Description

SUMMARY
I believe PGS is in the early stages of a mid-year cyclical upturn and trades at <8x my 05 FCF estimate. The seismic industry has transitioned from horrible to sound yet most investors still hold a past bias. This bias is beginning to lift and will continue as significant earnings leverage is generated. Moreover, PGS is under-followed (only one US firm) and management is taking action to realize value. The current share price is supported by trough type hard asset liquidation value; however, it deserves a meaningfully going concern value. This could be reached in the next 12 to 24 months given improving industry trends and corporate actions.

BACKGROUND
PGS emerged from bankruptcy 11/03. Some basic background on the 3 business lines:

1) Seismic: This business primarily consists of boats that are specially equipped to map the sea floor to determine where hydrocarbons are likely to be found. It is a critical input to the E&P process. E&P companies rely on seismic data to drill in the right place and improve their ROI. PGS has 10 vessels, 9 of which are considered “high-end”. There are roughly 33 high-end vessels in the industry in total (some would say slightly more or less than 33). In terms of total acreage shot in last 12 months, the top 4 players were (approx) PGS (33% share), SLB - Western Geco (32%), CGG (12%) and VTS (11%). PGS has one of the newer and more stream-lined fleets and therefore is a lower cost operation. It would take roughly 2 years and $75m to build a good 3d vessel (i.e. high end). In Q3 PGS earned a 20% EBIT margin in this business and it would take a 50% margin for a number of quarters, by our calculation, for any rational competitor to begin to even consider new supply (we think they will actually lag rationality due to the poor history and new management teams in the industry – but this needs to be watched closely). Seismic had been a terrible business for years because there was over supply and companies would shoot seismic on spec (multi-client) in hopes they would be able to sell it later (and “show” earnings growth), which further compounded the oversupply situation. After a meaningful amount of the industry going through bankruptcy due to this practice, the business model and industry structure has changed. Very little seismic is shot on speculation (down from over 50% of total seismic activity to less than 15%) and the number of players has been significantly reduced (essentially 4 players). Wall Street thinking has not shifted along with the reality and they continue to (erroneously) consider this a horrible business, which is part of why there is an opportunity to buy these companies below their intrinsic value. Lastly, PGS management has stated publicly they are very open to consolidation. #3 player CGG has already offered to merge with PGS but at unreasonable terms that were rightfully rejected. If consolidation does happen it would reduce the number of players from 4 to 3. At a minimum, capacity could be taken out and pricing would increase even more than I’m expected. Moreover, a reduction to 3 main players could further reduce the trough pricing we’ve seen in the past and transform the industry. The thesis does not rely on consolidation but it would be a big plus. Separately, there is also an onshore seismic business but is small in relation to the overall biz.

2) Floating Production: Four large vessels which are used to store and process oil in areas where there is no pipeline available to service the offshore oil well. PGS specializes in the North Sea and has combined oil production capacity of 339K bbl/d. Contracts tend to be long-term and range in expiry from 2008 to 2014. This is a much more stable business than seismic and therefore has much lower risks as well as upside. The fleet is solid and PGS has a strong position in the harsh environment boats. Moreover, there is room for additional exploration wells and production outsourcing in its geography. The company has said specifically there is no synergy between this and the other businesses and they would spin it off or sell it if it was the right thing to do for longer-term shareholder value.

3) E&P Business: I won’t go into much detail here because it is the smallest part of the business and the company is currently taking bids to either sell part of it or all of it. Essentially, the company has been successful in obtaining leases from Norway and the Pertra field has been particularly prolific. It is a solid little asset and I discuss the valuation below.

VALUATION DISCUSSION
From a downside valuation, I use the following as a quick and dirty calculation, which calculates to $67 versus today’s value of $66.71. However, as the cycle turns and the company takes steps to realize shareholder value, the upside case is 50% or greater. To get seismic margins from 20% to 50% could translate into another $100m in fcf and I think the multiple would also expand. On my estimates, PGS could generate > $200m in fcf in 05 (i.e. 7x). Last quarter alone the company generated $80m in FCF although it was seasonally strong and some WC sources. In sum, I think you are protected at today’s value and the upside could be significant (you can pick your own upside scenario => one can get dramatic #’s).

• Seismic: CGG recently offered $900m for PGS’s seismic business. This was inadequate and rightfully rejected by PGS because it represents a trough asset value (and 9x my 05 seismic FCF estimate). This is where the primary upside resides; however, let’s use this for our downside case.

• FPSO: Replacement value of $2b but let’s cut by 50% to get to roughly $1.1b (11x fcf), again as a downside scenario.

• E&P: Let’s assign a 5.5x multiple and we get $150m as a floor valuation.

• NOL: PV is $125m (2/3 Norway and 1/3 UK).

• Debt of $1,064m

• Using total shares o/s of 20m translates into $67 for trough liquidation value. You pick your upside scenario.



OTHER
I think management and the board (particularly Chrmn) are conservative and good stewards of the business and capital. One negative is the chairman recently reduced his position from around 10% to 5% of the company. He is a very shrewd investor. I don’t consider this a major negative because it had become a very large portion of his overall net worth (we believe), and he has stated he won't sell the other half or leave the board.

In terms of issues that would make me change my view, one would be if I saw significant new supply announcements that would change my thesis.

The stock also trades in Norway under PGS NO on Bloomberg

Catalyst

Catalysts

• Seismic - Demand is rising and little meaningful supply is coming on-line. Pricing bottomed in 2004 and could continue to increase for a multi-year period due to the cost and time to bring on new supply of high performance boats. Our industry checks indicate that E&P customers are already scrambling to lock in supply for summer 05. In terms of the most recent data point, competitor VTS announced a problem with one of their four boats to due a fire on board, which further tightens capacity (see VTS company press release).

• FPSO – There is an opportunity to consolidate in the N. Sea and management has made it clear there is no synergy among the businesses and they would spin this off if it would create shareholder value. This market is fairly tight with no let up likely.

• E&P – A transaction (either JV or outright sale) could be announced shortly. Newspaper article today said the company received two bids consistent with their prices expectations.

• Other – recently listed on NYSE, completed their full audit, and will receive credit rating shortly.