Disclaimer:  We have a position in this name and may change our position without further notice.  It is also a very illiquid small cap.

Over the last 17+ years, Zedi has developed the leading solution for remote well metering for the Canadian oil & gas industry.  Traditionally, companies would have their gas wells produce gas directly into the pipeline system, but first get measured by a chart meter (think of the old utility meters on the side of your home).  Once a week or month, someone would go out to the well site and replace the chart and then take the written chart to be read.  The written chart allows the company to figure out its production, which in turn allows them to get paid for the gas and pay the appropriate royalties.  Sounds fairly backwards?  Well this is still very prevalent in Canada, but more importantly is standard practice in the US and the rest of the world.

Zedi developed a device called the Smart-Alek.  This device measures gas flow electronically that can transmit data real-time (or at least 3x daily) to the companies through Zedi’s systems.  It has developed a model similar to Blackberry (when Blackberry was in its prime) that has upfront payments for the equipment and a reoccurring revenue stream for the data link.  Despite being such a small company, the solution has penetrated 22.5% of all Canadian oil and gas well.   Its next biggest competitor is only a quarter of its size in the field (Critical Controls). 

As with this kind of technology, there are many add-ons Zedi’s system can do once the core is in place, such as production accounting and production optimization where one can control the values and pumps on these wells.  Most importantly, it allows companies to reduce downtime (real time info on wells that become problematic) and personnel to read the chart and service the well (Zedi’s systems are compliant with Canadian oil & gas auditing standards).  They are well penetrated with the Tier 2-4 companies in Canada, but Tier 1 companies are mixed as many of them have tried their own solution (not many of them can touch Zedi’s cost when it comes to running their own systems). 

Gross margins are fantastic, 30-50% for the upfront equipment and ~80% for the reoccurring revenue.  Once installed, generally users don’t take off these devices until the well dies.  There isn’t churn like the wireless industry and no term contracts.  It’s a win win for the customers as they get a lot of technology and save a lot of money getting more information (the upfront cost of the unit is less than 1% of the cost of the well, and in the case of these large Montney wells, even much less).

Zedi’s issue has been deploying this technology out faster.  Essentially no one would put this device on an existing well (costs money to rip out the old solution and the production rates generally don’t justify it on an old well), and with Canadian rig count down significantly since 2008, Zedi’s volumes have been down.  This has shown up in the numbers as revenues have come down since 2008 (and have only recently moved back to that level).  However the revenue component has changed significantly, before 2008, only 25% of the revenue was coming from the reoccurring revenue stream, today, its over half.  The fear in the market is that Zedi only deals with natural gas wells and natural gas is in the dumps.   This is partially true (natural gas is definitely in the dumps).  Zedi’s product measures flow on natural gas, however a lot of the oil wells being drilled in Canada are related to light oils which still throw off a stream of natural gas (50% of their incremental business are oil wells).  Additionally the device also works on electronic submersible pumps (ESPs) to communicate with home base.  The oil segment now composes ~50% of Zedi’s incremental business (3K oil wells already).  More importantly, 70% of those oil wells have advance products such as control systems which bring in incremental revenue.  Additionally, Canadian drilling is starting to approach levels it hasn’t seen since the 2008 time frame, as this liquids drilling phenomenon is starting to hit its stride in Canada.  And with the funkiness of the Canadian drilling season (no drilling during “Spring Breakup” due to the ground thawing), we haven’t seen a huge revenue boost until these wells start getting tied in.  Winter drilling is shaping up to be quite strong, so these next couple of quarters should be interesting.

With all the FCF the business spits off, Zedi has been aggressively spending money to complement the business (clean balance sheet and share count has been declining).  This has led to some interesting purchases to facilitate penetration and broaden the product offerings.  There are a couple of them I will highlight.  The first is buying the charting companies they are trying to replace.  Essentially, Zedi is trying to get in front of their customers and hopefully direct them to their solution in the future, but in the meantime, Zedi has a solution that electronically reads charts faster than the traditional process.  Earlier last year this manifested into Zedi purchasing the largest charting company in the US, Southern Flow.  The transaction was at a lower multiple than Zedi’s and done with cash on hand plus some revolving debt.  It put Zedi in 13 locations in the US, while getting Zedi a sales and marketing force for its products in the US.  The other transformative transaction was buying this technology called Silverjack.  Essentially its an oil pump for smaller flow rates oil wells, so it is a smaller solution than what Lufkin’s pumps do.  They didn’t pay a lot for it, but this potentially gets them another offering for the light oil market.  It remains to be seen how fast this product takes off (or doesn’t), but this could potentially be a game changer for Zedi (outside of the Smart-Alek product).

This clearly sounds great, right?  So what went wrong? 

1)   Bad 1Q11 – the core business didn’t grow and people questioned if the product is still relevant since gas is hurting.  Apparently there was an issue where one vendor (they have a partnership with a large oilfield service company to install the Smart-Alek on their ESP wells) transitioned the way they deployed their ESPs, which caused a lot of Zedi’s products to be deactivated.  The company claims this has reversed course, and this has shown up in the numbers, but with Spring Breakup, the numbers haven’t blown anyone away

2)   Declining gas prices since 2008

3)   Liquidity – extremely illiquid, many days it doesn’t trade.  One investor has over 17% of the shares

4)   Small market cap – sub $100MM doesn’t really hit most people’s radar.  Apparently once it is reaches that mark, brokers should start covering it

5)   Stock buybacks - FCF was being used to buy other companies when the stock price collapsed.  Though this might be the right course for the business long term, Zedi’s business was massively undervalued and management didn’t direct FCF to buying back stock until the 4^th quarter or so.  They have apparently now bought back over 0.5% of the stock

6)   Clarity - Management didn’t do conference calls in 2011 until the 3Q last year because it realized its competitors were listening on the calls.  They reversed course, but that didn’t help it build liquidity.  Additionally, the presentation and description for the company are not very informative.  It is hard to get a handle on what this company does or how it makes money.

7)   Canadian tax loss selling – the rules in Canada are different for tax losses (apparently you can carry losses back), this led to some rampant year end selling once the stock moved down with the market in August.  Not sure why illiquid names make sense to dump, but this one did

So what is Zedi worth?

Currently this $74MM market cap company is valued at an 11% FCF yield and 6.7x EBITDA based on trailing 4Q numbers.  The company has $10MM of net debt, but $20MM of net working capital.  If we assume a rate of growth that was achieved in the 3^rd quarter (which takes into account some major acquisitions), Zedi trades at 5.5x for 2011.  For a company that covers over 200% of its fixed costs by its reoccurring revenue stream (which is 65% of the total revenues), Zedi is well capitalized to continue to grow aggressively (15% organically, doubling inorganically over 2-3 years).  Its hard to model Zedi’s growth due to the adoption curve of its products/high incremental margins, but just looking at the current base business, Zedi is quite undervalued.  If we assume 10x EBITDA (low capital intensity business) for this growing business, Zedi should be worth $1.21, which is 68% higher.  If the products start adopting at a faster rate internationally (outside of Canada), the company could experience transformative growth, plus trading liquidity should improve as well.  In the meantime, the company is buying back stock if the market doesn’t realize it, which is a true endorsement to the low capital intensity of their business (Zedi’s share count hasn’t grown in 5 years).