Seeking Alpha
Deep value, special situations, event-driven, arbitrage
Profile| Send Message|
( followers)  

Thesis

Gulfmark Offshore (NYSE:GLF) is currently selling for low valuations based on both book value and free cash flow due to short term uncertainty. While they are larger than most of the companies I follow, the company’s business is misunderstood by most investors, which has been a source of persistent undervaluation that entrepreneurial investors can take advantage of. There is also significant uncertainty surrounding the business, which has depressed the stock price.

What do they do?

Gulfmark owns and operates boats that enable off shore oil drilling. They operate boats ranging from AHTSs, which tow drilling rigs, to PSVs, which service them. Of note, they also operate two specialty vehicles designed to respond to disasters like oil spills, which I’m sure have been very busy with the recent BP disaster.

They currently own 73 vessels and operate another 14, for a total fleet size of 87. Also, they have two more large ships that will be delivered by year end. Gulfmark operates mainly in three areas: the North Sea, the Americas, and Southeast Asia.

Naturally, this business is highly dependent on oil and gas exploration, which in turn is heavily dependent on oil and gas prices. The Americas are mainly dependent on gas prices, while North Sea and Southeast Asia are mainly dependent on oil prices. If you have an extremely bearish outlook for either commodity, this likely isn’t the investment for you. If, however, you have a neutral or especially if you have a bullish outlook for the commodities, read on….

Do they have a moat?

Almost none. This business is as close to a commodity business as it gets. However, you can command higher prices if your boats have DP2, a form of GPS that allows your boat to anchor right next to a rig without crashing into it. All of GLF’s new boats have this.

The best way, however, to earn above average returns is to either be the lowest cost operator or to sign long term contracts at advantageous times. GLF has done a decent job of this, as they managed to stay profitable throughout the crisis thanks mainly to their long term contract cover. They also have between 40-50% contract coverage for this year and next, which gives them some degree of earnings stability and cash flow stability.

Operational risks?

The biggest risk is prolonged low oil and gas prices. The business requires a substantial upfront investment in the purchase of a boat. This makes the supply of the industry basically fixed in the near term. In boom years, high demand drives prices for supply boats up, and almost all of the increase in price flows directly to the bottom line.

In bust years, demand is substantially below supply, and boat companies are willing to supply their services for basically breakeven cash costs (pretty much the cost of labor), meaning most companies post substantial losses. You can see this cycle on any of the major companies bottom lines- GLF had annual earnings of $7.56 at the peak of oil prices, but this fell to $1.99 during the financial crisis.

Playing off that, the risk that has most depressed the stock price is fear of oversupply. In the next year, a lot of boats that were started during the oil boom will be completed and come online. Coming into a soft market, this could lead to a glut of boats and destroy day rates.

However, I think this is a relatively short term problem. In the next two to three years, I think demand should outpace supply, and GLF’s contract cover for this and next year should allow them to weather the storm of incoming boats. If you go to the HOS presentation I have linked to at the end of this post, they forecast that in 2013, the demand for new build boats will at least equal and most likely exceed the supply, which should lead to higher rates.

Valuation

Because this is a commodity business, I believe the company should sell for the value of their assets, perhaps a slight discount due to the cyclicality of the business. GLF currently sells for around 0.8x book value, and just below tangible book value. However, for reasons discussed below, I believe book value is substantially understated.

GLF makes a large initial investment in the boats, and then depreciates the boat over the next 25 years. Depreciation expense represents one of the largest expenses for the company, at over 16% of revenue. However, in the late 1970s, service companies built their first boats and decided to depreciate them over 25 years. Thirty years later, these boats are still very much operational and will be for another five to ten years.

Thus, the depreciation expense is extremely accelerated. Also, while depreciation represents a significant expense, boat companies have found that their boats actually appreciate in value over time. You can see this on the income statement of any of the major boat companies (look at TDW or HOS)- they consistently sell old boats for values well in excess of what they are recorded for on the books. Due to this, GLF’s book value is most likely substantially understated.

Finally, while this is an extremely capital intensive business, it does not require much reinvestment once the boats are purchased. As noted, the boats have proven to last for many years past their useful lives. The only maintenance capex needed for these boats is drydocking every two to three years. The drydocking expenses are minimal, between one to two million dollars when it happens.

Thus, annual maintenance cap ex can be estimated between $500k to $1 million per boat. I listened to Hornbeck’s management team, and the numbers they said suggested that annual maintenance cap ex number are at the lower end of this range. They own 55 offshore supply vessels (the types of boats GLF owns), 9 oil tank barges, and 10 ocean going tugs for a total of 74 boats (GLF owns a similar number of boats, though none of them are tank barges).

HOS estimates annual maintenance cap ex at $40 million per year. Looking through the financial presentation I’ve linked at the bottom, you can see GLF estimates substantially lower maintenance capex for their boats, averaging about 8-8.5 million a year. Compare this to the $60 million per year they depreciate, and you can see net income substantially understates the earning power of the company and that the boats require very little continued investment once they are operational.

Thus, GLF requires very little additional cap ex to keep operating their boats. Free cash flow was significantly negative throughout the past decade as the company completed a huge new build program that gave them the youngest fleet in the industry. With the new build program complete (the last two boats are delivered this year), GLF should start generating significant free cash flow that can be used to pay down debt or buy back shares.

Catalysts

GLF generates about 38% of revenues from the Americas segment; most of this comes from the Gulf of Mexico. There is tremendous uncertainty in this business due to the oil spill. I have no idea how this will affect earnings; my best guess is rates go up as everyone tries to rent vehicles to go drill wells and try other things to contain the oil spill.

The company also has a hidden asset. In 2009, they had to write off just over $46 million because a ship yard they had contracted with defaulted. SG&A has been increased the past few quarters as they undergo legal proceedings, and any recovery on this would increase book value.

However, long term, the company’s value will ultimately be determined by the level of offshore drilling worldwide, which in turn will be determined by oil prices. What I like about this play is there isn’t much downside if oil prices go down from here, while there seems to be tremendous upside if oil prices remain steady or go up.

Price target

I have a price target of $40 on GLF. I arrived at this by applying a 25% multiple to the current tangible book value. Recent acquisitions have actually been at multiples much higher than this; however, most of the acquisitions occurred during the peak of the boom years, so it’s difficult to use those prices as an indicator. I think applying a premium to book value makes sense, since many of these assets were purchased in a world of much lower oil and commodity prices, and GLF consistently sells boats 1.5, 2, or even 3x book value.

In closing, I just want to emphasis this is much more of a macro play then I normally recommend. Due to operational leverage, earnings can swing wildly with increases and decreases in off shore exploration, which could be significantly impacted by the oil spill. Still, I feel comfortable recommending it as a value investment due to the understated book value and the fact an investor at today’s prices will likely experience little downside in the event of prolonged depressed oil prices.

References:

  • HOS presentation - here
  • GLF presentation - here

Disclosure: Author holds a long position in GLF

Source: Gulfmark Offshore: Significant Hidden Assets