An investment in Geospace Technologies (GEOS) is a bet on an increase in seismic exploration activity in the oil and gas sector from current low levels. It implies that continued curtailment of seismic exploration activities cannot be sustained for an indefinite period of time and that seismic technologies will continue to be an important tool used by the oil and gas industry to find and exploit oil and gas reservoirs.
Management has managed this downturn decisively. They cut costs thoughtfully, kept their solid balance sheet and even achieved positive cash flow in 2017. At the same time, they invested in the future of the company by keeping R&D expenses steady. From an accounting perspective, I get the impression that the company is run conservatively. Adjusting for the large and ever-increasing amount of non-cash write downs that depressed accrual income over the last three years, there has been an upward trend in operating performance which might continue in 2018.
Excess inventory at customers’ hand will take some time to come down. Management is however confident that future demand will be supported coming from product replacement due to technological advances. In addition, two of the three major competitors are focused on regaining financial flexibility. GEOS might profit from the current weakness of competitors.
Doubts about GEOS technological leadership in permanent reservoir monitoring systems increase uncertainty on how the company will perform in a recovery. Based on my assessment, orders in the permanent reservoir segment are not needed to justify the investment case at current valuation. It rather provides optionality for further upside potential.
With the second largest shareholder recently sending a letter to the board and requesting a share buyback program, this provides a good reminder for the long tenured management to fully consider shareholder interests in capital allocation decision making.
Houston based GEOS designs and manufactures instruments and equipment used in the oil and gas industry to acquire seismic data in order to locate, characterize and monitor hydrocarbon producing reservoirs. The company also designs and manufactures non-seismic products, including industrial products, offshore cables and imaging equipment.
Horrendous performance over the last three years
From the following table you can see that the seismic segment is divided into three sub groups (including traditional exploration, wireless exploration and reservoir) and that the non-seismic segment has two sub groups (including Industrial and imaging). Following softening demand for seismic exploration activities GEOS posted a series of grim results over the last three years. The non-seismic segment although relatively small delivered healthy operating income over this period.
Let’s take a longer-term perspective at the income statement:
As a result of lack in demand and pricing pressure revenue fell by 79% from its peak in 2013, back to where it was in 2004/5. Since 2005, the company has evolved and increased capacity. For instance, between GEOS IPO in 1997 and through fiscal year 2014, the company expanded manufacturing, warehousing, engineering and office space from 99,000 square feet to 648,000 square feet with the number of employees increasing from 351 to 1,149 (707 at the end of FY 2017). Consequently, the cost base has increased requiring more revenue to generate profit.
With inventories already high at the end of 2014, factory activities have been running at a minimum and consequently, revenues have not been able to absorb fixed factory overhead costs. These costs combined with impairment charges depreciation expenses on underutilized rental equipment and reserves against inventories led to massive losses over the last three years.
A different perspective on earnings
Let’s have a look at cash operating income:
From this perspective there has been improvement since 2015. Cash earnings provide a healthier impression of the company’s recent state of operations than pure accrual numbers. In this context, GEOS has been able to regain control over operating losses and showed first signs of improvement in spite of an extremely difficult environment the company is currently confronted with.
In the following I provide a brief discussion of the adjustments I made to get to cash operating income:
Accrual operating income has been adjusted for non-cash items including depreciation and amortization (D&A), impairments, inventory obsolescence expenses, stock based compensation and profit from sale of rental equipment. In addition, cash items capital expenditures (capex) and proceeds from sale of rental equipment for each period have been included.
For instance, in 2017, GEOS reported an accrual operating loss of USD 54.3 m. Adding back USD 17.8 m of D&A, USD 5.3 m impairment of long lived assets, USD 21.5 m of inventory obsolescence expenses, USD 5.7 m of stock based compensation and deducting USD 1.6 m of capex and USD 9.1 m of profit from sale of rental equipment results into a cash operating loss of USD 15.2 m.
Is the company spending enough?
D&A of USD 17.8 m exceeds 2017 capex of USD 1.6 m by a wide margin. For comparison, capex reached USD 33.5 m in 2014. Consequently, the question arises whether GEOS’s current capital budget is underspent. However, please note that the company invested USD 26.7 m in rental equipment in 2014 compared to only USD 0.5 m in 2017 (with new leased equipment during the period mostly being transferred from existing inventory) and that USD 12.5 m of D&A were attributable to rental equipment depreciation. Therefore, over the last three years the company has been using existing inventories being transferred to rental equipment leading to almost nonexistent investment in new rental equipment and therefore lower capex.
Potential recovery of inventory write-downs
Inventory obsolescence expenses sum up to USD 36.5 m over the last three years. Starting from an inventory level of USD 145.9 m at the end of 2014, management tried to work down from these inventories levels since then. Due to the lack of demand for their products, they started to take reserves for an inventory obsolescence in 2015. However, management pointed out, that the equipment where they built reserves against, would be sellable in a good healthy market as well. Currently, inventories stand at USD 77.6 m.
Cost cutting yes, but not at the cost of product development
Management has reduced the cost base over the last years and recently announced another cost cutting program targeting cash savings of USD 6.0 m annually. However, despite the industry downturn management continued to invest in research and development (R&D)
This is an extract from the company’s 2017 10-K:
“Past periods of revenue growth were primarily driven through our internal development of new products for the seismic industry. In past years, our seismic product innovations included the introduction of borehole seismology tools, seabed PRM systems and wireless data acquisition systems for both land and marine applications. These innovative technologies are the result of our unceasing investment in research and development initiatives, even during difficult industry cycles when we experience a significant decline in customer demand for our products. A majority of our product research and development cost relates to our product engineers. Our engineering staff has been key to our past success, and we intend to continue our tradition of retaining and attracting quality engineering staff and providing appropriate compensation and benefits. Going forward, we intend to continue significant investments in product research and development of new seismic technologies as well as non-seismic products in order to diversify and grow our revenue base.”
Management keeps spending for innovation with new products and enhancement of existing products, such that when seismic exploration activities pick up, they are well positioned to deliver those products to the market.
Strong financial position provides back up for prolonged recession
GEOS generated positive free cash flow in 2017. From a pure cash flow perspective, GEOS generated free cash flow of USD 13.3 m in 2017, the first positive after two years of cash outflow in 2015 and 2016. The 2017 result was positively influenced by a USD 13.0 m tax refund, but is still an encouraging signal with regard to financial flexibility.
This brings me to the company’s balance sheet which is in excellent shape. At September, 30, 2017, GEOS had USD 51.2 m cash and short-term investments no long-term debt outstanding and borrowings buyable under their credit agreement were almost USD 24 m. In addition, all of the company’s various real estate holdings were owned free and clear and without any leverage. Real estate is booked at cost and besides the large cash pile presents another substantial cushion.
Customers, competitors and products
In the seismic segment, GEOS sells products to seismic service contractors. Based on company’s estimates there are fewer than 50 seismic contracting companies in the Western hemisphere and fewer than 20 seismic contractors who are engaged in marine seismic exploration. Consequently, a relatively small number of customers, some of whom are currently experiencing financial difficulties, account for most of the company’s revenue. Contractors have reduced the count of active seismic marine vessels and land crews from that of prior years and symptomatic of this shrinking market is an ongoing consolidation between GEOS’s customers. Consequently, the dependence on an even smaller number of customers is likely to increase in the future.
As a result of the drop in oil price, exploration and production companies reduced seismic exploration activities and therefore many of GEOS customers are currently utilizing only a fraction of their owned seismic equipment. This unutilized equipment is available for immediate deployment if future demand for seismic services were to increase. Therefore, any increase in seismic activity will first benefit GEOS customers, with contractors increasing orders for GEOS products once their backlog continuously recovers. So, the availability of excess customer-owned seismic equipment combined with substantially reduced capital budgets has curtailed the customer’s need to purchase or rent seismic equipment from GEOS over the last three years.
Nevertheless, management is confident that future demand will come from product replacement due to technological advances. For instance, existing legacy cable systems eventually will be replaced with cable free /wireless systems which offer a number of advantages. Management sees the company well positioned to profit from customers switching from traditional seismic equipment to wireless equipment where the company is in a good position.
The company’s land-based wireless seismic data acquisition system is called GSX/GCX. According to the company, the GSX system requires less maintenance than traditional seismic data acquisition systems leading to less environmental impact and ease of operation. Since its introduction in 2008 and through September 2017, GEOS sold 403,000 GSX channels (67,000 in 2017, 4,600 in 2016 and 7,000 in 2015) and they currently have 73,000 GSX channels in their rental fleet.
Competition for land based acquisition systems comes from Sercel (an affiliate of CGG), ION Geophysics and FairfieldNodal. CGG and ION Geophysics are both listed companies. CGG is currently undergoing a financial restructuring. It does not look much better for ION Geophysics with USD 115.1 of net debt on its balance sheet as of September 2017 and USD 12.7 m of interest expense for the first nine months of 2017 compared to a market cap of USD 216.5 m and revenue for the first nine months of USD 139.6 m and negative free cash flow of USD 7.6 m. During periods of financial distress management and employees get distracted from day to day operations and customers who depend on ongoing service support will think twice before they buy from close to insolvent suppliers. GEOS could profit from this situation.
GEOS also has a strong position in the ocean bottom segment. GEOS marine-based wireless seismic data acquisition system is called OBX. Similar to the GSX land-based wireless system, the marine OBX system can be deployed in virtually unlimited channel configurations and does not require interconnecting cables between each station. GEOS’s deep water versions of the OBX system can be deployed in depths of up to 3,450 meters and for up to 50 days. Through September 2017, GEOS sold approximately 600 OBX stations and has 6,700 OBX stations in its rental fleet. According to management, OBX systems make up the majority of rental revenues.
One of the pioneers in ocean bottom systems is FairfieldNodal. However, the choice of OBN systems is limited because most systems are proprietary to their operators who use their own vessel fleet. Magseis ASA and inApril are two smaller upcoming players in this field and less established than FairfieldNodal and GEOS.
Customer concentration gets even more pronounced with permanent reservoir monitoring system products (PRM). GEOS markets PRM to large oil and gas companies. Since this product’s introduction in 2002, GEOS received system orders from only three offshore oil and gas operators (BP, Shell and Statoil). At the same time, there are not more than ten PRMs in use globally. GEOS has not delivered a system since 2014 nor has it received orders since 2012. However, when they receive an order the effect on total revenue will be massive. Statoil’s order in 2012 was worth NOK 900 m. Management considers their PRM product to provide “best performance and long-term functionality of any PRM system ever deployed”. PRM systems are used for producing assets and reservoir monitoring has to be done on a regular basis. However, in most cases only temporal surveys are brought in to try to image those reserves.
Management continues in its Q4 2017 analyst call laying out that: “… there’s a lot more of a return when one examines the broader aspect of the financial side in having a permanent system. Where in that you get a reap of those capital expenses now versus operating expenses, but requiring investment that you will then get your return in anywhere from five to seven years or so. So, there’s a certain amount of a discerning need with respect to those operators to examine the financials and the benefits that they can reap in longer term.”
Consequently, PRM offers substantial return enhancement in the future but requires a capital expense now compared to periodic surveys that require a relative small expense with lower return on investment.
However, doubts about GEOS technological leadership in this field have come along with a lost bid on two offshore fields operated by an existing PRM client to a competing technology. This is relevant, because obviously there are not that many potential bids in the current environment. As a result, management charged a USD 5.3 m impairment against factory equipment used in the production of PRM. In the end, the question is whether GEOS electric sensor technology is superior or inferior to the competing fibre optic technology. This is currently unknown. At the same time however, a scenario where a PRM order suddenly arrives is not reflected in GEOS current market valuation at all.
Most of the traditional seismic products (in contrast to GSX, OBX and PRM) are characterized as low margin commodity or consumable products with intense competition. Management believes the level of industry demand for these products to be a good barometer of seismic crew activities since these products are consumed, damaged or lost while being utilized in seismic field operations. As GEOS focuses future product development at higher margin specialty products and new technologies, they expect future sales of these lower margin traditional seismic products to decline.
The following table summarizes revenue from each seismic segment for the last eight years:
In contrast to the seismic segment, operating income from the non-seismic business line increased each year over the last three consecutive years. The company has been successful in transferring sensor technology to non-seismic applications. For instance, the company’s automated water meters have been exhibiting fast growth as they got accepted by many municipalities. According to management further growth can be expected and with operating margins of 15%+ this is a highly attractive business segment.
A capable management team and first signs of shareholder activism
Walter Wheeler became CEO in January 2014. He has been with the company since 1997 and has an engineering background. Many members of the board including the current CEO used to work for ION Geophysical before joining GEOS. There has not been much fluctuation in the board since GEOS becoming a public company 20 years ago. In line with this, the former CEO became Chairman of the board in 2013. In spite of the current leadership’s long tenure and a relatively high equity compensation component, insiders are holding less than 4% of the shares outstanding.
There is no doubt that management has done a better job than most competitors in navigating the company through the downturn. Nevertheless, there is a risk that management teams become complacent when they stick together for such a long time.
Recently, Lemelson Capital Management, a small fund from the US, and an investor in GEOS for at least three years announced it is holding 10% of the company. This makes Lemelson the second largest shareholder. Lemelson started an activist campaign by sending a letter to the board urging for an immediate share repurchase program. So far this has been unnoticed.
Management emphasized in the past, that they see the company’s cash pile as strategic asset to make GEOS a “survivor through this difficult time”.
I think it is good to see that large shareholders are showing more commitment now and are offering more options. Management does a good job, but some assistance from owners in capital allocation should be useful.
GEOS is currently trading at 14 USD a share leading to an equity value of USD 188.1 m. The tangible book value stands at USD 195.1 m with USD 51.2 m in cash and roughly USD 40 m of real estate at cost and no debt outstanding. Inventories, already reflecting large write-downs, add another USD 76.6 m. Historically, GEOS compounded equity by 6.4% since the IPO in 1997. This includes a 40.7% drop in book value from its peak in 2014. Before the crash in oil prices, GEOS traded at two to three times book value.
From an earnings perspective, I would be comfortable to buy this company at ten times operating income. At an enterprise value of USD 136.9 m this requires roughly USD 14 m of normalized operating income. Assuming that corporate overheads stay flat (roughly USD 12.0 m) and operating profit contribution from non-seismic increases to USD 5.0 m, this leaves USD 21 m of operating income for the seismic segment. This requires revenue to rebound quite a bit, but the required level of profitability is far away from the heydays in 2013/2014 and should be achievable once demand stabilizes. With the help of a recovery and additional demand for wireless systems and slow continuous growth in non-seismic products this scenario should be achievable. Any product orders for PRM systems would then provide further upside. Once, the company will have returned to such numbers, the market should apply a higher multiple. Historically, shares traded between 15to 17 times operating income.
Over the last trading days, I bought a 3% position at an average price of USD 13.8 per share. Depending on the quarterly results, which will be released after market close today, I plan to adjust the weight of this investment in the portfolio.
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