SAExploration Holdings (NASDAQ:SAEX) became a public company when it was acquired by Trio Merger Corporation (TRIO), a special purpose acquisition corporation (SPAC), in early 2013. TRIO went public through an IPO process in 2011 for the sole purpose of raising cash to purchase a business. This particular SPAC was managed by Eric Rosenfeld of Crescendo Partners, an activist and event-driven hedge fund formed in 1998.
*You can learn more about Mr. Rosenfeld by reading this interview from the Graham and Doddsville newsletter here.
Prior to Trio Merger Corporation, Rosenfeld had successfully launched two other SPAC vehicles, Arpeggio Acquisition Corporation and Rhapsody Acquisition Corporation. Arpeggio Acquisition Corp. went on to purchase HIL International ($HIL), which generated a 4x return for shareholders from 2004 to 2008. Rhapsody Acquisition Corp. went on to purchase Primoris Services ($PRIM) which thus far has produced a 6x return since 2008.
Joel Greenblatt served as a special advisor to TRIO, and presumably had an opportunity to review and approve of the acquisition of SAExploration. He also owns a partnership interest in Crescendo Partners, and thus has some vested interest in the success of SAExploration.
SAExploration Holdings, Inc. conducts seismic data surveys in logistically complex, hard to reach topographies across the world on behalf of major oil and gas companies. The company captures data using a variety of wired and wireless sonar devices; processes the raw data using high-speed computers and non-proprietary software; produces 2D, 3D, or time-lapsed 4D seismic maps; and, interprets such maps for major oil companies giving them a much higher success rate in their drilling operations. SAExploration initiated operations in 2006 in Lima, Peru as South American Exploration, which was founded by current President and CEO, Brian Betty. Over the past eight years, the company has grown organically and become geographically diversified with operations in North America (mainly Alaska and Northern Canada), South America, and Southeast Asia.
The company is seeking to build a competitive advantage in geographically complex, logistically challenging environments. Those familiar with the industry understand there is very little money to be made in simply acquiring data, processing it, and producing the maps. This aspect of the business is actually highly commoditized. Nearly anyone with $100m could purchase the equipment and software, and hire the labor necessary to do it.
What is not easily replicated is the logistical expertise required to perform such work in hard to reach, complex environments. Acquiring data around the Cook Inlet in Alaska is a much different task than doing so in North Dakota or Texas. (You can get a sense for the difference by simply using Google maps to see satellite imagery of the different regions.) By focusing on this more difficult work, on average 80% of contract revenue for SAExploration comes from logistics services, while only 20% of revenue is derived from shooting and producing the maps. As you would expect, logistics work offers a much higher margin, which in turn produces greater returns on capital. And because superior logistics is dependent on experience and expertise it is not easily eroded by natural mechanisms of capitalism.
SAExploration is also on its way to producing the best "quality, health, safety, and environment" (QHSE) track record in the industry, ever. As of the latest press release in June, the company's record stands at 670 continuous days of zero lost-time injury incidents. QHSE is widely accepted in the seismic industry for measuring a company's operational excellence. While there is no enduring advantage given to excellence in operations, I do think there is a temporary "front-runner" advantage that cannot be ignored here.
Management recently indicated that the exploration and mapping industry is a $19B industry and growing. There is a general tailwind as drilling becomes more complex and reserves become more difficult to access and assess.
In the shorter term, oil and gas exploration and production spending levels depend materially on the price of oil and gas. Higher prices in oil and gas create greater margin for major integrated oil companies to spend on mapping services. During such a cycle, oil and gas companies increase their budgets for exploration and production activities. Falling prices, however, impair margin and have the opposite effect on budgets. This dynamic creates cyclicality in the mapping business. That is important to understand because many players in the industry operate with significant financial leverage. Should there be a protracted global decline in oil or gas prices, it will result in restructuring and bankruptcy for marginal competitors.
Tax incentives and other development concessions can alleviate some of this cyclicality. Alaska is currently offering substantial tax incentives ($.40 - $.60 per dollar through 2016) to integrated oil companies for exploration activity, thus it can be a worthwhile expense despite significantly lower oil and gas prices. Similar dynamics exist for major oil companies that have been granted development concessions with certain foreign countries. Such concessions require companies to spend a certain amount on exploration, or face substantial penalties for not doing so. Both tax incentives and development concessions make it economic to pay for mapping even if there is lower margin on drilling and extraction.
Seasonality and Geographic Diversity
Geographic diversity is critical for a public company in this industry, as it allows the company to report smoother earnings throughout its fiscal year. (Although I am not concerned about smooth earnings, many institutional investors show preference for it). Without diversity, earnings are likely to be lumpy, as there is much seasonality in the operations of the business if they are concentrated to one area of the world. For example, much of the work done in North America can only be done in winter when surfaces are frozen. In the remaining warmer months, work slows dramatically, and with a significant fixed cost structure, earnings fall materially.
In 2013, the company generated 46% of sales in North America (predominantly Alaska and Northern Canada), 46% in South America, and 8% in Southeast Asia. The climate patterns in these geographies are diverse and allow for near optimal utilization of the company's assets and personnel. Over time, Management hopes to generate a third of its sales in North America, a third in South America, and a third in Southeast Asia.
Recent Revenue and Cash Flow
On June 13, 2014, management reported backlog of $283m. This figure included $74m of new contracts that were recently awarded to the company. Management expects to convert 65% of the backlog, or $184m into incremental revenue during the remainder of 2014. Remaining $99m should be converted into revenue in 2015.
At the time the company released its 1Q 10-Q, backlog was at $322m. A couple of observations about the change in backlog from March 31st to June 13th: (1) the decline from $322m to $283m is to be expected given typically light 2Q when work in Alaska and Northern Canada is completed, and equipment and personnel transitions to the Southern Hemisphere; and (2) removing recent contract wins of $74m from recently reported backlog of $283m gets us to $209m, suggesting a substantial amount of the backlog ($50m - $100m) was converted to revenue between this time period.
Peers in this industry are valued on an Enterprise Value to EBITDA multiple. So it would make sense to quantify an average EV/EBITDA across a diverse group of SAExploration's competitors. The problem with that approach is most of SAExploration's peers are involved in developing non-propriety libraries of seismic maps, which are held on their balance sheet, and amortized over time on the income statement. As a result, these companies report an artificially high EBITDA, as these amortization expenses are added back into that particular measure of cash flow.
So we have to make a subjective adjustment to the average peer EBITDA multiple to account for this difference in operations, as well as the difference in growth expectations. Based on recent publicly available data, the average peer multiple is approximately 5x. I think 6x - 8x is more appropriate for SAExploration given the differences I noted previously.
I expect the company to earn about $337m in revenue this year based on 1Q sales figures and what I expect the company to convert into revenue from their published backlog. (This assumes no further growth in 2014, so I believe it to be a relatively conservative assumption). Reaching this level of revenue will allow the company to use their capital efficiently, and achieve an EBITDA Margin of 15%.
$337m Revenue * 15% EBITDA Margin = $50.5m EBITDA
Management has guided 2014 EBITDA to come in between $45m and $55m, so $50.5m is right at the midpoint.
*It's worth noting that management is incentivized to the tune of more than 496,000 shares if it achieves at least $52m in EBITDA this year.
Enterprise value of the business is approximately $262m based on a market cap of $126m, and pro-forma debt and cash of $150m and $13.4m, respectively.
$262m EV / $50.5m EBITDA = ~5.2x EV/EBITDA
If we apply our midpoint EBITDA multiple of 7x to $50.5m we get an Enterprise Value of $353m. We come up with an equity value of $217m by subtracting a net debt position of $136m. An equity value of $217m translates to approximately $14.50 per share with 14.8m fully diluted shares outstanding.
Based on today's prices that equates to a base case upside of 70%.
An alternative approach would be to value this company on a free cash flow basis. To come up with an estimate of free cash flow, I'll use the following measure: FCF = EBITDA (unadjusted) - Maintenance Capital Expenditures - Interest Expense - Taxes.
We'll start with the assumption that the company earns $50.5 EBITDA based on $337m in revenue and a 15% EBITDA margin. Maintenance capital expenditures are very low as this is a capital light (think logistics) business model. Management has suggested maintenance capital requirements are less than 2% of revenue on an annual basis. I estimate it to be something closer to 1% of sales based on the fact that the company's equipment is brand new. On 1% of revenue, maintenance capital expenses are $3.3m. Interest expense will be $15m per year based on $150m debt issued at a 10% coupon. Taxes will be approximately $12m this year. This is extremely conservative as it assumes about a 70% ongoing effective tax rate. Based on recent hiring of tax advisors, I expect this to come down in line with a more average effective rate of 35% to 40% in the next year or two.
Putting that together I get:
$50.5m EBITDA (unadjusted) - $3.3m Maintenance Cap-Ex - $15m Interest Expense - $12m Taxes = $20m FCF
Therefore, we're getting a conservative $20m in FCF on a market cap of $126m, which works out to a 16% FCF yield. If you'd prefer, you could apply a 10x multiple to arrive at an equity value of $200m. Again, with 14.8m diluted shares outstanding that equates to $13.50 per share.
Potential Reasons for Mis-Pricing
Given the general efficiency of the stock market in pricing businesses, it's important to spend some time thinking about why this particular one may be mis-priced. I come up with a number of possible explanations.
1. Operational issues in 3Q 2013 obscuring true earnings power of the business and creating greater uncertainty amongst potential investor base
During the 3Q of 2013, the company suffered significant (albeit temporary) operational issues, which resulted in negative accounting earnings during the quarter. The unexpected news caused a great deal of fear amongst investors, and as a result, shares sold off significantly. The reaction was likely exacerbated by the fact that the company had only been public for one full quarter prior to the mistakes.
Rational investors will see these events for what they were-temporary events that have no effect on the normal earnings power of the business. That said, average investors may be ignoring this business until they're convinced those one-time issues were indeed one-time.
2. Small and illiquid float
A majority of the 14.8m shares outstanding are currently held by insiders and directors, and as a result the float is only 3.5m shares. Average daily volume over the past 3 months has been roughly 18k shares, or $150,000 per day on an average price of $8.50 per share. Such low float prevents this stock from being added to small cap indexes. It has been argued that companies excluded from indexes are ripe for mis-pricing as capital continues its flight to passively managed products and consequently to stocks that are included in indexes.
3. Very little coverage by sell side analysts and blog platforms.
According to the company's website there are only 3 analysts currently covering the stock. Only 200 Seeking Alpha members are receiving alerts on the company. It is clear to me that very few sophisticated investors are paying attention to this company. With less coverage on the progress of this company, it's possible potential buyers are overlooking the opportunity completely.
4. No dividend
While a dividend in-and-of-itself warrants no premium to me, many investors are craving current income from their equity positions. Not offering a dividend is the right capital allocation decision in my mind, but it will cause many to take a pass.
Due to its short track record as a public company, operational mistakes last year, and accounting control issues this year, it will take time for investors to become comfortable with the business. It may take a full year or two before the financial statements reflect true earnings power under normal operating conditions, which means it may take at least that long until the market re-rates the company on a more appropriate multiple. Very few investors have the patience or the capacity to hold an equity investment with a duration extending beyond a few months. Investors are increasingly short-term oriented, and as a result institutional investors are hard pressed to add ideas to their portfolio that will take longer than a year to play out. Without this investor base, SAExploration will likely remain mis-priced.
The company recently concluded its $150m debt offering. Assuming the company retains about $13m for working capital, the company will have a net debt position of $137m. If the company gets to $50m in EBITDA this year that puts us at 2.7x Net Debt / EBITDA. By no means does this indicate over-leverage, but it does become alarming if there is a protracted decline in oil and gas prices, or additional operational errors that significantly delay revenues.
Interest coverage on the basis of EBITDA is a relatively comfortable 3.7x.
Decline in oil and gas prices
Should oil and gas prices fall severely and for a long period of time, the seismic mapping industry will suffer greatly. Many players in this space operate with significant financial leverage and have a material fixed cost basis. Should revenues fall due to fewer available contracts, many companies, SAExploration included, would be at risk of restructuring.
Decline in oil and gas prices plus operational mistakes plus leverage
A steep decline in oil and gas prices combined with an operational mistake or two and financial leverage would be a lollapalooza that would likely result in a bankruptcy. The probability of such a combination of events occurring simultaneously is very low, but it is a risk that needs to be accounted for in an upside-downside estimate.
For SAExploration, all of their revenue is secured through contracts for proprietary mapping awarded by oil and gas companies. Peers generate revenues through a combination of contracts for propriety mapping and licensing of non-proprietary mapping. Should the volume of contracts diminish significantly, it is possible competitors will become irrational by bidding contracts at prices well below marginal costs simply to ensure their ability to cover their fixed costs. All it takes is one competitor to become irrational and it will force the others to follow suit.
When SAExploration was brought public last year, management agreed to a 12-month lock-up on their shares, meaning they were forbidden from selling any shares until June 30, 2014. Now that the lock-up period has expired, there is a risk that insiders will begin monetizing a portion of their stake in the company by selling shares. Should this happen, share prices will be under pressure as sellers would surely out number buyers.
Proper alignment of incentives
Insiders and directors combined own well over 50% of the shares outstanding. In addition, Eric Rosenfeld purchased $1m worth of stock in the open market in 2013 when the stock traded around $10 per share. It's clear the folks in charge of stewarding shareholder capital have skin in the game.
Further reassurance is provided by management's compensation bonus structure. Should management achieve at least $52m EBITDA this year (on an organic basis), they'll be rewarded with hundreds of thousands of shares. Since cash flow is a key driver to the valuation of this business, it seems to me this is well aligned with shareholders.
Investment research produced by Horizon Kinetics suggests that businesses operated by their founders have characteristics of outperformance over the long run. SAExploration is one such business. Brian Beatty, current CEO and founder, started the company in 2006 and he is a significant owner of its shares.
This is a low-risk high-uncertainty investment. The combination of such characteristics in an investment opportunity lead to very favorable risk-reward dynamics. In a base case scenario with conservative assumptions on growth, there is at least 70% upside. Even if there is a significant delay in the market's re-pricing of this business, you'll collect at least a 15% equity "coupon" based on free cash flow.
Disclosure: The author is long SAEX. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Acme Capital, LLC may buy or sell securities mentioned in this article for client accounts or for the accounts of principals at any time and without further notice. For a full accounting of Acme Capital’s holdings in any securities mentioned, contact Acme Capital at email@example.com. Past performance is no guarantee of future results.