Editors' Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.
Schlumberger Ltd. (NYSE:SLB) is the world's leading supplier of technology, integrated project management and information solutions to customers working in the oil and gas industry worldwide. it is one of the sector's dominant players along with companies like Halliburton Company (NYSE:HAL).
On the other side of the oilfield services sector spectrum are small companies like ERF Wireless Inc., (OTCQB:ERFB) a provider of enterprise-class wireless and broadband products and services, with a subsidiary, Energy Broadband, Inc. that provides terrestrial wireless broadband services to oil drillers in rural areas in the U.S. and Canada.
ERF Wireless, Inc. put out a press release on June 26, 2013, titled "ERF Wireless Completes Hearings of Arbitration Process With Schlumberger," which briefly described that it took Schlumberger Ltd. to binding arbitration over a contract between the two companies, which was signed in 2009.
A look into ERF's 8-Ks and 10-Qs and annual reports yield only minor references to the action that started with mediation in the fourth quarter of 2010. ERF's management has not discussed Arbitration in any detail, but anticipation seems to be growing as the ruling by the three-member arbitration panel should be forthcoming in the near future. The following is what our research has yielded regarding the reasons for the arbitration.
On January 16, 2009, ERF Wireless announced in a press release that it had entered into an exclusive reseller agreement with Schlumberger Information Solutions Remote Connectivity North America, a division of one of the largest oil field service and technology companies in the world, Schlumberger Ltd. According to ERF Wireless' 8-K dated January 20, 2009, "Schlumberger will exclusively resell the wireless broadband products and services of ERF Wireless in North American oil and gas markets, including offshore. The agreement requires ERF Wireless to exclusively provide its wireless broadband products and services in the oil and gas markets to Schlumberger for resell under the Schlumberger label. ERF Wireless may continue to provide wireless broadband products and services to its existing oil and gas customers in North America on a non-resell basis." This agreement should have been a catalyst in turning ERF Wireless into a much larger company. The contract contained minimum market penetration guarantees and minimum payment guarantees. The contract was expected to bring in about $120 million in revenue over the initial three-year term of the contract according to statements by ERF management on a March 4, 2009, investor conference call. But the contract did not generate any revenues for ERF because Schlumberger did not resell ERF's products and services. This matter is now headed to binding arbitration at the behest of ERF Wireless and ERF Wireless may be in position to receive a substantial cash award.
At the time of the agreement Schlumberger provided "the oil and gas industry communications services - including satellite, wireless, terrestrial, data and voice technology - for 15 years," according to an RCR Wireless article. The article dated February 2009 quoted Slavo Pastor, Schlumberger VP of Information Solutions, speaking about the agreement giving Schlumberger the "ability to deliver cost effective communications to the oil and gas industry in the ERF Wireless coverage areas… This will increase real-time activities and collaboration between remote sites and office-based asset teams." ERF Wireless, through its rural Wireless Internet Service Provider (WISP) networks, could deliver terrestrial based high-speed wireless internet broadband at 10 to 20 times greater speeds (1.5 to 5 Mb) than satellite (128Kb), which was, and still is, the predominate internet service at the drill sites. This tremendous data delivery advantage caught the attention of Apache Corp. (NYSE: APA) in 2008 and after some product development, Apache became ERF Wireless' first oil and gas industry customer as mentioned in an article on Bloomberg on October 21, 2009. ERF Wireless quickly grew its customer base to 10 customers in the oil and gas industry with its superior technology and competitive price for broadband communications. This is when Schlumberger approached ERF Wireless about a reseller agreement. At the time the agreement made a lot of sense - Schlumberger had the existing customer base and a large sales force, ERF Wireless had the superior technology offering at a comparable price. This should have been a strong collaboration for both companies.
After the agreement was signed, ERF Wireless did not receive any money owed from the minimum agreements in place in the contract, nor did ERF Wireless receive any new business from Schlumberger, which would have required ERF Wireless to provide equipment and technical support to install and service the equipment. When looking at the contract (here) there are a few possible explanations. One is the possibly that ERF Wireless had a material breach of the agreement, but that is not the case, as Schlumberger has not filed a counter claim against ERF's claims. Another potential reason is found in section 2.1(C) of the exclusive reseller agreement released by ERF Wireless in the January 20, 2009, 8-K, which states:
Exclusive Provider. Schlumberger agrees that it will consider ERF its exclusive provider of the type of wireless broadband products and services included in the services throughout the territory, provided that such collaboration is not prohibited by operation of law.
The exclusivity set forth in the previous paragraph is subject to ERF Wireless offering its services at commercial quality acceptable to Schlumberger.
The question of whether ERF's services were at commercial quality at the time of the contract is a matter of Schlumberger's opinion in the agreement. However, there is plenty of evidence that the services were commercial, as ERF Wireless has grown its oil and gas industry revenues with its original customers that were carved out of the Schlumberger agreement and ERF continued to service them on its own. The simple fact that ERF Wireless' customers continued as customers indicates the service was indeed commercial.
In November of 2010 Schlumberger sold its Global Connectivity Services (GCS) business to Harris Corporation for $397.5 million in cash, subject to post-closing adjustments. Although there is no indication that the sale was planed prior to January of 2009 when Schlumberger entered into the agreement with ERF Wireless, the discussions of the sale probably had to begin around the time of the reseller agreement for the acquisition to become a reality. The reason we believe a long lead-time was necessary on this sale was that Harris made two acquisitions in the satellite communications industry in 2010 and combined the companies to form Harris CapRock Communications, according to the November 8, 2010, press release from Harris. Harris acquired CapRock Communications in July of 2010, which indicates that initial discussions, extensive due diligence of assets in over 50 countries, merger and integration planning and price negotiations for both of Harris' target companies had to be ongoing for quite some time. It is speculation on the writer's part that Schlumberger would not want a company like ERF Wireless further eating into its US market share while negotiating the sale of GCS, and thus have the potential to negatively impact the sale price. The acquisition of GCS was announced in November 2010 but did not close until April 2011, which could have incented Schlumberger not to release ERF Wireless from the agreement, as the acquisition called for "post closing adjustments," which could have led to Schlumberger to have to return some of the purchase price back to Harris.
Another area of the contract to look into is section 10.3 of the reseller agreement dealing with "Termination for Cause." There is an interesting clause at the end of 10.3(ii), section 10.3 states:
10.3 Termination For Cause. Except as otherwise provided in Section 10.3 (B) below, either Party will have the right to terminate this Agreement immediately upon written notice at any time if:
(A) The other Party is in material breach of any term, condition or covenant of this Agreement and fails to cure that breach within ninety (90) days after written notice of such breach.
(I) With respect to ERF obligations, "material breach" will include (but not be limited to): (1) an act, inaction or occurrence resulting in Schlumberger's inability to offer the ERF Technology to the Oil and Gas Sector on an exclusive basis; (2) an act, inaction or occurrence resulting in Schlumberger's inability to offer the ERF Technology to the Oil and Gas Sector arising from an impediment to ERF rights as licensor or to Schlumberger's license rights (including but not limited to foreclosure of liens, ERF bankruptcy preventing Schlumberger's continued license rights, or similar occurrence); (3) ERF failure to provide personnel of sufficient education and/or experience to meet its obligations under this Agreement as set forth in Section 5.3; (4) if ERF becomes bankrupt; has a receiver or administrator appointed to it; compounds with its creditors or where proceedings are commenced for it to be wound up or to carry on its business; or (5) ERF failure to provide support under Section 5.4 after notice from Schlumberger and ninety (90) day opportunity to cure such failure.
(ii) With respect to Schlumberger's obligations, "material breach" will include (but not limited to): (1) failure to pay amounts due; (2) breach of the license rights and other restrictions imposed by this Agreement; (3) Schlumberger's failure to make reasonable efforts to sell the ERF Technology in the Oil and Gas Sector; or (4) Schlumberger becomes bankrupt; has a receiver or administrator appointed to it; compounds with its creditors or where proceedings are commenced for it to be wound up or to carry on its business. The Parties agree that ERF will have the right to terminate the Agreement under Sections 10.3(ii)(1) and (2) by giving notice and a ninety (90) day opportunity to cure any breach. The Parties agree that ERF will have the right to terminate the Agreement under Section 10.3.(ii)(3) on the fourth (4th) anniversary of the Effective Date. (writer's emphasis)
This last sentence is very interesting as termination of the agreement for cause due to a material breach was the right of either party (ERF Wireless or Schlumberger) requiring a written notice and a 90-day cure period.
If the breach was not cured, the contract could be terminated at the end of the 90 day cure period except in the case of section 10.3.(ii)(3), a material breach of "Schlumberger's failure to make reasonable efforts to sell the ERF Technology in the Oil and Gas Sector." In this one case ERF could not terminate the contract until the fourth anniversary of the Effective Date. The fourth anniversary of the Effective Date is a year after the expiration date of the three-year agreement. The only thing that saved ERF Wireless from bankruptcy, due to this reseller agreement, is the fact that the founder and CEO, Dr. Dean Cubley, and his family invested several million dollars into ERF Wireless to keep it solvent and viable. Dr. Cubley and his family have invested over $15 million in ERF Wireless since its inception. If ERF Wireless had gone into bankruptcy Schlumberger would have been able to terminate the reseller agreement due to the material breach of bankruptcy of ERF Wireless in section 10.3(4) of the reseller agreement.
From Schlumberger's perspective, this arbitration is probably no more than an irritation. Schlumberger has a market cap over $100 billion and cash of $5.9 billion according to Yahoo Finance. Whatever happens in the Binding Arbitration, it will be of no real consequence to Schlumberger. In the case of ERF Wireless, it looks like the little guy has a chance simply because they are still around. ERF's management must have made a large investment in these arbitration hearings, which indicates it feels is has a case that has a great amount of potential value for the company.
The real speculation game is what will the arbitrators believe.
This is not the first case of a large company securing the exclusive rights to the product of a smaller company and then for whatever the reason the larger company failing to sell the product causing harm to the smaller company. However, there are minimum sales requirements in this agreement and the Binding Arbitration will attempt to quantify what, if anything, is owed to ERF Wireless, and force payment of that amount. If the management of ERF Wireless was correct on the conference call and the minimums were worth over $100 million over the life of the contract, the ruling stands to be a very significant event for ERF Wireless and its shareholders. ERF Wireless has about 17 million shares fully diluted, including the insiders' preferred super voting rights shares, which means that for every $25 million the company is awarded, share value goes up over $1/share.
Since the exclusive reseller agreement expired in January 2012, ERF Wireless has been marketing its technology and has found new customers, including a new Fortune 200 oil and gas exploration company. ERF Wireless grew oil and gas revenues 90% in 2012 according to an interview with the CEO, and the gross margins expanded over 200% in the third quarter of 2012.
On a fundamental basis the share price of ERF Wireless looks undervalued, as the shares of ERF Wireless were $3/share in January 2012. Any award or settlement ERF receives from the arbitration will be an added bonus. Additionally an award will be more valuable than the cash amount if ERF's management utilizes this money to grow the company more rapidly in areas where customers are growing like North Dakota, Texas and Oklahoma. If this expansion takes place any award will increase the value of the fundamental business. ERF Wireless could be a big winner, not only in the Binding Arbitration outcome but also for the 12 to 24 months afterwards.