TGC Industries, Inc. (NasdaqGS: TGE) is a small-cap seismic survey company that helps oil and gas companies find oil and gas. Over the past 5 years, TGE performed spectacularly well: it grew its revenue >12-fold, its fully-diluted EPS > 18-fold and its free cash flow >32-fold. However, its sales have stumbled badly in 2009Q2 in a sector-wide rout. As a result, it is available for what we believe is an attractive price of 3.8x EBIT and 2.8x FCF.
Seismic data acquisition industry
Seismic data acquisition companies are hired by oil and gas exploration companies to blast sound (and sometimes dynamite) into the ground (or underwater), capture the echoes that come back and formulate an underground map of the Earth’s strata which can help pinpoint the locations where oil and gas are most likely to be found. This in turn helps optimize drilling activity. It also helps oil and gas companies “manage” more mature fields by delineating exactly where the oil and gas pockets end, and how much is left.
Seismic surveys are performed by “crews.” Each crew numbers 35-45 members, and a lot of specialized machinery. One crew costs around $7m to operate, all in. TGE discloses the number of crews it operates on a quarterly basis.
Seismic survey industry growth is primarily driven by oil and gas prices. As these prices rise, more exploration activity becomes economically feasible, and more seismic data acquisition projects are commissioned. As the price of oil rose from around $40/barrel in 2004 to about $90/barrel in 2008, the number of seismic crews operating in the US (onshore) rose from 50 to 73. However, as oil dropped back to $40-45/barrel, the number of seismic crews dropped to 60. So overall, the number of crews has declined more slowly than the price of oil, and is at higher levels now than it was the last time the oil prices were at current levels. We believe this indicates that seismic data surveys have become more of a competitive necessity and demand for these services is likely to grow faster than the broader energy industry.
At first blush, seismic sounds like a highly volatile, high-tech industry where an upstart can easily displace incumbents through superior technology. TGE and its competitors boast about their “state of the art equipment” on websites and in SEC filings. However, we have reason to believe the pace of innovation is not so rapid, and barriers to entry are higher than they seem:
- Market concentration: The top four public competitors deploy about 50% of the crews working in US onshore. The competitors are TGE, Dawson Geophysical (DWSN), Geo Kinetics (GOK) and CGG-Veritas (CGV).
- Market share stability: Total market share for the same top four competitors has held remarkably steady at ~50% since at least 2005. Each of these competitors have been around for a lot longer.
- Slow technology adoption curve: Seismic data gathering is done using several methods. The oldest is “2D.” The most currently popular method is “3D” and the newest is “4D.” We won’t go into technical detail on the exact differences between these methods, but suffice it to say the newer methods are more technically sophisticated and more expensive. If seismic were a highly innovative industry in high flux, one would expect that newer and newer methods to be introduced and adopted in quick succession, kind of like PC chips or hard drives. However, adoption of the “3D” method went from 88% of US onshore crews in 2000 to 96% in 2009, giving us +8% adoption in 10 years – hardly Moore’s law. To be sure, there are incremental improvements in the technology deployed, but we are skeptical of the “permanent revolution” PR being promoted by the industry.
- Senior-level sales: According to TGE, most sales depend on interaction with customers at the executive level, and are “based principally upon professional relationships developed over a number of years.” This could help explain why the cast of players does not seem to change much from one year to the next.
Why is TGE different?
TGE has been in business since 1986, when it was spun off from another Texas-based seismic company. TGE distinguishes itself from its top three public competitors (DWSN, GOK, CGV) in a couple of strategic ways:
a) Market focus: TGE focuses exclusively on the U.S. exploration market. Furthermore, most of its work is done onshore. A small minority is done on land-to-water. The three competitors have a much more diffuse geographic focus, and do both ground and water operations.
b) Standard equipment: TGE standardizes the equipment among its crews to ARAM Aries. We believe this is a significant and under-appreciated benefit: It makes crews and hardware more fungible, and improves the logistics: Every crew is trained on every piece of hardware. It also improves TGE’s purchasing power with its vendor. TGE is smaller than its four competitors, so it’s easier for TGE to maintain a standard hardware environment.
c) High insider ownership: Officers and directors own 28.7% of TGE shares outstanding, a much higher percentage than at competitors. We believe this is primarily a positive, in that it provides a lot of shareholder/owner alignment. This alignment was evident in TGE’s aggressive cost cutting in response to slowing demand in 2009 (more on this below).
As a result of these differences, TGE has achieved higher returns on capital (ROIC) and faster revenue growth than competitors over the past 5 years:
| 5yr Avg ROIC | Revenue Growth, 2009 vs. 2003 |
CGV | 28% | 5.49x |
DWSN | 21% | 5.46x |
GOK | 3% | 14.79x |
TGE | 36% | 12.27x |
Only GOK grew faster than TGE, but this growth came at the cost of much lower profitability, and was probably value-destroying: GOK had negative free cash flow of over $40m in the five year period.
TGE’s revenue growth happened because of market share gains as well as productivity increases:
- TGE’s share of US onshore seismic crews from 6% in 2004 to 12% in 2008, and
- Annual revenue per crew rose from $6.7m to $9.6m in the same timeframe. We believe this reflects price increases as well as incremental increases in the sophistication of the equipment and services rendered.
Why is TGE Cheap?
Considering TGE’s growth and profitability, we believe it is cheap on a couple of metrics, including FCF/EV of 36% and EBIT/EV of 26%, calculation below:
Shares Outstanding (m) | 18.00 |
Price per share, 10/16/09 | $4.82 |
Market Cap ($m) | 86.76 |
Debt ($m) | 14.90 |
Cash & ST Investments ($m) | 30.60 |
Enterprise Value ($m) | 71.06 |
FCF, TTM 6/09 ($m) | 25.90 |
EBIT, TTM 6/09 ($m) | 18.60 |
FCF/EV Yield | 36% |
EBIT/EV Yield | 26% |
Why is TGE so cheap? Perhaps the biggest reason is the sharp decline in its number of crews: From 2006 through 2009 Q2, TGE operated at a steady 8-9 crew level. At the end of 2009 Q2, it downsized to four crews. This was a pretty drastic drop. In the latest analyst call, CEO Whitener said:
We have been experiencing weaker demand... We are also see continued price pressure and therefore our margins have deteriorated and are off from the normal levels. From my perspective this is the most severe downturn occurring in the shortest period of time in all my years of being in the business.
This downsizing happened too late to affect revenue in 2009 Q2 much, but it will certainly take away from 2009 Q3 and Q4 revenue. The question is: how bad will it get?
Downside scenario
Let’s assume TGE continues operating with four crews instead of eight, and does not grow further, ever. Considering TGE’s past record of profitable growth, this would be a very conservative scenario. TGE’s annualized revenue per crew for Q1 and Q2 2009 was about $14.7m. That’s if we assume conservatively that it operated 8 crews throughout the two quarters, and only downsized to four crews on first day of 2009Q3. From there, we can construct a pro-forma earnings-power estimate. In this scenario, EV is 6.8x EBIT: Not a screaming bargain but not very expensive either.
Pro-Forma Income w/4 Crews | ||
Annualized Sales / Crew | 14.7 | Based on Q1, Q2 2009 |
Crews | 4 | End of Q2 2009 |
Total Revenue | 58.6 | |
EBIT Margin | 18% | 2004-08, Avg |
Steady-state EBIT | 10.46 | |
Current Enterprise Value | $ 71.06 | |
EV/Steady-state EBIT | 6.8 | x |
We think it’s interesting to note that TGE was very aggressive in cutting costs (crews) when it saw its demand dropping – more so than competitors – and was therefore successful in staying profitable and even generating peak FCF through the down-cycle so far.
In reality, as we’ve seen above, TGE has had the most profitable growth of its competitor universe. It is also expected to grow the most in the future: analysts forecast TGE’s EPS to grow 41% over the next 5 years versus 20% for GOK and 10% for DWSN.
We do not believe the drop in crew capacity is due to a unique aspect of TGE because it can be observed industry-wide: U.S. onshore seismic crews dropped from 72 in March 2009 to 60 in June 2009, a 17% drop.
Upside Scenario
The upside scenario is that TGE returns to the 8 crew level (say, by 2010 Q3) at which it’s operated over the past few years. TGE is currently trading at 2.75x FCF whereas its competitors are at an average of 6.16x FCF. If we apply the competitors’ multiple, TGE would be worth about $10.80/share.
There are a couple of other recent developments that could provide additional upside, although they are not counted in the valuation:
- On Oct 16th, TGE bought Eagle Canada, a small seismic data and survey provider based in Calgary, out of bankruptcy court. TGE paid $10.3m in cash. Eagle Canada had revenues of $26.5m in 2008, so TGE paid about 39% of 2008 sales. Given TGE’s valuation, this should be accretive right away. I think this acquisition also illustrates the types of opportunities available to players with the strongest balance sheets, like TGE.
- TGE has begun assembling a “data bank” of gravity and magnetic data covering many of the major oil and natural gas producing areas in the US. This can potentially lead into a new business model where companies purchase the data rather than commissioning a new survey each time. The data bank does not bring in significant revenue yet, but we think it could be quite interesting if successful.
Catalyst
- TGE returns from 4-crew level to something closer to its long term steady-state of 8 crews
- Credit flows more freely to exploration companies, boosting their CapEx, which in turns drives more Seismic business in the US
- Eagle Canada sales and crews show up in TGE’s financials in 2009 Q3, Q4
Disclosure: No position in TGE
