Thesis
TGS-NOPEC Geophysical ("TGS") is an asset-lite provider of multi-client seismic data to exploration and production ("E&P") companies in the oil & gas industry. The company's main offices are in Houston, Texas & Asker, Norway. The company trades on the Oslo Stock Exchange. I will use USD figures throughout this writeup. Stock price $12.00 (75.10 NOK), 105m FDS, $1.25b EV, $300m net cash ($3/share), $942b EV.
TGS's stock price has taken a hit from $21 to $12 as since the start of the BP oil spill, which results in a $900m hit to EV. This implies that exploration will cease long-term in the Gulf of Mexico and that TGS will be unable to substitute this activity with sales in other regions. TGS is a well-run business that earns high returns on capital, due mainly to execution and business model rather than a definable structural advantage. The company has a great balance sheet, minimal fixed costs, no potential liabilities resulting from the BP accident, and it trades at 5x the average EBIT over the past 5 years, 4x EBIT on 2010 numbers, 8x EPS, and 6x EPS ex-cash. I think that TGS will emerge from the current environment with its business model intact and that owning it is a reasonably conservative way to benefit from the uncertainty regarding the long-term negative impacts of the BP accident.
Business Description
In the Seismic industry, companies like TGS collect raw data and provide analyzed results to E&P companies that are useful in finding oil. E&P customers use the data as part of the screening process to selecti drilling locations. Initial screens are low quality and non-exclusive, low cost & time. Final screens are exclusive and of higher value, but time & cost intensive. A typical due diligence will be first a 2D seismic non-exclusive (~$1,500 per sq mile), second a 3D seismic non-exclusive (~ $15,000 per sq mile), and finally a 3D exclusive (~4 to 7x the cost of a non-exclusive). The larger the ultimate outlay, the easier it is to justify multiple screens. A Gulf deepwater rig can be up to a $300m investment before production starts - the screening cost is ~ 4% of the total outlay.
Seismic companies offer to shoot exclusive or non-exclusive. Exclusive shoot costs are fully covered by the buyer and are priced via tender, and the seismic company gives over all data rights to the buyer. In contrast, a non-exclusive shoot is partially pre-funded by several customers and the results are shared, and the seismic company retains the data rights in its collected library. The library data has a long life in terms its predictive value (the geology changes slowly), however its economic life is short due to competition in the E&P industry. When new data becomes available, everyone who is interested generally purchases within the first few years. Sales related to old vintages do occur (also because new techniques are developed for analyzing historically gathered raw data), but this is less common.
Seismic companies used to have a preference for non-exclusive because the potential profitability is higher. However, the industry also generally has had a high fixed cost base in due to fleet ownership. This mixed badly with greater than expected lumpiness in non-exclusive sales and sent several players into restructuring in 2002 / 2003 (See Petroleum Geo Services writeup from 2003). Since then, the pendulum has swung the other way, with companies focusing primarily on covering fixed costs via tendered exclusive contracts and putting excess ship capacity to work in any shoot they found half decent, all at the expense of return on capital. This has been a boon to TGS's business, because it focuses on non-exclusive shoots and leases its ships on short-term contracts (4 months to 2 years). This model leaves the company open to risk of tight capacity from ship providers, which limits the attractiveness of the business, however ship supply is expected to increase nearly 40% from 2009 through 2011 to 58 units, of which TGS uses 7.
Impact of BP Accident
Looking at the Gulf of Mexico, the region provides ~45% of TGS sales. The region provides for just 2.5% of world production and 25% of total US oil production. The large risk to TGS in the is that there is dramatically decreased long-term drilling in the Gulf of Mexico. I think that is unlikely, given the multiple political factors involved, and even so, oil companies would continue offshore exploration elsewhere. ~50% of TGS sales are deepwater-related, so decreased worldwide deepwater exploration would be an issue. Deepwater drilling has only been around for ~10 years, is rapidly growing, and accounts for less than 10% of world oil production, although it is a very large piece of the marginal supply increase.
In the short-term, the newsflow catalyst is a sale of future drilling right in the Gulf of Mexico scheduled for March 2011, which will be pre-auctioned in November 2010. E&P companies will buy seismic data, which would be 35% of 2010 2nd half sales at TGS. If this is postponed, it would have an impact on TGS's financials in the short-term.
TGS management has come out twice re-stating FY 2010 guidance of $560-600m revenue, which implies EBIT in the mid-$200m range and net income in the mid-high $100m range. Recently, they stated that some customers have delayed purchase decisions. I think there is a very good chance that guidance is lowered at some point, however I think it is more due to uncertainty at buyers than long term demand changes in the business, and I think it is more than reflected in the current stock price.
Management
The company founder and retired chairman, David Worthington, owns 2% of shares and votes, the ex-CEO and current chairman Hank Hamilton owns 2%, and the current CEO Robert Hobbs owns shares and options of just 0.1% but still has a valuation of USD 1.3m.
TGS has paid out $65m in dividends this year and is the middle of a $30m share repurchase.
Valuation
TGS has a $1.25b market cap, $308m net cash, and a $942 EV. I believe the company will earn $220m EBIT this year, which comes out to $156m net income and $1.50 EPS, and that EBIT is likely to grow going ahead. The company will end the year with almost $400m net cash (ex-dividends) and is price at FYE book value of 1.3x, compared to historical price of ~2-4x book value.
Risks
TGS capitalizes the cost of its seismic shoots and amortizes them over their useful life (4-5 years) with most amortization in years 1 & 2. This makes EBIT more of an estimate than many other businesses. In its favor, TGS consistently reports sales attributable to library vintages that have been fully written off. From another angle but making the same point, management gives their expectation of future revenues by vintage, which can be compared to actual reported revenues as time goes on - looking historically, I have found management to be conservative.
I have mentioned the broad Gulf of Mexico and deepwater risks. There are other variations with higher probabilities but lower impacts. BP's Gulf of Mexico operation probably accounts for 10% of sales, which could be lopped off. Additionally, if small players are restricted from deepwater because they can't cover costs of a possible accident, which could impact sales by 20% in the region.
As mentioned above, there is a "pre-auction" schedule for November 2010 that relates to E&P companies getting leases in March 2011. I believe this accounts for 35% of H2 sales at TGS; if it is postponed TGS will significantly lower guidance and sentiment would remain bad /worsen. I see this scenario as unlikely given the previously discussed stats, even if regulation is increased, investment in offshore oil production will continue give current oil prices.