Last Thursday (after market close), Geospace reported quarterly results.
The company reported the first gross profit since the second quarter of 2015, which is mostly a result of lower non cash inventory obsolescence expenses and a declining cost base (the workforce has been reduced by more than 50% since 2014). In addition, they announced a meaningful contract win with a new customer to rent 9,000 OBX nodes (ocean bottom) for a period of 180 days. During the quarter management re-initiated investment activity in the rental fleet with transfers from inventories to rental equipment being more than ten times larger than last year. A continuous increase in demand for rental equipment will be of significant importance to regain profitability due to the high margin contribution from this segment.
GEOS management remains cautiously optimistic in its outlook for the rental fleet. A bolder prediction was made by the CEO of ION Geophysical, a competitor in the Ocean bottom segment:
“We are confident that the OBS market is growing, projected to be at pre-downturn levels of USD 1 bn in 2018, with significant growth projected by the industry in the following years. OBS will continue to take market share from the distressed streamer markets spurred by the improved economics of the next generation of systems as well as growing adoption by E&P companies as a technology of choice to manage their reservoirs.” (Ion Geophysical Q4 2017 conference call)
The non-seismic business continued to perform well. In addition, management reported that they are currently developing products for the border and perimeter security markets. These products are based on the existing seismic sensor technology and might have the potential to further diversify the business in the future.
Cash outflows sum up to USD 10.1 m during the first six months of the current fiscal year. However, operating cash flow (before changes in working capital) improved from a negative USD 6.1 m during the first quarter to a negative USD 0.6 m during the second quarter. The company is holding USD 41 m in net cash.
Lemelson Capital, the third largest shareholder holding 8.4%, intensified his activist campaign (although recently reducing his equity stake). Edit 5/16/2018: Lemelson increased his stake to 9.3% according to the latest 13D/A. He sent two more letters to the company basically demanding the replacement of GEOS management and pressing for the sale of the company. I do not know what is going on behind the scenes, but my impression is that support from other shareholders for these requests is limited. Management has not officially replied yet.
From my perspective, management seems to be very experienced. They are also handling the current downturn with great care. However, I am concerned about the low level of insider ownership:
Looking at the last decade, stock-based compensation has been a large component of management remuneration. For instance, the total intrinsic value of options exercised during fiscal years 2011 to 2013 was USD 35.2 m. This is a substantial part of net profit generated during this period. To be fair however, the share price increased more than 25 times from its low in 2009 until the end of 2013. So, for shareholders with the right timing to sell a lot of wealth has been realized. On the other hand, long term shareholders have been continuously diluted. Since 2009, the share count increased by 1.4 m shares or 12%. This might be similar with many other US listed companies. Nevertheless, management’s ownership in the company moved in the opposite direction. As of December 2009, executive management and the board as a group had an interest in the company of 1.3 m shares (adjusted for a 2:1 stock split) or 10.9%. This has been reduced to 0.5 m shares or 3.9% as of December 2017. At the same time, the board’s and management’s composition has not changed a lot (there is a new CEO, with the current Chairman being the former CEO). Consequently, from the outside it appears that Geospace has (i) a seasoned leadership team that has (ii) already received a relatively large remuneration during the last upswing and (iii) reduced their ownership over the last years.
Currently, I get USD 41 m in cash, working capital of USD 79 m and properties & land at cost of USD 36 m. In addition, there is the operating business itself with USD 13 m fully expended annual R&D spending, a profitable and growing non-seismic segment and the potential for a recovery of the seismic segment. The market is currently valuing the business at USD 150 m.
On Friday, I increased my position to 3.5% of the portfolio at USD 11 per share.