- Odyssey's SS Central America salvage value currently in excess of $32mn.
- Odyssey's share of estimated proceeds so far is worth greater than $18mn.
- Court filings indicate that the remaining salvage could be much larger than expected.
- Alleviates balance sheet concerns and allows investors to focus on longer-term projects.
- Oceanica environmental application complete; strong national support in Mexico.
Odyssey Marine (NASDAQ:OMEX) took the opportunity afforded by its annual general meeting (AGM) to update shareholders on significant progress in the company's three principal initiatives. Of particular note, the company hinted at a recovery that has already yielded in excess of $30mn from the SS Central America (SS CA). This early success comes after only a few weeks of operations and bodes well for additional substantial recoveries.
Additionally, the company highlighted the fact that the Oceanica environmental filing is complete and awaiting submission. Domestically-sourced fertilizer feedstock projects are receiving attention at the highest levels of Mexican government because of their strategic nature.
This brief note will address the significance of the initial SS CA salvage results. It will also consider compelling new evidence from recent court filings supporting the case for a larger salvage than most expect from the SS Central America. It will outline some of the reasons OMEX shares have been weak recently, and review information from the AGM regarding Oceanica and the HMS Victory.
Living Up To Its Name
News of Odyssey Marine's SS Central America recovery has been limited due to the fact that the Receiver is in charge of information flow. The court-appointed Receiver has every motivation to keep news about the success of the operations to a minimum. He doesn't want to interfere with the admiralty judge, and his job is made easier if he is able to manage expectations of the various factions that are clamoring for a cut of the proceeds.
Yet, the Ship of Gold is delivering, and we now have evidence to support this fact. Clues provided at Odyssey's AGM on Wednesday indicated that the value of recovered items on board the Explorer, as of a few days ago, was in excess of $25 million. When added to the approximate value of $4 million from the first salvage, and additional gold from ongoing operations, the total is now likely to exceed $30 million.
At the AGM, Odyssey spoke about the fact that they've already recovered over $100,000 of face value in gold. At $20/oz this translates to over 5,000 ounces. This gold is likely a mix of ingot and coin, both of which can be given approximate value, based on comparable transactions.
There is an active market for SS CA ingots, and we can get a good read on value looking at recent Heritage Auctions. Ingots have recently traded for between $2,800 and $7,600/oz, depending on ingot size. For this exercise we will assume that RLP/OMEX can sell the ingots on the lower side of the range at $4,000/oz wholesale.
SS Central America double eagle coins regularly trade north of $10,000 on eBay and the wholesale spread is said to be 10-15 percent. Mark Gordon noted on Odyssey's year-end call that they had monetized Republic gold coins at around $6,700 in 2004. Notably that figure includes some less valuable $10 pieces, and the monetization occurred at a time in which gold was selling for one-third the price it sells at today. To remain conservative, however, we will assume that the SS CA gold can be sold at the same $6,700/oz. Finally, we'll assume that 60 percent of the recovered gold is coin and 40 percent is ingot.
If these assumptions hold, the Explorer carries over $28mn in face value of gold. Further bolstering this argument, management also mentioned in the Q&A session that they were forced to increase their $25mn insurance line for recovered items aboard the Odyssey Explorer. Even if we're not precisely at $28mn, we know we're in the ball park.
Thanks to court filings, we also know that the initial recovery of almost one thousand ounces in ingots, is in custodial care with the Federal Marshals, and not on board the Explorer. Using the same ingot price of $4,000/oz yields a wholesale value of $4mn for this gold. Thus we get to at least $32mn in total salvage value, plus whatever ongoing operations are recovering (according to Greg Stemm, the crew is salvaging gold virtually every day at this point).
Odyssey is due $18mn of the first $32mn in known salvage value. If we use the Loan Agreement as our guide to understanding Odyssey's pay structure, it looks like $10mn is about where the breakpoint in fees should occur. Remember that Odyssey will receive 80% of salvage value until a fixed mobilization fee and day rate value are reached, after that it will receive 45 percent of the value. The Loan Agreement steps down the Advance Rate at a $5mn draw, implying that at approximately $10mn in bank salvage value Odyssey's anticipated costs are covered. Thus, if Odyssey recovered $32mn in value, they would get $8mn of the first $10mn in total value (covering projected costs & margin), and then 45 percent of the remaining $22mn, or $9.9mn. OMEX's total value received for a few weeks of initial work would then be approximately $18mn.
The market missed the first clue about the significant success around the operations when Odyssey reported a $4.8mn draw in an 8K on 5/16. That draw implied a total recovered value between $13mn and $20mn, but the market assumed much less.
The reason for the discrepancy lies in the terms of the Loan Agreement with Fifth Third. Under terms of that agreement, OMEX is only given credit for double eagles and gold bars. Since the operation is likely finding passenger gold at this point, a material amount of the recovery is probably coming in the form of other coins, jewelry, nuggets, and other precious artifacts. Further, the collateral values ascribed to the double eagles are below market rates.
The fact pattern from the salvage thus far suggests the SS CA will be a very rewarding operation for OMEX and RLP. Odyssey brought up 60 pounds of gold in the first two-hour reconnaissance dive. The company then spent a couple weeks undertaking set-up and pre-disturbance surveys of the site which were required before the actual recovery began. Following the survey work, OMEX has spent two to three weeks operating, and has salvaged in excess of $25mn in additional value. In fact, according to Greg Stemm's comments at the AGM, the salvors hadn't even begun excavation of the ship's hull until just a few days ago. The rate of recovery as well as the unfinished business must be seen as extremely promising.
Finding large quantities of gold quickly doesn't necessarily mean that there are vast quantities remaining at the wreck site. It's a very strong indicator, however, and when you pair it with commentary from people who have seen the wreck site multiple times and studied its history for decades, it becomes even more convincing.
Bob Evans, Chief Historian for Thompson's original salvage, and someone who may know the SS CA better than anyone in the world, believes that "tens of thousands" gold coins remain to be found. Tommy Thompson has said that more than 18 tons of gold remain, and Dr. Charles Herendorf, Chief Scientist for the original group, concurs. The value of remaining gold that these experts imply begins north of $120mn and ends at points much higher.
Ironically, additional support for a large salvage comes from CADG. Tommy Thompson's firm has been locked in a battle with RLP over the unsealing of inventory records from the most recent salvage. Unsurprisingly, CADG, which gained notoriety for its lack of disclosure and alleged fraudulent behavior, wanted the inventory records kept secret. RLP, perhaps wishing to distinguish itself from Tommy Thompson by making records more transparent, asked to make the inventory public following CADG's attempts to malign current salvage operations in the media.
Below is commentary from a Motion filed a couple weeks ago by CADG regarding the unsealing:
The sealing of the inventory of recoveries is necessary not only to the protection of the archeological provenance and historical significance of the S.S. CENTRAL AMERICA wreck, but also to the preservation of the value of the remaining Down Gold which constitutes a national treasure of epic proportions. (my bolding)
In RLP's response to CADG's Motion, the Partnership noted that the initial success had been "dramatic" and that, "It anticipates continuing future successes."
Virtually everyone who is closely involved with this salvage (or those in the past) is expecting a significant recovery. RLP, CADG, OMEX, Evans, Thompson, Herendorf, and other experts believe this will be a large recovery. Most of these individuals have seen the wreck, they've witnessed some of the gold that remains on the site, they know the history and other facts that you and I do not. It is only stock market investors who seem to feel differently for now.
Several weeks ago, I published a short blog entry assessing the prospects for the SS Central America recovery and noted the following:
I believe OMEX will ultimately net somewhere between $25 and $100mn from the excavation, but the range of possible outcomes runs from zero to north of $500mn.
Based on the pace and status of recovery, management's posture and tone at the AGM, and the commentary and actions of RLP and CADG, I am beginning to think that Odyssey's net is more likely than not to fall in the middle to upper portion of the $25-100mn range.
What would a $50mn net (~$105mn gross wholesale) recovery mean for Odyssey Marine? A recovery of this size would benefit the company from several perspectives. First, stating the obvious, it would remove any liquidity concerns. Since much of the recent 30 percent decline was due to these concerns, the relief of this pressure would be meaningful. Second, it would give the company a very healthy balance sheet to begin the next high-probability salvage (commodity or HMS Victory) so that OMEX is not forced to rely on project finance, and can retain a larger proportion of the project's net proceeds. Third, and perhaps most important, it would provide yet another convincing data point validating OMEX's strategy of salvaging lower-risk, commodity-type shipwrecks.
Technically, the SS CA is a historic wreck, however, because the company was given the precise coordinates, had high confidence that there was remaining salvage value, signed a very secure contract, and anticipated an easily monetizable cargo, it was close enough to fit the new program. Odyssey has now proven the point that profitably salvaging shipwrecks while doing high quality archaeological research is a sustainable model (Garisoppa, Republic, Central America), and they may be the only company in the world to have proven this in so many instances. Success begets success, and this work will likely lead to more projects beyond the company's already announced pipeline of deals.
Breaking The Cycle Of Fear
Odyssey quickly lost 30 percent of its value following its quarterly update a few weeks ago. The most obvious reason for the decline was that the company's cash balance had deteriorated to levels that left investors uncomfortable. Many investors didn't understand why management would allow the balance sheet to be presented this way. Some feared that the company was facing a liquidity crisis and doubted management's assurances that plenty of non-dilutive capital was available. After all, they reasoned, why would OMEX's management let cash balances fall to these levels if they had real options?
The answer to the above may not satisfy the concerns of some investors, but I'm convinced it is the truth. If you look at Odyssey's history, the company has reported many quarters in which its balance sheet was considerably more tenuous than it was when the most recent quarter was reported. For instance, at year-end 2010, the company finished with just $235k in cash and more than $19mn in current liabilities. Management has always found a way to survive these episodes, so the fact that cash balances were at $5.8mn at quarter-end didn't trouble them in the least.
The other factor is that management knows a lot more than we do about the progress of the SS CA salvage and OMEX's various financing options. This knowledge gave them confidence to pay down over $13mn in debt during the first quarter, an action that revealed little concern of an impending liquidity crisis. The problem was that they wrongly assumed that the market would appreciate their informed reassurances when the balance sheet was unveiled.
As is obvious now, investors generally don't share management's perspective. Shareholders worry about the fact that in the past, when times got tough, management answered by issuing equity or some other type of dilutive financing. They have taken the perspective that history will repeat.
This balance sheet narrative makes sense and is at least partially correct. Yet, there's more to the story. Nothing about the quarterly financial statements was a surprise to the market. We all know approximately how much cash OMEX burns, and we knew that the company would run out of cash at midyear were they not to generate cash, cut spending, or complete some form of financing. We also knew there had been little or no operational income, and no financings during the quarter. Thus, the fact that the stock dropped so precipitously was a surprise. A common refrain amongst shareholders that day was, "What am I missing?"
What we were missing was the Russell 2000 (R2K) reconstitution, which was crystallized on the last trading day in May. OMEX is currently included in the R2K, but investors betting that the stock would be excluded in the rebalancing tried to anticipate the company's removal, and sold (or shorted) shares before-the-fact. This is purely a technical feature. Investors playing the reconstitution trade don't necessarily know the fundamentals of OMEX, and they don't care to know them. They understand the mechanics of the Russell rebalancing and that's all they need to know. OMEX is near the bottom of current R2K stocks in market capitalization, and investors logically placed a bet that the shares would be excluded when the index is reconstituted.
Two investors in OMEX with large brokerage firms told me that their trading desks forecast that upward of 5-7 million shares of selling pressure were associated with the reconstitution. The rebalancing volume probably helped to perpetuate a cycle of fear in OMEX shares and added more pressure than the 5-7mn shares might have otherwise. Rebalancing pressure may partly explain why OMEX shares failed to respond to the good news regarding the bank draw and implied SS CA recovery.
As this article notes, the reconstitution trade is largely behind us. Most of the action takes place in April and May. By the time the formal reconstitution announcement is made in June, the stocks which are newly included or excluded have already made their moves. According to the experts, OMEX has largely priced-in exclusion from the R2K.
The Russell reconstitution is driven by market capitalization. It looks like the cut-off for inclusion in the R2K will come in at approximately $165 million in market cap. Stocks which are currently included in the index will remain in the index if they fall within 2.5% of the cutoff, so the effective cutoff is actually $160mn. This is approximately $1.88/share for Odyssey (if you look at the chart for OMEX on 5/13 you'll see how the stock went into freefall when it pierced $1.88 to the downside).
It's unfortunate that short-term balance sheet concerns cropped up at the same moment the rebalance was taking place, as the combination served up exactly what the shorts had been trying to engender for so long - fear. The long-term value in OMEX, however, has never been higher than it is now, and the reconstitution was a one-time event that is behind. Odyssey's market value can now return to levels dictated by fundamentals, such as the gold they are putting on the deck of the Explorer.
Management has made it very clear that this time is different, and that they have a variety of non-dilutive financing options. So, what are those options, and why are they so confident? Based on body language and what we know about the SS CA recovery, one option is to allow operations to repair the balance sheet. This is not a great stand-alone option for shareholders, as it will allow too much near-term uncertainty while we await further recoveries, bank line additions, and bank line draw-downs.
In his note on 5/16, Mike Malouf of Craig Hallum mentioned the possibility that the company might strike a deal that would presell the rights to future coin recoveries. Oceanica might also issue some equity or debt and use proceeds to pay OMEX the $9-$10mn it is owed. My guess is that management wouldn't discuss these options unless the terms had already been agreed for the most part - this would account for their confidence. This said, whether or not they deem any of the deals worth pursuing remains to be seen, and may be influenced by the pace of the ongoing SS CA recovery.
The most shareholder friendly manner for the company to repair its balance sheet is by adding value from operations. Additional cash cushion afforded by long-term debt or working capital would certainly be welcome, but these options only provide liquidity, they don't add value. This is why it is so heartening to see the SS CA operation begin to put value on the books of OMEX. The SS CA salvage is proving out the company's business model, and it is improving the company's net position in a more favorable manner than most are aware. This is very good news for OMEX shareholders and something the market will come to appreciate.
The idea that Odyssey won't be able to monetize the SS CA salvage rapidly enough to repair its balance sheet doesn't square with reality. The company has already effectively monetized $4.8mn in value and given the status of current operations, it appears that another $5.2mn will be available very soon (most of it is likely already available).
After the first $10mn of bank-assessed salvage value, Odyssey can monetize/draw at a rate of about $1 for every $4 assessed in double eagles and gold bars. I expect, however, that Odyssey will renegotiate its Loan Agreement to allow for the inclusion of other common items as collateral (as they mentioned on their last call) and to expand the facility.
If we assume that Odyssey expands the collateral pool under the Loan Agreement such that it comprises 85 percent of salvaged value, and we haircut our wholesale salvage values by 15 percent to align them with a conservative bank's assessment, then the formula for calculating available funds under the Loan Agreement would be 18 percent of incremental total wholesale value salvaged (0.85*0.85/4). Thus, approximately each $27.6mn in total salvage value over the initial $10mn threshold yields access to $5mn in cash. Based on this logic, Odyssey is not far from having access to an additional $5.2mn under the Loan Agreement. They would have access to an additional $10mn at $65mn in total value, and so on.
This cash may also be supplemented in the near-term by the sale of one-offs. Some of the less common items (jewelry, one-off rare coins, and gold bars) might be sold more immediately by RLP to produce near-term cashflow. For instance, Thompson found a handful of these rare "slugs" on the SS CA, one of which was purchased recently for $600,000. This could allow for quick monetization of value included and excluded from the Loan Agreement after the admiralty judge has ruled.
The last point is that some investors are under the mistaken impression that OMEX simply borrowed $4.8mn from Fifth Third to fix the hole in its balance sheet. This is not the case. The $4.8mn is just a conservative advance on part of the value due to OMEX from the recovery. The cash represents a portion of the value the company is adding through the SS CA operation. There's more of that value coming, and more cash from the bank as well.
With the high probability of an additional $5.2mn cash available very soon (and more becoming available in coming weeks from the SS CA), and the prospect of $5mn-$10mn in cash from other financing sources in the near-term, it appears that concerns over Odyssey's balance sheet should quickly recede. If we add these two sources to the over $8mn in cash Odyssey referenced on 5/15, the total could exceed $23mn in cash in the next several weeks (we could deduct operating expenses and make an allowance to reduce some current liabilities to make the figure more accurate). This would represent more than enough cash to get the company to its next salvage project, and most likely to a full monetization or partnership for Oceanica. Going forward, hopefully management will appreciate the need to signal the market by showing a healthy cash cushion regardless of how little cash they believe the company needs to operate.
Short-sellers have proposed that the legal proceedings surrounding the admiralty case of the SS CA will complicate and delay the monetization of the recovered valuables. The reality is that this is not the case. The matter in court will have been decided well before these items are sold. One-off sales would have to wait for resolution, but these items won't be ready to sell for weeks.
The majority of salvaged items were never going to be sold immediately. RLP would want to package the recovery together in some form, so they would likely wait until the operation is complete or mostly complete. Any buyer of coins in bulk would want to know if all of the gold had been recovered before making a big purchase. Also, the recording, inventorying, and evaluation of so many items is going to take time.
Judge Smith is recognized as having a "rocket docket" per recent court filings, and she has established a time frame for resolving the substitution matter. Based on Judge Smith's comments, it appears she is very skeptical of CADG's position (rightly so) and likely wants the matter resolved quickly.
As explained in a previous article, the legal issue is a non-issue. Tommy Thompson's CADG can make all of the noise it wants, but the facts remain the same. Thompson is a federal fugitive and CADG is run by someone who seems to have seized control of the company illegally - without permission of the owner. There is a very realistic chance that the admiralty judge throws out CADG's case on the basis of the fugitive disentitlement doctrine. RLP just recently made this Motion.
Regardless of these circumstances, and of how the admiralty matter is decided, the Ohio court has jurisdiction over both CADG and RLP and has already ruled that RLP acted exclusively as CADG's agent with respect to the SS CA. Thus any ownership rights of CADG with respect to the SS CA revert automatically to RLP regardless of the admiralty court's salvor-in-possession ruling.
CADG cannot win this fight, and Judge Smith has already established a timeline to resolution which will pass before RLP is ready to market the gold. OMEX will continue to monetize its rights to SS CA proceeds through the bank facility as the recovery proceeds.
The AGM highlighted the fact that Oceanica has completed the environmental application and is in the process of submitting the final version. The company is confident that the work they've done will halp pave the way for a smooth environmental approval process.
The reception that Oceanica will receive in Mexico is highly influenced by the strategic nature of the asset. As noted in previous comments on the subject, the Mexican government has made very clear its intention to develop a home-grown fertilizer industry. President Nieto has made the initiative known directly in the press, and indirectly through Pemex (the state-owned oil company).
It's no wonder that bringing fertilizer self-sufficiency to Mexico has become a political imperative. The "tortilla-riots" of 2007, which posed a real threat to the political incumbents at the time, were coincident with a massive spike in fertilizer prices. Further, Mexico doesn't fertilize 60 percent of its farmland and imports nearly 90 percent of its fertilizers. Bringing fertilizer production to Mexico will help the President advance the interests of small farmers, feed the population, and at the same time improve the nation's balance of trade.
Pemex just recently initiated its fertilizer plan, buying a dormant urea plant in Veracruz for almost $500mn (including costs to restart the plant). This ticks the nitrogen box for Pemex. They still need deals to feed the country with phosphate and potash. As this article notes, "Pemex's petrochemical branch is pursuing three alliances with private companies to increase fertilizer and ethylene production that will probably be announced this year." It's hard to imagine that one of those private companies isn't Oceanica, given the scale, national importance, and quality of this project.
Oceanica appears to have a high likelihood of gaining environmental approval in the next quarter. Widespread political support for new fertilizer sources at the highest national levels will go a long way to help secure approval. The 1,200 page, scientifically-validated environmental filing should be submitted within the next few days to a Ministry that has a supportive environmental approval process according to page seven of this document. Also, from the Mining Journal:
The key to Mexico's success is the pragmatic approach taken to permitting. Bruce McLeod, president and chief executive officer of Mercator Minerals, says: "In terms of permitting and government assistance, they have one of the most appropriate processes. Basically, if you have a project that can co-exist with the environment and you are ready to work with the local communities, you stand a good chance of getting a permit to explore and develop a deposit. The process is fair, transparent and it is about meeting the government's criteria." Link
As noted in a previous article, seabed phosphate extraction is a low-environmental-impact endeavor as long as it's undertaken in an area that is not environmentally sensitive. This is the case with Oceanica as it is far enough offshore (40km), in a remote stretch of ocean floor that is not used as a spawning ground or fish hatchery. Seabed phosphate operations can supplant environmentally unfriendly land-based phosphate strip mines. Oceanica's environmental filing demonstrates with organic studies, plume modeling, and various other empirical data, that the extraction process does not endanger the environment.
The other notable development regarding Oceanica was the news that Royal Boskalis (OTC:KKWFF) has been involved at a very granular level in helping to develop the concession. Boskalis is a $4bn revenue multi-national dredging specialist. Boskalis, which has received no payment from Oceanica/OMEX, would not be so generous with its time and expertise if the people there did not believe in the economic viability of this project. Boskalis's experience and input may partially explain why Odyssey believes the Oceanica phosphate can be produced with a very competitive cost-structure:
Boskalis is also involved in mining. Dredging techniques can be used for top layers which can be removed without the need for blasting. This allows for savings of up to 50 per cent compared with open-pit mining. Dredging techniques have been successfully used for the processing of mining products including gold, diamonds, rutile, phosphate, coal, iron ore and uranium. Boskalis Website
The environmental filing is complete according to management. We should learn more in the next few days after it is filed.
Anyone betting that OMEX will run out of cash has run out of luck. The SS CA recovery has made this clear. Additional financing sources may further underline the point in the weeks and months ahead. Shorts should also note that OMEX is capable of cutting its operational costs to virtually nothing if it ever feels it necessary. This is not in the game plan, however, as there are too many promising projects close to being harvested, and it doesn't make sense to do so.
Retreating balance sheet concerns and rebalancing pressures mean that investors can once again focus on Odyssey's long-term fundamentals. The SS CA, like the Gairsoppa, is demonstrating that OMEX's new business plan is finding success. The Oceanica environmental filing will occur in the next few days, and management believes that they will get a go-ahead on the HMS Victory project soon. Proceeds from any of these projects are likely to be multiples of OMEX's current market capitalization.
Additional disclosure: A final note of disclosure: I am not a lawyer and this note is solely a reflection of my opinion based on my knowledge of the circumstances. I consulted with an experienced admiralty lawyer in making my assessment, and we are in broad agreement on these issues. All the same, these are my words, not his. The Author has obtained all information herein from sources he believes to be accurate and reliable. However, such information is presented "as is," without warranty of any kind - whether express or implied. The Author makes no representation, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results obtained from its use. All expressions of opinion are subject to change without notice, and the Author does not undertake to update or supplement this report or any information contained herein. This is not a recommendation to buy or sell any investment. We may transact in the securities of OMEX at any time subsequent to publication.