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Geospace Technologies Corporation (NASDAQ:GEOS)

F2Q13 Earnings Conference Call

May, 03, 2013, 10:00 am ET

Executives

Gary Owens - Chairman, President, & CEO

Tom McEntire - VP & CFO

Wick Wheeler - EVP & COO

Analysts

Veny Aleksandrov - FIG Partners, LLC

Ryan Fitzgibbon - Global Hunter

Georg Venturatos - Johnson Rice

Joe Maxa - Dougherty & Co.

Bill Dezellem - Tieton Capital

Greg Garner - Singular Research

Hamed Khorsand - BWS Financial

Operator

Welcome to the Geospace Technologies’ Second Quarter 2013 Earnings Conference Call. Hosting the call today from Geospace is Mr. Gary Owens, President and Chief Executive Officer. He is joined by Tom McEntire, the Chief Financial Officer.

Today's call is recorded and will be available on the Geospace Technologies’ Investor Relations website following the call. At this time, all participants have been placed in a listen-only mode and the floor will be open for your questions following the presentation. (Operator Instructions)

It is now my pleasure to turn the floor over to Gary Owens. Sir, you may begin.

Gary Owens

Good morning and welcome to the Geospace’s second quarter conference call for fiscal year 2013. We appreciate your participation in the call today. I am Gary Owens, the company's Chairman, President and CEO. Also with me are Mr. Tom McEntire, the company's Vice President and Chief Financial Officer, and Mr. Wick Wheeler, the company’s Executive Vice President and Chief Operating Officer.

Before I begin discussing the quarter, and if you would like to listen to a replay of today’s call, it will be available by going to the Investor Relations section of our website at www.geospace.com.

I should point out that the information we will discuss this morning is time sensitive and therefore may not be accurate on the day one listens to the replay. I warn you that many of the statements we will make today will constitute forward-looking statements within the meaning of the Private Securities Litigation Act of 1995. These statements are made with management’s current expectations and knowledge. These statements are based on risks that are known and unknown and are influenced by uncertainties and other factors that we are unable to predict or control. Some or all of these risks and uncertainties may create undesirable results or cause our performance to differ materially from any results or performances we may express or imply. These risk and uncertainties include the risk factors you can find in our filings with the SEC, including our annual filings on Form 10-K and our quarterly filings on Form 10-Q.

Yesterday, the company released its second quarter earnings for fiscal year 2013 and reported net income of $16.9 million or $1.30 per diluted share on revenues of $76.4 million. It was the second most profitable quarter in the company’s history with net income increasing 48% over the second quarter of last year. Tom will give more information on the quarter in a few minutes.

However, as good as the quarter’s financial results were, we were still disappointed in the final results. We frequently remind everyone that our business is lumpy and that our sales in our industry can rise and fall without much warning. This was the case with the quantity of wireless channels shipped in the quarter. We brought in three new international customers that all three purchase small sized systems and a few of our existing customers bought additional channels for their existing systems. However, we did not land any large scale contracts in the quarter which impacted our revenues and profits accordingly. Wick will talk more about the outlook when he speaks.

We did ship the Shell system to Brazil as we indicated in our last conference call and we did recognize the expected revenue from the Statoil contract. The execution of these two orders was one of our primary focus for the second quarter and those accomplishments are very important for the company. Tom will add some color to the financial aspects of these orders in a moment.

Another focus of the company this past quarter was opening of our Colombian warehouse and service center in Bogota. This operation completed its first rental transaction during the second quarter and additional rental equipment is expected to be delivered to the Bogota warehouse in the third quarter. The grand opening was held in March with a myriad of contractors and oil company personnel and attendants. We are very thankful for their support from both these groups and are anxious to introduce their product technology to this important region.

Sales of our borehole product line were considerably better in the second quarter versus the first quarter. However, borehole product sales are still below historical levels. We expect the slowdown to continue until their higher levels of activity in the shale-plays in the U.S. or worldwide.

During the quarter, the company added 54 more employees at our Houston facility, primarily in manufacturing and engineering. At March 31, 2013, our worldwide employee count stood at 1,253 a new record high for the company. This increase in employee headcount and work activity is challenging the capacity of our manufacturing operations. Later, in our prepared remarks Wick will talk about how we plan to address this growing thing.

But right now, I will turn the call over to Tom who will cover the company’s financial results in more detail.

Tom McEntire

Thank you, Gary and good morning everyone. I will start by discussing an overview of our consolidated results of operations for the second quarter of fiscal year 2013, and then I will drill deeper into our revenues for each of our core product segments. Finally, I will close with some information concerning our balance sheet and cash flows. While we will update our estimates of revenue recognition for the Statoil contract and our cash flows for fiscal year 2013, we will not provide any earnings guidance during this call.

For second quarter ended March 31, 2013, we reported revenues of $76.4 million, an increase of 36% over revenues of $56.2 million for the second quarter last year. Our net income for the second quarter of fiscal-year 2013 was $16.9 million or $1.30 per diluted share, an increase of 48% from last year’s net income of $11.4 million or $0.89 per diluted share.

We report our revenue segments in four different categories; they are traditional seismic, wireless seismic, reservoir seismic, and then non-seismic. I will discuss each of these product categories for the second quarter of fiscal year 2013 and their comparison to the second quarter of fiscal year 2012.

Revenues from our traditional seismic products for the second quarter of fiscal year 2013 were $13.9 million, a decrease of 37% compared to revenues of $22.2 million last year. The decrease in revenue has primarily resulted from lower demand for our marine products as well as lower demand for geophones and geophone string rentals during the winter season.

Regarding our marine products, it should be noted that we experienced higher than average sales during the second quarter of fiscal year 2012, and our marine product sales for the current quarter were more representative of our normal run rate. It is not unusual for marine product revenues to fluctuate significantly from quarter-to-quarter.

Revenues from our wireless seismic products for the second quarter of fiscal year 2013 were $15.7 million, a decrease of 27% compared to revenues of $21.5 million last year. We attribute this decline in revenue to a historically erratic flow of orders for our wireless products. We continue to believe that demand for these products are strong and this demand is resulting from the industries’ transition away from less efficient legacy cable-based seismic data acquisition systems.

During the second quarter, we sold 13,000 wireless channels; in addition, we added 12,000 net channels to our rental fleet during the second quarter resulting in 77,000 wireless channels in our international rental fleet at the end of the quarter.

Revenues from our reservoir seismic products for the second quarter of fiscal year 2013 were $40.2 million, an increase of 701% compared to revenues of only $5 million from last year. For the quarter, we recorded revenues of approximately $17 million for delivery of the Shell system. In addition, we recognized $21 million of revenues using the percentage of completion revenue recognition method for the Statoil order. We expect future revenues from this product segment to be dominated by our seabed reservoir products as we continue to manufacture the Statoil system.

Regarding future revenue recognition for the $160 million Statoil system, we now estimate that approximately 45% and 55% of the Statoil contracts revenues will be recognized in fiscal years 2013 and 2014 respectively. Revenue from our non-seismic products for the second quarter of fiscal year 2013 were $6.4 million, a decrease of 12% compared to revenues of $7.3 million last year. This decrease is partially attributable to lower sales of our industrial sensors and thermal imaging products to our European customers, which we believe is related to the region’s economic crisis.

Now, I will move on to discuss other elements of our financial statements. For the second quarter ended March 31, 2013, our operating expenses, which consists primarily of selling, general, administrative, and R&D expenses were $10 million, an increase of 16% compared to $8.6 million from last year’s second quarter. The increase in operating expenses primarily reflects higher personnel costs and other general expense increases associated with our increased sales and our asset expansion. As a percentage of sales, operating expenses were 13.1% for the second quarter of fiscal year 2013 compared to 15.3% last year. Our effective tax rate for the second quarter of fiscal year 2013 was 32.6% compared to 32.1% from last year’s second quarter. We continue to expect our effective tax rate for the remainder of fiscal year 2013 to be between 32% and 33%.

Our balance sheet remained strong. At the end of the second quarter we had a $173 million of working capital, $23 million of cash and short term investments and no long term debt on our balance sheet; our $25 million credit facility remains untouched at this time resulting in total liquidity of $48 million at March 31, 2013. We believe the strength of our balance sheet continues to put us in a good position to meet the opportunities ahead. For the remainder of fiscal year 2013, we intend to utilize capital to manufacture the Statoil System and to build up our OBX inventories. In addition, we will continue the expansion of our wireless rental fleet including OBX rental units especially as we seek to meet the market needs in South America. We currently estimate that our fiscal year 2013 gross investments in rental equipment could be approximately $30 million or more.

As history shows, we expect these rental equipment investments will be significantly offset by cash proceeds from the sale of rental equipment to our customers, similar to what we've experienced so far this fiscal year. In addition, we plan to increase our total fiscal year 2013 investment in plant and equipment to approximately $15 million to $20 million. We believe our cash balances on hand, our internal cash flows, sales proceeds from rental equipment, stage payments from the Statoil contract and the viable borrowings under our credit agreement are sufficient to finance our capital needs throughout fiscal year 2013.

Now I will turn the call over to Wick, who is going to discuss various matters concerning our company's operations.

Wick Wheeler

Thanks Tom and good morning everyone. Despite the fact that second quarter revenues for our wireless system were less than anticipated, there are indicators that suggest there's still solid demand for these products. So far this quarter we have introduced sales in rental [ores] for our land rental system totaling about $9 million worth roughly half going to international customers. We had considerably more than this amount in outstanding growth even though there is no assurance that a sale will result. Looking further forward, we're responding to multiple rental quotes for independent seismic surveys both local and abroad that would each require very hefty channel accounts and as history shows, many of our rental agreements end up turning in to sales.

I should note however that should any of these discussions lead to further agreements, delivery for all but a few would be no earlier than the last quarter this fiscal year if not next year. Turning to our OBX bed nodal system, the list of potential customers continues to grow. While ongoing interest in the large channel OBX system remains centered on our deepwater version of this product, new interest and opportunities have started to develop for mid-size systems comprised of our shallower version. Several new field test with potential new customers are underway. Maintaining and achieving desired production rates for OBX system, especially the deepwater version with intense machine requirements still holds its challenge, but significant improvements in these conditions are occurring.

Our reservoir seismic revenue will continue to be dominated by the ongoing work to fulfill the Statoil order and this will continue well in to fiscal year 2014. Nonetheless, discussions continue to occur with oil companies regarding other permanent seabed monitoring systems, however such discussions and the events of organization of these projects typically take time, and while not impossible there is no real anticipation of any major award for new permanent reservoir monitoring system in this calendar year. Meanwhile, much of our production facilities will remain busy with Statoil’s order through 2014.

As is readily apparent, a common theme running throughout the outlook of all our products is a need for capacity. Capacity in our product inventories to take advantage of otherwise missed opportunities in a lumpy market; capacity in tools, equipment and machinery to build these products in a timely fashion; capacity needed to expand into emerging foreign markets; capacity to efficiently incorporate an office new Geospace employees as we meet these objectives. To this end we are busy working to fulfil our needs for additional capacity. We committed approximately $10 million to new machinery and related infrastructure during our second quarter, a good portion of which will be fully operating in the next few weeks.

We successfully kicked off our Columbian operations with active rentals in place and serious new customers on the horizon. Just recently we successfully secured the purchase of 9.6 acres tracked immediately adjacent to the south border of our existing Pinemont property. Final closing should occur next week. Our immediate intention is to utilize a small portion of this property to provide relief to the crowded parking conditions endured by our employees, and at the same time we will be evaluating the potential construction options to expand our Pinemont facilities.

Operator that concludes our prepared remarks and we are ready to open the line for questions.

Question-and-Answer Session

Operator

The floor is now open for questions. (Operator Instructions) Our first question comes from Veny Aleksandrov, FIG Partners.

Veny Aleksandrov - FIG Partners, LLC

So, my question is on the traditional and marine side, I understand from the comments that there was some forward demand, but also these segments manufacture, some of the equipment that goes in to the seabed orders right?

Gary Owens

Well, I don't think we will lump those into the same. The Seabed reservoir monitoring systems are lumped into that category, the marine category is more of the strict marine towing operations.

Veny Aleksandrov - FIG Partners, LLC

Right, but the geophones produced in the traditional segments or some of the components from there go and are used by the seabed segment, is it correct?

Gary Owens

That is correct, but again those are lumped into that product when they are used in that product.

Veny Aleksandrov - FIG Partners, LLC

My second question is the seabed order that went to Shell, you say that there is one part of it to be built in Q2, what is that?

Tom McEntire

Veny this is Tom, I did not understand your question, could you repeat it.

Veny Aleksandrov - FIG Partners, LLC

Yeah, you delivered the Shell seabed system in Q2, and there are still I think in the press release it said $1.2 million to be [mute] more?

Tom McEntire

Right, there are some additional components that were not delivered that Shell did not want us to deliver through March 31, and so we expect to be delivering those in the third quarter.

Veny Aleksandrov - FIG Partners, LLC

Okay, and that will be the end of this system?

Tom McEntire

That is right.

Veny Aleksandrov - FIG Partners, LLC

Okay, thank you, and then my last question, if I can, the existing customers that got more GSX , can you share this name with us or you would rather not?

Tom McEntire

We don't have permission to use their name; I'd rather not jump off that cliff.

Veny Aleksandrov - FIG Partners, LLC

That's fine. Thank you so much.

Operator

Our next question comes from Ryan Fitzgibbon, Global Hunter.

Ryan Fitzgibbon - Global Hunter

Start off on the OBX side of business, Tom you mentioned you guys are going to build some inventory, you are right now and tend to throughout the remainder of the year, and then Rick you mentioned that you are seeing some good inquiries on that side of the business, could you walk us through what kind of size opportunities you are seeing out there and when those may materialize?

Gary Owens

Yeah, they range across the map. In the immediate term, we are discussing some short-term rentals and some of those numbers around 1200 modules and some of the quotes, and Rick cautioned you that that might be a later date as far as sales numbers are going, but some of those range from 3000 to 5000 module quotes. We are really kind of early to betting the farm on a specific number at this point, but if the question is what is the range, they are all over the map up to 5000.

Ryan Fitzgibbon - Global Hunter

Gary, do you have -- can you talk a little bit about the inventory you have right now and how quickly you could deliver an order?

Gary Owens

We are still trying to figure that out. We are building those as fast as we can, and Rick talked to you about installing some machines that we thought would be up and running here in a few weeks. Those machines are aimed on the short-term side at immediately increasing our capacity in the OBX. So, the answer to that question is going to be how quick those vendors respond, all of those vendors are late, and they continue to give us states that are late.

So, I just don't know what that number is going to be, but the earliest promises we made are in our fourth quarter for some of those that we don't have orders for, so we are aiming at being able to deliver one or two of those some time later in our fiscal year, but whether or not the sales demand will be in that same quarter, we will see, but that's been the request. So, we are trying to meet those commitments.

Ryan Fitzgibbon - Global Hunter

My second question is on the GSX side of the business, Rick you mentioned you have sold about $9 million of equipment so far, half of it is to international. Can you talk about what you are seeing from the international customers, if there's anything of size that we could potentially hope for to hit in 2013?

Wick Wheeler

Well, actually many of these inquiries are for foreign use that we are seeing, but those are really the ones that were rental inquiries that I had mentioned, probably won't fall into at the very earliest our last fiscal quarter this year. Most of those in fact are related to international uses.

Ryan Fitzgibbon - Global Hunter

And do you think those would be direct sales or more to the rental fleet?

Wick Wheeler

Well, these will probably start out as rentals, but you know our rentals are a vehicle for sales. So, we still enlist rentals for that very purpose to encourage those sales. Many of these will be going for long duration contracts if they turn out. So, there would be quite the incentive to buy these.

Gary Owens

And some of the quotes are for sale, we don't have a guess of which ones are going to happen or not, but we had some quotes that are aimed for later in this quarter. We have some that are aimed for the quarter after this and our fourth quarter, but every time we try to guess which one of those is real or not and which one of these quotes for rents turn into either immediate sales or partial sale, it's just difficult, but we, as far as new contracts coming out that require channels, there is quite a few of those going on as Rick said.

Operator

Our next question comes from Georg Venturatos, Johnson Rice.

Georg Venturatos - Johnson Rice

I wanted to touch on the wireless side in a little more detail. Obviously, we have been getting some traction internationally, can you talk a little bit more specifically about the regions that you are seeing quotes from today and then as well as what kind of the pulse is on the domestic side from contractors?

Gary Owens

I think the three major regions in the short term are North America, South America, and Europe. We do have some quotes in other places other than that, but I think off size, they will be limited to those areas.

Georg Venturatos - Johnson Rice

Okay. And I know you don’t talk specifically about margins in that business, but just in general, have you seen any pricing pressure with regard to the wireless channels?

Gary Owens

Every time we talk to a customer, there is pressure. I mean yes, I mean we do have that pressure.

Georg Venturatos - Johnson Rice

Okay. And then on the facility expansion, I know you mentioned you have kind of a two-year time horizon in terms of building that out. Can you talk a little bit more about may be some additional capacity that you are going to have throughout that period, may be before final completion or do you expect that to be kind of -- are you anticipating that all to kind of come at once?

Tom McEntire

Yeah. Hi, Georg, Tom. We did buy a facility in the first quarter or last summer or early first quarter, and we have also rented another facility here in Houston that were operating out of. So, we do have some additional capacity. We have been bringing in the equipment. That has given us some additional capacity in our current space, and so we are doing everything we can, but the new building will certainly go long ways in helping that.

Another thing, a strategy that we are employing here in Houston is moving a lot of our commodity manufacturing over to Russia, and so there has been a pretty big push on getting those products out of Houston and again freeing up capacity to work on what we would consider higher priority products.

Operator

Our next question comes from Joe Maxa of Dougherty.

Joe Maxa - Dougherty & Co.

Thank you. I wanted to talk a little bit more about the OBX opportunities. Obviously you talked about some big potential orders. Can you talk about the geographic mix of where you are seeing this opportunity and then also what do you feel as been the big driver for the strong interest?

Gary Owens

That's a really long answer on that, okay. Geographically Asia, North Sea, Brazilian waters, Gulf of Mexico and fresh watering and shallow waters spec, they range from Peru to northern part of South America. So we do have an African quote, that’s a African quote and east African because that impact that same we made to the rush -- to a small OBX system is going to be working on the east coast, yes Mozambique in particular.

Joe Maxa - Dougherty & Co.

That is fine.

Gary Owens

And why you would go OBX, I think this range is from more efficient use because the cable issues that are related to outcome, our cable problems especially underwater. As opposed to streamers I gave you to use from options on recording multiple component recording and the geometry of your shooting because not tied to a boat any where. So it depends on the objective for the geo business when you are designing that what is goes are and certainly for reservoir monitoring the multiple component aspect that would add some value to some people.

Joe Maxa - Dougherty & Co.

And what do you think -- it seems like you’ve had potential in orders out there, you deserved any particular emphasis that are holding up orders given the market or I know we talked about potential just for a while?

Gary Owens

Anytime there is a technology available that's going to alter or change the way you historically have done your business there is a lot of caution and there is consideration of vessels and what goes on in the vessels you know and neither usually big ticket kind of crew, so you got money issues and most of those guys want contract or commitments pretty well firmed up before they jump into those. So there is just, there is different stories on everyone of those situations, so it always takes time and it took time on the wireless, it took time on the boreholes side and lord knows it’s taking a long time in the reservoir side. So you know our job is to provide technology, to give them new ways to do things and the very front end of those introductions are usually painful.

Joe Maxa - Dougherty & Co.

Okay. And let me just see if I understood correctly, you have big opportunities in both OBX for GSX you know you could see an order two come and ship this year still, I guess I heard correctly and then the question is whether you can manufacture, is that…?

Wick Wheeler

Yes, but there is no certainty in any of that.

Joe Maxa - Dougherty & Co.

Right.

Gary Owens

We are arguing how to frame though; the answer to be accurate and reliable, but we need a little bit more time to know the exact answer to that question.

Joe Maxa - Dougherty & Co.

And you are building up the OBX inventory, what is your overall inventories on the quarter; I am just wondering if that increased and what would that look like; is the 10-Q out?

Tom McEntire

Well, you know we filed it last night and I think its SEC has it in their Q, but for whatever reason if they haven’t pushed it out you know so we can put it on our website, but I'll tell you anyway; we have a $111 million of inventory at the end of the quarter.

Joe Maxa - Dougherty & Co.

And is much of that increase sequentially due to OBX?

Tom McEntire

A little bit of it is but I would say more of its related to Statoil; you know we are getting in a lot of raw materials related to the Statoil contract that haven’t been really pushed out under the floor yet so its staging of raw materials.

Joe Maxa - Dougherty & Co.

So what do we look for, I know you gave a break of 45%, I should do the math so $21 million a quarter is that about right one for the next couple?

Tom McEntire

That would be the straight line guess if you had to do; if you know the $21 million that we had this quarter was as purely coincidental, you know there is a large calculation that goes into coming up with that number and it turned out to be right on the mark of what we were estimating on the straight line businesses, but that would be best estimate we would have for now.

Operator

Our next question comes from Bill Dezellem, Tieton Capital.

Bill Dezellem - Tieton Capital

Would you please discuss the change in the Statoil contract or revenue recognition?

Tom McEntire

Bill, this is Tom the change in the Statoil contract for revenue recognition, can you be more specific?

Bill Dezellem - Tieton Capital

You pointed out that the revenue recognition that you were going to have, gosh I am actually missing what the number is in the release, but I was thinking 45% and 55% isn't that a change from what you had originally?

Tom McEntire

Yeah, I am sorry. We're now able to more precisely estimate when we're going to be finished with the contract that our capacity can in fact pull that in to fiscal year 2014, and so we're confident we can do it in Statoil will allow us to ship it in 2014 if we complete it. So that’s what prompted our estimate change.

Bill Dezellem - Tieton Capital

The change is really not a Statoil change but it's an ability at Geospace to produce change and Statoil will allow you to deliver basically.

Tom McEntire

That’s a good way to put it.

Bill Dezellem - Tieton Capital

And then a couple other questions here. First of all, the three small wireless systems that you delivered to Mexico, Russia and Indonesia, should we be thinking about these similar to a few years ago here in the US where you started with small orders with the wireless and that led to larger follow on sales, and I guess lumping in together with that same question, do we think about the small OBX sale in Russia the same way?

Gary Owens

Yeah, this is Gary. We expect all of those guys to have follow-on sales at some point in the future. We joke with our customers that channels our addictive and that’s been the general trend, crew sizes just gets bigger.

Bill Dezellem - Tieton Capital

And so they are just because it's outside of the US there is no reason we should view it any different than the history that you’ve created here in the States?

Gary Owens

Yes, no drug has a geographical boundary and this one doesn’t either.

Bill Dezellem - Tieton Capital

Keep the drug flowing. And speaking of the drug, it appears as though you took it to Poland and so would you discuss the process with the Polish customer that they had the initial small order and then it sounds like they now have a larger order, here this quarter and just use them as an example of well how they drug affected them.

Tom McEntire

So to the business Tom, we all three can probably try to respond to your question but yeah I am not going to mention the customers’ name but they got a contract in Poland and I believe they used our equipment in North Africa early on under rental basis and when they got the contract in Poland they liked the equipment, they wanted to rent some more and they got into the contract and towards the end they decided they wanted to purchase it and so that’s what happened. In our first quarter they purchased a small system and then in the second quarter they purchased a much bigger system. So they liked the product and they are moving on to other contracts, and we hope like Gary was mentioning that they will end up being one of these customers that adds more crews and adds more channels and does more work and can very efficiently compete in that competitive market there.

Bill Dezellem - Tieton Capital

And may I interrupt from your comment, Tom that this is a contractor rather than an operator?

Tom McEntire

Yes. It's a seismic contractor.

Bill Dezellem - Tieton Capital

Okay. Great that’s helpful and I was finished up there with my questions. But since you brought in the rental piece, I am going to ask one more if you’ll indulge me. The rental fleet continues to grow; I am curious do you expect it to continue to grow from this point or at some point are we close to a change where you have as many customers find the equipment that they have been renting as you do new rentals and so we start to reach a more steady state from our rental fleet standpoint?

Tom McEntire

Yeah, we flattened out last fiscal year with 50,000 plus channels and it looked like we really weren’t doing much during each quarter, but in fact we were adding more and selling some and adding and selling but the change wasn't much. But this year we have added a lot of new channels primarily up in Canada, those channels did not get sold into the market this year in the second quarter like they did last year, so we have a bump in increase. But my expectation to your main question is that the channel count will kind of fluctuate around this area, if we could see it drop, if we had some sales. We got some increase for buying some used rental equipment right now and those could happened but like Wick was talking about, we have some very large channel count opportunities to quote on that we don't have enough buyable channels to ship them. We have some but not enough and we could be adding. So hard to predict, but I wouldn’t see a steady rise from here, but I think will be around this area for a while, Bill.

Bill Dezellem - Tieton Capital

Okay, and Tom not to try to be silly here but I think I heard you say, it could go down, if you end up with some purchases but it could go up if you end up with some of these large request and essentially you are kind of at your customers [whim] and you are really not sure.

Tom McEntire

Yes that's exactly right. I mean its always going to be based on the market and what the market’s doing and if we have idle channels in the rental fleet that we feel like we are overstocked you know those go up on the block for sales, so that's the way it works.

Bill Dezellem - Tieton Capital

Okay, we will take that as a down flat or up answer. So thanks for your (inaudible).

Tom McEntire

I've got them all covered.

Operator

(Operator Instructions) our next question comes from Greg Garner, Singular Research.

Greg Garner - Singular Research

So just to summarize what I hear on the GSX I just want to make sure any commentary from this summary here would be appreciated. Generally the inquiry level as good as it has been and maybe its changed a little bit, so it would be great to hear any commentary there. But the inquiry is coming more from the international side and so in anticipation of orders in the next quarter to there's also a longer lead time on the international side for delivers. So is that the right way to characterize where the water flow may come from in the GSX revenues.

Tom McEntire

I think that's accurate, that's exactly what we are seeing.

Greg Garner - Singular Research

Okay and in the time to produce if you received an order for 10,000 channels not how long would it take to, is there some in inventory or is it yet to…

Tom McEntire

If you show up today we deliver today.

Greg Garner - Singular Research

Okay, and from I'm talking about the new ones, not from the rental fleet.

Tom McEntire

Any flavor you want.

Greg Garner - Singular Research

Okay. So is it safe to assume the rental fleet is even with the increase here pretty much 100% utilization.

Tom McEntire

No. its never safe to assume that. The channels you know come in after the customers are finished if they decide not to buy them and they will sit idle until the next contract comes up. So you should never assume that there are 100% rented. But because a lot of our channels are sold at the end of contracts, sometimes they are rented 100% of the time before they are bought, but of the 77,000 channels that we have in the fleet right now the Canadian winter season ended back in the March, early April and so a lot of those channels are idle right now.

Greg Garner - Singular Research

So this is more of a seasonal factor here during the thaw typically this time of the year or that utilization rate to be lower than normal.

Tom McEntire

Exactly.

Greg Garner - Singular Research

And question about the Statoil, when as you are installing it when does it become operational for Statoil to where their gathered data that might be shared industry wide for other potential parties to understand the benefits of this kind of system. We have been like years later does it take a while to gain that or does it actually happen while you are installing or any color there would be great.

Gary Owens

They will probably know something themselves next year. Whether or not they will share that and when they will share and what part of it they will share is not known at all. I can tell you they are focused inside at the moment, but they see or learn how to do something that they think is beneficial to the industry, then they will have to make a decision whether they want to show what they can do with that. And some companies do that more transparently than others, but it will be early next year at earliest before we know what they see.

Greg Garner - Singular Research

So early next calendar year?

Gary Owens

Yes.

Greg Garner - Singular Research

And so I guess it looks very favorable, they made reaction to well I guess there is all speculation obviously here to purchase another order or to expand the existing one if they saw improved quite a bit or it normally just take some time really to gain data. It seem like it might for reservoir characterization.

Gary Owens

Yeah, I mean, someone like that can talk about the preparatory step we're doing, a job on another field and get prepared without actually entering into a contract. And so they're not going to wait till after they see evidence to begin evaluating where to put another one, but they're unlikely to put that in to a contract form or tender form until after they get some time under their belt.

Greg Garner - Singular Research

Thanks. That helps me understand that. And just a quick question on the OBX, the modules there, should I look at that as a similar revenue per module as a revenue per channel on the GSX is that totally off days or is there some course?

Gary Owens

Unrelated.

Greg Garner - Singular Research

Okay. So I guess we will just see as that revenue comes in as to what the typical revenue per module may be?

Gary Owens

Yeah, I think we need some history to be very reliable on that.

Operator

Our next question comes from Hamed Khorsand, BWS Financial.

Hamed Khorsand - BWS Financial

Couple of questions for you, on the remaining revenue piece of the shale order, is that portion where it's zero gross margin or is there just normal gross margin on the remaining piece?

Tom McEntire

Hamed, this is Tom. No, it's got margin in it. We shut most of the low margin or past (leave) items in the second quarter which hurt our margins from the reservoir side. So when we ship this final $1.3 million, it will have average margins.

Hamed Khorsand - BWS Financial

Okay. And then given that the Canadian winter is over, is there still a chance of any pending orders out there that you could capture or is this is for the next couple of quarters?

Gary Owens

There may be Canadian-based contractors who buy equipment but not for Canadian summer.

Hamed Khorsand - BWS Financial

And then from your Russian operations, is that the same thing goes wrong there, is it going to be more and other waters and start to think the Russian area?

Gary Owens

If it's not in Russia, it will be very close to Russia, I mean it is most likely their clients are going to be Russian and it is not Russian, so it’s have bordering geographical area.

Hamed Khorsand - BWS Financial

And the one thing I am having difficulty understanding in your comments is that you are saying that you are hearing capacity, but on the other front as I am saying is inventory is rising. So could you just comment on that as beyond just a raw materials, I mean, is it finished goods inventory rising as well?

Wick Wheeler

Some of it is. The OBX has been pointed out, there is quite a process in manufacturing that particularly unit that's for deepwater use. And to that end, hard what is important is to be able to react to customers needs when those opportunities present themselves. It doesn't really work very well and (inaudible) to next year. So to that end, we are in fact working to increase our OBX inventories than final goods.

Gary Owens

Let me add something to that, this is a brand new product for us and when you come up with the concept and you begin the engineering effort and you’re beginning early discussions with customers, you build up an expectation of what the demand is going to be and what a demand from a customer would look like. But as time has gone on, it appears to ask that a particular contract might be considerably larger than what we were anticipating and what we had the capacity to do.

So we are now trying to react to a different level of business than we were anticipating and because we don't have that kind of capacity to do, we are having to build up inventories to try to meet that as we are trying to increase our capacity which is going to take some time to do. So to Rick’s point, we are building up inventory because we can't build, we don't anticipate that we are going to be able to build it fast enough for some of the larger orders.

Tom McEntire

It’s notable to mention that inventory build I would say is equally or more related to the Statoil order not just OBX. So I think you will see certainly from the Statoil side when we start shipping these systems over to the North Sea, then you are going to see reductions in those quarters where we ship out big components of this Statoil system.

Hamed Khorsand - BWS Financial

And my last question is, without any kind of a big contract announced and increasing headcount and just spending capital spending, could operating margins return back to last year’s levels or was it hugging the 29% line or was it going to be north of 30%?

Tom McEntire

I'm going to give you the Bill Dezellem answer. If you dig on either side (inaudible), it’s going to be product mix oriented and earning, you need to give me more information so I can respond to your question.

Hamed Khorsand - BWS Financial

Well, I mean, I'm just looking at it from the standpoint as to you are dependent on large order contracts to keep the activity going, but you are adding headcounts, you are spending a lot more. So we are gradually seeing operating margins decline. So I'm just trying to figure out if operating margins declined below 30% as we go forward and you guys are adding to the headcount more and more?

Gary Owens

We had increased headcount in operating, but the primary rise in employees are in manufacturing. So the reason you hired people in manufacturing is that you either have a demand or expected demand to build something and in that particular case it doesn't hurt operating margins because those guys are absorbing costs as we are building. But the test of all of that is what is demand at any one particular quarter and as time we are saying if that demand is focused on a certain product mix, it will be better and if it’s on the extreme opposite end of that product mix, it will what have the corresponding effect but we don't have expectations that it really changes but it can.

Operator

There are no further questions. I would like to return the conference to Mr. Owens for any additional or closing remarks.

Gary Owens

Thanks everybody for participating in the call and we will see you in about I guess 90 days, talk to you later.

Operator

Thank you. This does conclude today's teleconference. Please disconnect your lines at this time and have a wonderful day.

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