Description

Veritas DGC is a beaten up stock in the beaten up seismic data industry. It’s a cycle play, and what makes it attractive is that it’s cheap (0.67x book and <9x normalized earnings), it’s got a decent balance sheet, it generates free cash, and there are signs that the industry might be emerging from its multi-year depression. Plus, it’s in a consolidating industry, and is a potential acquisition candidate.

Veritas, not to be mistaken for the storage software company, is a “geophysical services” company. Basically, they acquire, analyze, and package seismic 2D and 3D data of underground formations, and sell them to oil and gas companies that use the data to decide where and how to drill for hydrocarbons. Veritas has 19 survey crews (13 land and 6 sea) that run around and collect the data, and about a dozen data processing centers that, uhh, process the data into useful formats.

Revenues in the latest fiscal year (ended July) were $503 million and EPS was $0.08 if you exclude a big goodwill impairment charge (but include some other charges which I consider to be part of the business). Just over half of revenues are in North America, about a fifth are in Latin America, and the rest are spread out around the world. It’s not the most glamorous or high return on capital business in the world, but over the cycle, returns can be OK. VTS’s return on equity peaked in 1998 at 26%, with not much leverage. The cycle is brutal, of course, as any industry dependent on oil and gas exploration spending would be. VTS’s earnings record is more stomach-churning than a bungee jump -- $0.53 in FY96, $2.90 in FY98, $0.27 in FY00, $1.01 in FY02, and break-even in the quarter just ended.

What’s causing the current downturn? Their customers have consolidated, leading to reduced seismic spending, and many E&P firms have focused more on increasing productivity of existing wells rather than exploring for new ones. A big part of the reason for this is needed financial discipline (customers are focused on paying down debt), but some of it also has been caution regarding whether the recent high oil and gas prices can be sustained. The key for VTS is that seismic spending can’t be put off forever – it can only be delayed for a few years at most. Oil and gas companies have to start increasing reserves again, since that is their raison d’etre after all, and to do that, they need the services of a VTS (or other seismic company) to decide where to look for the oil/gas deposits. Seismic spending is so low right now that I don’t think oil and gas prices have to stay high for VTS to benefit. When spending returns, VTS should be a big beneficiary, as capacity has been taken out of the market over the past decade, and earnings leverage is pretty big.

Let me flesh out why I think the shares are cheap, why I think the turn is not so far away.

Cheap. First, there’s book value. VTS at a $9.24 share price has a market cap of $310 million and an estimated book of $465 million, or $13.80 per share (estimated, because their October 10-Q hasn’t been filed yet). So the stated price/book is 0.67x. It’s not quite a hard book because although there’s no goodwill, there’s a $370 million intangible asset called a “multi-client” library. This is basically the capitalized underground map library that VTS builds and owns, and from which data is sold to its customers. It’s amortized, of course, but there’s always the question about the valuation of this asset, especially during a brutal downturn like the current one. Veritas takes periodic write-downs of this library, and I wouldn’t want to hazard a guess as to what this library might really be worth, but given that there is a cushion of $155 million between the market cap and the current book value, I’m willing to believe that the economic value of the book remains comfortably above the market cap. Second, there’s earning power. VTS in its two previous peaks earned $1/share in FY02 and almost $3/share in FY98. There’s absolutely no reason why VTS can’t get back to at least a $1/share in earnings if customers just get back to normalized levels of spending. And if high oil/gas prices are sustained and a real bull market in the exploration and drilling industry ever emerges (rather than just a recovery), I don’t think $2/share is asking for much – that would be still only be a 15% ROE. All in all, I don’t see how this $9 stock isn’t worth at least few bucks more, with a good chance that this could easily be a $20-30 stock. This stock isn’t the easiest thing to value, since there are no good comps, and it’s highly cyclical. But giving it a P/E multiple of 12-15x that $1-2/share of normalized EPS sounds more than reasonable. The stock peaked at $60 in 1998, when it earned $3, and at $40 in 2001, when it earned $1/share. The book value of $13.8/share is just a downside estimate of value.

The turn. The signs are spotty, but VTS mentioned in its latest conference call that activity is picking up, and that for the first time in two years, customers are releasing some money for end-of-year spending. I’ve spoken to a whole bunch of E&P firms and majors, and just about every single one is telling me that they are increasing their budgets for exploration spending by a good amount next year. There seems to be quite a bit of pent-up demand. That can change in a heartbeat, so I wouldn’t bank too much on an upturn in the next quarter or anything, but I would be surprised if an upturn didn’t happen within the next 4-6 quarters. While it’s a tough thing to predict, the earnings leverage for VTS should be good. Pricing pressure is severe right now, but capacity will be tight when an upturn occurs. The long view certainly gives a favorable impression. Industry land crews in the early 1990s easily numbered over a thousand. I’d be surprised if there are more than 90 today. Marine crews number around 50, but I doubt if more than two-third of those can do 3D, which is the more advanced and preferred seismic technology (over 2D) these days. So with VTS owning six of the 33 or so 3D marine crews worldwide, for example, there’s really no way that VTS can’t benefit along with an industry upturn.

VTS has the wherewithal to survive if a turn doesn’t come as soon as I anticipate. As of July, it had $73 million in cash and $194 million in debt. By cutting back on capital spending, they generated $18 million in free cash in the year ended July. They won’t be able to restrain capital spending forever, but it’s variable along with revenues to some extent, and Veritas should be able to keep it in check for a couple more years easily if revenues don’t pick up. Management plans on keeping capex to a level where they can throw off free cash this year again also. Debt pay down and maintenance of a strong balance sheet is a priority to VTS.

An interesting potential catalyst is that VTS is an attractive takeover candidate. The industry has been consolidating for a number of years, and two recent bankruptcies of major competitors (Seitel and PGS – both done in by excessive debt) have made it clear to industry players that more is needed. And what makes VTS intriguing is that it is looking for a CEO, as the current one, David Robson, is stepping down for health reasons. I wouldn’t count on a takeover, but it wouldn’t surprise me at all.

Catalyst

Industry upturn
Potential takeout
Valuation