Description:

Wellstream is an Oil & Gas Equipment & Services Company acting as a niche market manufacturer supplying products to a broad range of offshore developments

worldwide. Among its main products are flexible pipes: risers and flow lines. In 2003 the company was acquired by Candover Investment Partners and a Management

buy-in group.  Since then, the company has installed a new site in Brazil, consolidating its solid position in the subsea equipment market. 

WSM stock is down ~60% from its highs in may 2008 alongside the huge correction in oil prices. However, we believe the company is in the sweet spot of a long-lasting

trend in deepwater and ultra deepwater spending. Recently, 2/3 of all oil discoveries have come from deep water, and development costs have risen significantly. 

There are significant challenges to develop a deep water field, such as pressure resistance, corrosion, security. Until now, only two companies have been able to produce 

flexible tubes capable of working at water depths higher than 2 km: Wellstream and Technip.

West Africa, Australia and Brazil are the main markets for offshore development, and Brazilian State Oil Company (PBR) is expected to spend above USD 20 billion

a year for the next 10 years to develop its pre-salt portfolio. All studies suggest that demand for flexibles will rise in the coming years. Besides the recent drop in oil

prices, having access to offshore fields is crucial for IOC's, as their fields' production is declining year after year. Non-Opec fields' production is declining 8% a year.

Wellstream operates two offshore pipelines facilities, one in Newcastle, UK and one in Niterói, 20 km from Rio de Janeiro, Brazil. 

The English site produces 300 nkm (normalized km) of pipes per year, while the Brazilian produces 270, after the recent capacity expansion.  

Earnings growth should come from the demand expected from the above mentioned new offshore fields, as well as from pricing due to supply constraint.

Considering all tests, a new producer would take at least 4 years to be authorized as a provider of flexible to a major company, creating important barriers to entry.

Competition

When we first started this study, barriers of entry were one of our top concerns. After all, with a £ 40 MM investment, the company was able to double its capacity.

The Incremental ROIC was then north of 100%. Although some expertise and know how was needed, technology also didn't seem to be too hard to copy. 

Why then only 2 companies in the world are doing those tubes today?

The main reason is that, before an Oil Company is willing to buy a flexible tube, the product as well as the supplier must be accredited and the process includes

a long battery of tests that take about 3 years to end.

Because these tubes are crucial for the security of exploration and development of fields and represent a tiny parcel of total expenditure, IOC's and NOC's didn't

bother to squeeze suppliers' margins in times of escalating oil prices.

Valuation

My base case estimates a fair stock price of GBp 7.2, for a 51% return considering today's price of GBP 4.79.  
   
   
                     2007   2008   2009   2010   2011   2012
Revenue              267    360    398    409    488    489
Ebit                  45     80     82     85    103    103
Net Income            32   57.4   58.1     60   72.4   72.5
Diluted EPS         0.32   0.57   0.58   0.59   0.72   0.72
FCF / Share         0.14   0.21   0.33   0.59   0.60   0.72
PE Ratio             8.4    8.3    8.2    8.2    5.2    5.2
FCF Yield           3.1%   4.8%   7.5%  13.3%  13.5%  16.2% 
PT ROIC              35%    48%    66%    64%   

Wellstream will become a positive free cash flow company in 2008, and it has firm commitments from major oil companies (especially PBR) that guarantees

the next 3 years of operations with more than 50% of capacity utilized.

In 3Q 2008, PBR has reached an agreement with Wellstream where it is supposed to order, in the next 3 years, a bit more than GBP 600 MM. Part of this 

order is already in the backlog, while part isn't. The fact is that this contract alone is responsible for filling about a third of WSM capacity for the next 3 years.  

This valuation doesn't consider any growth and considers: 

•1)           Prices declining for the next 3 years (-5%, nominal), and recovering slowly after 2011, on a GBP basis.

•2)           Gross margins decreasing from 35%, achieved in the first 3Q of 2008 to 32% from 2009 on;

•3)           Slightly increase in total tax rate, because expansion is taking place in Brazil, where corporate tax is higher than in Europe

•4)           15% WACC and 2.5% growth in perpetuity, to better fit today's difficult environment

Free calls for 2009 would be:

•1)           Currency gains due to Brazilian Real devaluation, as the share of costs in Real are higher than the share of revenues

•2)           The time lag between a contract being signed and raw material being ordered is about 6 months. 

The company was able to close contracts for 2009 when market was still tight and prices high and soon after commodity prices (especially metals) collapsed;

Due to a conservative approach, we also didn't consider any of those in our model.  

Growth

In the valuation above, growth is really a bonus for Wellstream. All Base case projections do not consider any capacity expansion, even though it is highly

likely if oil prices stop free-falling and the world economy goes back on track.

All the growth is expected to come from the discovery and development of new fields. As said, IOC's are losing their reserves at greater speed than they 

are able to replace them.Because most major oil discoveries have been made on offshore fields, there is few doubt that efforts will be directed to drill them. 

In this case, flexible tubes demand rises because there will be more exploration and production activity.

Brazilian Pre-salt fields alone are believed to store around 50 billion boe and government has already signaled that its development is a matter of national

 strategy, rather than economical circumstance. On January 23 Brazilian National Development Bank announced that it will have extra 100 billion BRL to finance

Brazilian industry, especially Oil and Gas Sector and Infrastructure. It was an obvious step to finance the development of the pre-salt fields. 

That said, it is expected that PBR accelerates the development of these fields be oil at 30 USD or at 100 USD.  

At this point, it is worth saying that:

•1)                WSM was awarded a contract to provide tubes for the pilot test in TUPI, at Santos Basin. Although not a big contract (around 10 mm GBP), 

it is a sign that they are working together.

•2)                The 600 MM GBP contract does not include any pre-salt field. It only considers the current portfolio of PBR. 

If we put the pre-salt in the equation, it is hard to estimate precisely the demand increase that would arise. Our best guess is that the pre-salt demand equals

40-70% of total industry capacity, but that could go much further. Considering 40% increment in the industry capacity and that Wellstream will keep its market share,

its DCF would imply a GBp 900 stock price, keeping our estimates of price and margins unchanged.      

Financing Position

The company has a very solid financial position, way below 1x net debt/ebitda, and most of its clients are NOC's and IOC's with solid financial position, 

which makes it unlikely that contracts are broken. Recently there has been a delay in an Australian project, but nothing substantial.

Company has a conservative FX management and the biggest contracts have really tied clauses to avoid inflation, currency and other "predictable" risks.

Management

Management is experienced.  Actually, the senior management is composed by senior officers with decades of experience in the sector. 

The company has been created from a LBO, and operational track record has been very good.

However, they still haven't faced the situation of having cash on hand, so their track record for deploying capital is unknown. Acquisitions don't look likely.

 An important part of employees compensation is stock based, bringing them aligned to companies' long term goals. As of Jan 20, Senior Management

had 13% of the company.

Risks

Being an oilfield service company, oil price is certainly a risk for Wellstream. Although most of the oil from deepwater oilfields is only coming on stream

a couple of years from now, current prices influence Oil Companies will and capacity of investing capital. The current scarcity of credit also doesn't help. 

Long term oil price above 50 USD is also needed to make projects undoubtedly viable economically.  Another risk is competition, as discussed above. 

Because Wellstream is the only pure play in the sector a new major competitor would be devastating. 

They would be less prepared for a war price due to their size and inability to finance one division at the expense of another.

Conclusion

In an environment where the world is growing again, and so is oil demand, the challenge of declining production in major oilfields such as Cantarell, Samotlor,

Ahwaz and Greater Burgan among others will have to be faced. From oil reserves known today, the most promising are those found offshore, in (ultra)deepwater

oil fields. Even though the timeframe for this thesis to play out is unknown, it is hard to argue that it won't happen at all. Recently company announced that they 

expect 2009 to be similar to 2008, showing good resilience and confirming that visibility is good across the chain. 

For those willing to afford volatility in the short term, the case seems compelling.