One of the places to search for undervalued stocks is to look at insider buying. Recently, three directors have bought a non-trivial number of shares of Global Geophysical Services (GGS). The company missed its 4th quarter earnings estimate on 25th February [see earnings transcript] and appears rather cheap: shares sell at an all-time low and the P/B ratio is about 0.75.
Global Geophysical Services acquires and processes seismic data used by oil exploration companies to guide them in drilling and locating untapped reservoirs of oil and natural gas. Recently, quite a lot of business for seismic data providers was created by the current expansion of hydraulic fracking; GGS is no exception. The industry is highly competitive: seismic data acquirers bid on price; and since idle crew costs are high, the bidding often results in a very unfavorable price for the winner.
First, we will look at the 10-K form for 2011. One of the most interesting parts is the section describing risks; it is not very common to find so many dangerous risks threatening a single company. Here are a few of them:
- The industry is very sensitive to oil prices. A decline in oil prices leads integrated oil companies to reduce exploration expenses and seismic data providers are hit among the first.
- Revenues can be volatile and the company has no control over them: if budgets for exploration are cut, it means no business for seismic data acquirers and the idle crews have no alternative use though they have to be maintained. This results in high fixed costs and makes forecasting future working capital needs very difficult.
- Equipment for seismic data acquisition is contracted from competitors and cannot be substituted easily. The contract with one of the two key suppliers, Sercel, expires in 2013 and might not be renewed on favorable terms.
- The business requires constant technological innovation. Obsolete technology means no business at all.
- Weather-related disruptions may significantly harm the business. Many projects are realized on a turnkey basis and any delay results in a possibly significant revenue loss.
- The exploration business is regulated by various environmental and other laws; this applies to both the company and all their clients. Acquiring seismic data often employs explosives as a source of acoustic signal. Changes in regulations or unfortunate accidents may materially impact the company.
- There is a considerable political risk. Meaningful part of the business is conducted in countries known for unpredictable government actions harming foreign investments.
- And last but not least, GGS' substantial debt load can lead to a quick default.
One might think that many of those risks are well-known and companies have lived with them for ages. However, this is a very different situation compared to a major integrated oil company losing a few percents of revenue or profits because some of these risks have materialized. We do not need to go far for an example: Geokinetics (GOK), a close competitor of Global Geophysical Services, is currently in a restructuring process after defaulting on their debt obligations; they blame bad weather, uprisings in Arabian countries (e.g. Libya) leading to equipment loss, and a deadly liftboat accident.
|Income tax expense||-20||-13||0||0||-6||-5|
|Operating cash flow||117||127||116||80||41||12|
|Investments / capex||-163||-192||-213||-53||-85||-83|
|Financing cash flow||47||59||108||-40||57||51|
The table clearly shows that the company's operations have been profitable in five of the last six years, but all the operating income was consumed by income taxes and interest expenses. If we look at cash flows, operating cash flow has increased in the last three years compared to the previous ones, but it comes at the expense of increased capital expenditures. In other words, the free cash flow is negative in six years except 2009, and the deficit is paid up by newly borrowed cash. Consequently, the interest expense is increasing year by year and no profits remain for the shareholders; all of them go to bondholders.
What are the possible future scenarios for such a company? It might happen that everything will go about well and the company will trudge along, paying all the income to bondholders with no prospects of possible future dividends. The bonds are rated B+ by S&P and are currently trading for about 80 cents on a dollar yielding 17%. I think the yield might fairly reflect possible future moderate decline in earnings, but it is not enough to guarantee the safety of the principal: GGS has debt to equity ratio of about 300% and is stretched quite a lot because the interest cover ratio is hardly above 1 and has always been below 2. If any of the risks mentioned above materializes, the company can quickly file for a bankruptcy. Their credit facility of 70 mil. is already fully drawn upon; it does not make sense to issue equity with stock trading at 2.50 per share; and attempts to issue more debt at a 17% yield also does not seem plausible. If interest rates increase even moderately it can prove unbearable for GGS.
The liquidation value of the company is hard to evaluate. One of the most important assets is the Multi-Client Library booked at 232 mil., which is a collection of seismic data expected to be sold to multiple clients. However, this asset is depreciated at the rate of 67% p. a., and if no clients are interested in the data, it might prove almost worthless in a short time. The liquidation value of data-acquiring equipment is also doubtful since the equipment is very specialized and might not be compatible with other companies' processes. Consequently, I would like to see a much higher discount to par value for bonds to be sure of my principal; and I am almost sure there would be nothing left for shareholders in the case of a bankruptcy filing.
Finally, a short discussion of the management. In October 2012, Richard C. White was appointed the new CEO and also elected the Chairman of the Board. The new management apparently sees some improvements since they are buying stock at the open market. I also like the amount of information disclosed on the website. What I certainly do not like is the calculation of EBIT and EBITDA and remarks in the 10-K form saying how these measures are useful to investors and used by the management. What is the point of calculating EBITDA, when the most valuable asset -- the Multi-Client Library -- is depreciated at 67% a year and the company needs huge capital expenditures just to maintain revenues?
I do not see how the company can break the vicious circle of increasing debt, negative cash flow and all operating income being consumed by interest expense. It is possible that positive 1Q 2013 results may lead to an upward jump in the stock price, but long term, I see just plenty of risk. According to Ben Graham, "An investment operation is one which...promises safety of principal and adequate return," and I see neither in the case of Global Geophysical Services. I am still puzzled why investors were willing to pay $15 a share (about five times book value) in 2011 -- for a money-losing company that has no control over revenues and that gets all the vital equipment from competitors.