
• Seismic data is prohibitively expensive to recreate, which explains why there is almost no overlap in data sets. The replacement cost of PSDs seismic data library is about $3 billion, which explains why it is not a viable option to recreate an existing data set. This estimate is based on a cost of $6,000 per kilometer of 2D data and $35,000 per square kilometer of 3D data.
• Seismic data is a relatively small portion of the overall cost of drilling a well, at about 5%. Given the low portion of the overall cost of drilling and the fact that the data is essential and exclusive, the dynamics for pricing power are quite strong.
• Seismic data does not lose its value over time: though the Company continues to create new data (especially 3D data), the Company continues to generate significant revenue from data that was created in the 1960s, 1970s and 1980s. The economic life of seismic data is far in excess of the GAAP amortization period (4-7 years).

Acquisition of Divestco

PSD made an excellent acquisition that just recently closed (9/30/10).  The target, Divestco, owned a data set about equal in size to PSDs.  Divestco built its library by shooting new data (extremely capital intensive) during the boom years and took on debt in order to do so.  This strategy ended badly, and PSD was the only natural acquirer (Seitel was LBO'd and carries a huge debt load, so they couldn't do it) and had been working the deal extensively in advance of Divestco's capitulation.  The beauty of the deal is that they acquired just the data library (no employees, leases, offices etc.) and so they can just layer Divestco's data library sales onto PSD's and earn nearly 100% EBITDA margins in the process.  The purchase price was $75mm, comprised of $55mm in cash and $20mm in PSD stock and was structured as an asset purchase.  The asset purchase structure is key because 3D data can be amortized over three years for tax purposes, hence PSD will get a big tax shield in addition to the data library.  Divestco's LTM data library sales were $20mm on an LTM basis, and peak levels were $40mm.  However given the tax shield, the economics are such that revenues are going to flow through as free cash flow. 

In addition, Divestco had a very strong Q4 (at least $10mm in data library sales in Q4 alone) - hence nearly 20% of the purchase price has likely been recouped within just a few months of closing the deal.  I think this deal was an overlooked home run for PSD and will be highly accretive to shareholder value.

Though the stock has traded higher since the Divestco deal closer, I think the stock remains wildly undervalued and a significant amount of selling pressure remains in the stock despite its attractive valuation.  There are two technical factors that are in play here.  First, PSD has a lot of retail shareholders and they were looking for a dividend to start.  They didn't get one, they got an acquisition instead - this was considered a disappointment.  Second, the Divestco shareholders who received PSD shares in the transaction have been dumping the stock - a few are holding, but the majority of the 14.3mm shares issued to Divestco shareholders (about 21.2% of pro forma shares outstanding) have been coming onto the market.  PSD insiders and new institutional shareholders (including the author) have been buying into this selling and my best guess is that we are a little more than half way through the selling pressure.

Financial Discussion

When you look at PSDs financials, you will notice two categories of revenue: Data Library sales and Participation Surveys.  Until now, I have only discussed Data Library sales.  Participation Surveys refer to the activity of shooting new data sets as commissioned by E&P companies.  Participation surveys are highly capital intensive, but the E&P will typically fund 75% of the total cost.  The economics are as follows (using the example of a $1mm participation survey):  the E&P commissioning the project puts up $750,000, PSD puts up $250,000.  The E&P gets a short exclusive period to use the data, after which the newly created data becomes part of PSDs data set and is free to license it out at will.  The accounting for this simple transaction is a little odd - the entire $1mm is booked as CapEx and the $750k is booked as "participation survey revenue".  Though this is the accepted accounting, the industry (and I agree completely) typically will adjust the reported financials to remove participation survey revenue from the revenue line and simply look at this transaction as spending $250k in growth CapEx in order to expand the data set.  The key financial metric to focus on is "Cash EBITDA" which represents EBITDA after removing the revenue from participation surveys.  The important thing to note about participation surveys however, is that the Company is never under any obligation to do them in order to maintain its market position or support its business - the Company will typically pick and choose which participation surveys to engage in and views it purely as an investment - and believes it is typically an excellent use of capital over time.  The Company could very easily just milk its data library for the next 50 years without ever investing any capital in participation surveys.

Once you make this adjustment in the financial statements, the financial model is a very simple one for PSD - the only real variable is Data Library Sales as operating expenses will be relatively constant and the Company will not be a cash taxpayer for many years to come.  The sensitivity is illustrated below (in a very simplified form):

Historical data library sales for PSD and Divestco are as follows:

Isn't this Massively Leveraged to Natural Gas which will never go over $5?

Yes and no, but mostly no.  For the most part, I think this psychology presents a big opportunity for investors because it is flawed.  While it is true that PSDs seismic data is much more weighted towards natural gas than oil, a closer look reveals that there is significant activity occurring in Alberta that points to growth for PSD from current levels. 

The best leading indicator of demand for seismic data is the level of land sales in the areas where you own data - this is intuitive, as land sales typically lead to E&P activity, which requires seismic data.  Land sales in Alberta are currently running at an all time high, reaching $2.4 billion in 2010 compared to the previous high of $1.83 billion in 2005 (and 3x the levels that were generated in the years between 2007-2009, when land sales were around $800mm per year).  How could this possibly be given low natural gas prices?  The answer lies in the revised royalty framework announced by the government of Alberta in May 2010 and set to go into effect in January 2011.  The prior royalty framework had put E&P activity in Alberta at a severe disadvantage to neighboring provinces Saskatchewan and British Columbia.  The prior royalty framework, implemented in 2007, had led to an exodus of oil and gas companies from Alberta while money was flowing into Saskatchewan and British Columbia.  The Alberta government initiated a review of the royalty structure in 2009 and in 2010 reformed the royalty structure to be more competitive with neighboring provinces.  Since the new royalty structure was announced, money has poured back into Alberta and 2010 was a record year for land sales - I have heard industry insiders describe 2010 Alberta land sales as "frenzied".  Also noteworthy is that pricing of seismic data does not fluctuate with commodity prices; drilling activity may fluctuate and demand may fluctuate, but prices are held constant (or have actually increased for 3D data).  This is because there is no competing source of seismic data - there may be an oversupply of rigs which causes day rates to plummet, but you have only one source for your seismic which allows PSD to hold prices while industry conditions are challenging.

Thus, the simple correlation between PSD stock price and natural gas prices I believe is dramatically flawed.  To the contrary, you have record land sales that will undoubtedly lead to E&P activity and demand for seismic data. 

Here are a few news articles which describe the royalty changes as well as the record land sales.

http://www.calgaryherald.com/columnists/Tertzakian+Alberta+makes+stunning+reversal+fortune/3621379/story.html

http://www.cbc.ca/money/story/2010/12/16/alberta-land-sales-record.html

http://www.cbc.ca/canada/edmonton/story/2010/03/11/alberta-royalty-changes.html

http://www.660news.com/news/local/article/157976--record-oil-and-gas-land-sales-in-alberta

http://www.albertasurfacerights.com/articles/?id=462

Competition

Pro Forma for the acquisition of Divestco, there are only a few players remaining in the industry, and it is really dominated by PSD and Olympic. 

Through industry due diligence I consistently got very positive feedback with respect to the quality of PSDs data set and the quality of the organization as compared to competitors.  One person I spoke with, who was senior management (I will not reveal his name here) at one of the seismic companies listed below went as far as to say "Pulse is by far the best seismic data Company in Canada" and even though Olympic has more data as measured in kilometers, the higher quality of PSDs data set means that their data is more valuable.  PSD acquired a significant amount of their 2D data from Chevron and Shell, and the quality of this data is known to be extremely high.  A differentiator between PSDs data set as compared to Olympic's data set (which was acquired from Amoco - now BP) is that PSDs data includes detailed data on each drilling zone (at different depths), which has become quite important as drilling technology and horizontal techniques have emerged. 

Another important differentiator for PSDs data as compared to Olympic is that the drilling landscape is more fractured in PSDs regions as compared to Olympic.  Horn River is an attractive area and there is huge potential, but it is controlled by a relatively small group of oil and gas companies - which makes revenue generation in the area more focused on a smaller group of customers.  PSDs areas are far more fractured in terms of the number of operators (especially in the Montney/Cutbank Ridge) which allows PSD to diversify its revenue base and generate results with a larger number of smaller transactions.

Aside from Pulse and Olympic, the other players are quite small and have no plans or way to increase their scale.  VGS Seismic was acquired in 2009 by a hedge fund creditor (Plainfield) and is in runoff mode - monetizing their library but not acquiring data or doing participation surveys.  Scale is meaningful as it allows an operator to package data sets together in a way that is attractive to customers - you can offer 2D and 3D data together, and have the ability to provide a more comprehensive offering to serve customers.  In participation surveys, the scale advantage is more meaningful because you can package together surrounding data library sets along with the participation surveys.

Given the current landscape of players, with respect to participation surveys in particular, oil and gas companies really only have two choices and if they are shooting in the Montney, they are much more likely to pick PSD and if they are shooting in Horn River, to pick Olympic.  PSD is in a very good place to pick and choose only those participation surveys with the best economics and highest return potential.  Taking Divestco out of the market was really important in that sense because they were far less disciplined with respect to terms on participation surveys (a key reason for their demise).  PSD is extremely disciplined with respect to taking on participation surveys and I expect those that they take on in the next few years to produce excellent returns on capital.

Catalysts/Investment Highlights

1)  Free cash flow generation, debt paydown and dividend.  At $28mm of projected free cash flow in 2011 (based on a conservative case), the free cash flow yield is about 25% which I think is an absurd valuation for this business.  I have been through this many times with management and they are completely committed to a dividend once they pay down some of the debt they took on to buy Divestco.  Pro forma for the Divestco deal on 9/30, net debt was $55mm and I think net debt is already down to $45mm.  Given the free cash flow dynamics, the debt balance is going to evaporate extremely quickly.  I think a small recurring dividend will be announced in the next 12 months (possibly sooner than that), and in the next 18 months I could see an annual dividend of $.20 (which would still be a relatively small portion of free cash flow) for a dividend yield well in excess of 10%.  The good news is management and the board are shareholder friendly and totally committed to a dividend.  Canadian investors are very dividend focused and I think this is the key to liquidity in the stock and market appreciation - management gets this and they want to see a higher stock price as well so that they don't attract takeover interest at a low price.

2)  Transfer fees related to Encana/KoGas and Encana/CNP JVs.  The way data license agreements are written, when a licensee gets acquired or does a JV, a license transfer fee is triggered.  These transfer fees are typically about half of the original license amount, and in certain cases can be quite substantial.  Earlier this year, the Encana announced a joint venture with Korea Gas Corp (KoGas) to drill in the Montney and Horn River fields.  Encana owes PSD a transfer fee in connection with this transaction that I believe will be in the $5-10mm range and will be collected in the next 6 months.  This payment is related to Divestco data and I have confirmed with management that it has yet to be collected and PSD will receive the fee.

In addition to the KoGas JV, EnCana has announced but not signed a JV with China National Petroleum Corporation (CNP) on 6/24/2010.  This JV has yet to be signed, but management and industry professionals expect that it will be completed given the signals coming out of EnCana.  This is an enormous potential windfall for PSD.  It is uncertain the size of the JV, the timing of CNPs investments in the JV, and the exact areas that will be applicable, but management is giddy about the potential windfall related to this transaction.  Based on management conversations with people from Arcis, VGA and the former CEO of PSD, it sounds like the windfall here could be between $20mm and $40mm.  I'm not counting on this transaction as part of 2011 projected cash flow or in any other aspect of my valuation; it is purely incremental.  The timing, certainty of close and size of the transaction all remain unknown at this point, but the indications are positive and it is a nice wildcard.  See below for a few articles and press releases regarding each of these transactions:

http://www.encana.com/news/topics/kogas/

http://www.petroleumnews.com/pntruncate/248230748.shtml

http://encana.com/news/newsreleases/2010/0624-china-national-petroleum-corporation.html

3) Takeover Potential.  PSD has been subject to repeated takeover offers from strategic acquirers (Seitel in 2005) and has received substantial private equity interest as well.  In late 2006 a private equity firm offered $3.10 per share for PSD and in 2007 ValueAct offered $3.30 for PSD.  ValueAct continues to be the largest shareholder of PSD and has no interest in selling their position.  Each of these offers was turned down by the Company and I will point out that I believe value has been substantially enhanced since 2007 by virtue of the Divestco acquisition and the improving climate for E&P activity in Alberta.  While it may be viewed as a negative that management continually turns down takeover proposals, the fact that the interest is consistently there is a strong indicator of the underlying investment value.

In addition, I know that the Company remains a target today for private equity - the former CEO Ken McDonald teamed up with private equity firm GTCR to look at acquiring assets in the industry and has been interested in both PSD and Divestco (and likely made an offer to buy PSD, though I can't confirm it).  Though this partnership recently wound down after PSD acquired Divestco, I believe the interest is still there to the extent there is a deal to be made.

4) Record Land Sales.  As noted above, record land sales will certainly lead to increased drilling activity and seismic data purchases - I have little doubt about the correlation here.  I believe that land sales will prove to be a much more important indicator of seismic data sales than natural gas prices.

5) EnCana land reversion to the crown.  In Canada, land leases revert back to the government every 5 years.  A large chunk of the land underlying the Divestco data set is currently leased by EnCana and is set to revert to the crown in the next year.  Land reversion to the crown and subsequent resale to a different party will support robust data library sales related to the acquired Divestco data set in the next 2 years.

6) Insider buying activity.  There has been significant insider interest in PSD since the closing of the Divestco transaction.  It's always nice to see a situation where uninformed shareholders are exiting a stock and insiders are buying.  In particular, director Robert Robotti has purchased about 1 million shares in the open market (the largest chunk at 1.54 on 11/11.  Chairman Graham Weir has also been buying stock as recently as early January (at $1.70), and COO Brent Gale also bought stock in recent months. 

7) Rule change on rights reversion / well depth.  There is potential in the next few years for a regulatory change that will significantly benefit the seismic data industry.  Under current rules, drillers have rights to all producing zones both above and below the well depths where they have drilled.  Under proposed rules, the untapped zones at different depths will be opened up to new operators which would be a big opportunity as the new operator would require seismic data in order to drill in the new zones.  This is a less certain catalyst than those listed above, but I thought Id mention it as it could be another nice incremental opportunity.

Conclusion

PSD trades at an equity market capitalization of $117mm and has about $45mm of net debt.  The Company is likely to generate about $30mm of free cash flow, based on LTM depressed market conditions, and it is likely that cash flow ends up being significantly higher.  Insiders are buying the stock and uninformed shareholders are selling.  There are numerous clear catalysts and the best leading indicator (land sales) suggests results will get better from here.  The Company has repeatedly been an acquisition target.  Management is shareholder friendly, completed a home run acquisition, and plans to implement a dividend in the next 12 months.  Investors are obsessed with natural gas prices, but the direct connection between gas prices and PSD cash flow is questionable.

Given the cash flow dynamics and catalysts listed above, I think the downside protection at these levels is clear.  On the upside, I think the base and upside scenarios of levered free cash flow being between $.66 and $.82 per share are realistic in the next 2 years.  Given the strategic value of seismic data in the oil and gas industry and the level of investment in Western Canada, I will leave it up to readers to determine the right multiple that could plausibly be placed on that cash flow stream, but I see no reason that there isn't $5 or more of value here.  This may seem like an absurd/promotional assertion vs. the current $1.75 quote, but I think it holds up and amongst the major shareholders of the Company I don't seem to be alone in that line of thought.  Please let me know if you have any questions, I look forward to your thoughts/dialogue.