The Best Way To Play Odyssey Marine And Shipwreck Exploration

Feb. 3.12 | About: Odyssey Marine (OMEX)

A few of you may recall this article, from August of 2008, explaining why "August is the time to buy Odyssey Marine Exploration" (NASDAQ:OMEX). First, a few words on what's right with the article. Odyssey Marine "arrested" some wrecks -- true enough. This means that some token from the vessel (or ostensibly so) was presented to a court of admiralty in connection with a claim on the vessel - a claim in rem against the vessel itself, rather than a claim against its owner. An "arrest" doesn't prove either that the vessels at issue are the property of OMEX, or that OMEX even has properly identified the wrecks; it simply brings the supposed wrecks within the jurisdiction of an admiralty court. This means that the fight over the wreck sites can begin.

A Little History On Historic Wrecks

Let's think back to the famous wreck Atocha, found by Mel Fisher in 1971. Finding the Atocha at a cost of over $2 million didn't immediately enrich the Fishers. It simply embroiled them in a series of law suits over title to the find and to their share, if any, after taxes (try paying timely quarterly taxes on the appraised value of a trove of antiquities without destroying the market for the antiquities by dumping them). Among the claims raised by the government in the suit concluded in 1978 were claims that the government owned the wreck as abandoned property and as an assemblage of antiquities - claims supported by statutes the government had passed. The fact that the Fishers did well in the case decided in 1978 was not based on some immovable pillar of admiralty law, but (if you read the linked case) solely on the language and history of the statutes actually in effect at the time of the suit. The law has changed quite a bit since then.

Under the 1902 treaty between the United States and Spain (described here), the United States must afford Spanish warships not only "the same assistance and protection" as United States warships but also "the same immunities which would have been granted to its own vessels in similar cases." Since modern U.S. law on U.S. warships places the sovereign that launched the warship in absolute control not only of the lost warship but of everything within its debris field, and prohibits courts from determining that they have been abandoned without an express declaration of abandonment, the happy-go-lucky conclusions offered by some wreck enthusiasts regarding the outlook for acquiring title to a lost Spanish warship full of New World treasures require some serious consideration.

At the very minimum, would-be salvors steer themselves into unavoidable litigation with a well-funded government adversary. Even winning, Mel Fisher was tied up in court litigating title to his find until he had been through a trial and successive appeals, including to the Supreme Court, following which the Fifth Circuit Court of Appeals (before its area was split, placing Florida in the new Eleventh Circuit) wrote this gem, explaining how so many years of litigation (through the Court's opinion in 1982) still hadn't bought Mel Fisher peace from the claims of the State of Florida. That peace came later.

The State of Florida now holds a huge trove of artifacts from the Atocha, where it sits in bins in a warehouse and on every inventory grows a little smaller as people with access decide that the State of Florida won't miss just this one little bit. At least, according to the sources available to the Jaded Consumer. If you want to see anything from the Atocha, you need to visit the private museum established by Mel Fisher. The State of Florida's zeal for wrecks seems chiefly directed into a dragon-like avarice to hoard gold rather than a desire to educate the public about the history of Florida.

Mel Fisher may have long since joined the captain of the Atocha in the great treasure hunt in the sky, but his family continues to operate his salvage claim - established under prior law - every year. And every year, someone eager to find ancient curios in a proven site spends a small fortune bringing a vessel and divers to the coordinates they license from the Fishers for a season's operations in exchange for a cash payment and a share of the find. So why is it, you wonder, that you have not heard of many wealthy salvage teams?

Modern Salvage Economics

It turns out that competent salvors - people who can search a grid rather than getting lost under the boat, for example - are not a cheap class of worker. They have commercial diving skills that make them extremely valuable in the offshore industry, and thus in demand on every rig and pipeline in the entire Gulf of Mexico. Maybe the greenhorns aren't worth much, but do you want them pretending to map an archaeological site or claiming to have searched your designated block of sea for little green rocks that are just like sand but priced like emeralds from the Atocha? Do you trust them to leave Key West sober in the morning for work?

The Jaded Consumer has had the entertaining opportunity to become involved in some archaeological work - not on a Spanish galleon, but more closely connected with the history of the United States. And I have seen the budget for a few weeks' search in shallow water near shore. And so it is with some experience that I am able to say that British maritime historian Andrew Lambert had it exactly right when he said to CNN, "If you want to stand in a cold shower tearing up £50 notes, go shipwreck hunting."

So let's have a look at the economics of wrecks -- not of near-shore, shallow-water, bathtub-warm Key West finds within striking distance of a grocery store, but at the deep, dark, distant targets sought by Odyssey Marine Exploration. As seen on TV, Odyssey has a ship full of survey gear and a work-class ROV designed to manipulate objects at depths that make diving impractical. Risking a man's life in a 1-atmosphere suit is "impractical" next to sending an ROV that can be salvaged when it is lost. Mel Fisher parted with not only a seven-figure sum hunting the Atocha, but also several divers - including his son Dirk and daughter-in-law Angel -- and they were in a readily diveable depth of water.

But using ROVs has its own class of problems. Attached to the vessel by a lengthy umbilical cord that supplies power and communications lines, the craft can't stay on-target while the ship moves. The ship, therefore, must be a fairly high-dollar dynamically-positioned vessel. The ROV must be piloted competently or it can be tangled and lost at depth, and it must be maintained against the harsh maritime conditions if it is to remain operable. And as video clips of OMEX's tediously slow coin collection operations so plainly depict, it can take a long time to accomplish careful archaeological work at undiveable depths.

This long time is also money: an experienced ROV crew leader commands over a thousand dollars a day in the offshore energy industry. (Let's be honest; what an energy company like Shell (NYSE:RDS.A) pays for an ROV supervisor and what the supervisor receives from an employer like Oceaneering (NYSE:OII) aren't the same. Contractors among top crews may make only $600 per day before they go into overtime, but a crew that includes pilots, arm operators, and technicians will be expensive to keep at sea many days of the year.)

OMEX either pays high wages to its most skilled crew members, or it hires personnel without the expertise to get work in the energy industry, or it promises operators a share of proceeds in lieu of short-term compensation. A share of proceeds is the sort of promise that makes other salvage operations possible to fund: risk-taking workers forgo short-term pay for a shot at the moon. Since OMEX is awash in shareholders' money and wants to keep the proceeds, it presumably doesn't get a discount in exchange for a share of proceeds. (This doesn't mean shareholders aren't at risk of dilution by management's potential decisions to grant options to key employees, and how different is that to a shareholder?)

To illustrate the problem of high cost in the salvage business, consider the vessel U-864. Sunk during the Second World War with a cargo of 74 tons of mercury with a present value exceeding a million dollars, U-864's estimated cost of salvage exceeds $174 million -- and its location is known. Not exactly attractive economics. A permit has been issued, but regulators have postponed salvage again. Some advocate entombing the wreck in concrete and leaving the mercury at the bottom of the ocean. Probably cheaper, despite the seeming wealth of mercury.

Television Is Not A Sustainable Business For Treasure Hunters

A brief look at the programming offered by Discovery Communications (NASDAQ:DISCA) and National Geographic suggest that the public thirsts for the excitement of hunting for gold in Alaska, history in the Irish Channel, and the deep wrecks sought by Odyssey Marine. But a look at the economics of the deep-water exploration business reveals that this sort of exposure is merely marketing, not a business itself. Crewing a vessel long enough to find something worth airing costs a fortune, and an episode of television just doesn't pay that much. I've seen fifty grand promised to salvage groups for access to make a video production, but I haven't seen the millions necessary to fund a reasonably sized hunt, or a small deep-water excavation. There's a reason that vessels capable of supporting work-class ROVs rent for six figures a day in the offshore energy field: they're expensive to run.

The Treasure of Odyssey Marine

If the net recovery of Odyssey Marine is consistently negative, what exactly is its treasure? Like Mel Fisher, these folks want to chase the dream of finding the big score, with the romance of searching the unknown, and the possibility of becoming really famous (at least among wreck divers) and of getting on TV a few times to smile for Mom. Unlike Mel Fisher, these guys have figured out how not to get ruined doing it: Every time they run out of money, they ask you to refill their coffers. And that's the real treasure of Odyssey Marine -- they are chasing a romantic dream (and being paid a nice salary to do so) at the expense of investors who are unfamiliar with the outlandishly poor outlook for salvage operations.

The article quoted at the beginning of this piece listed a half-dozen wrecks OMEX had in its sights, described the opportunities they presented, then laid out how the present value of the cash streams to be produced from these wrecks was worth $17 per share, which (according to the article) did not include the additional wrecks OMEX was finding annually, which (it explained) were worth another $22.60 in net present value. The nearly $40 per share in net present value meant that, based on August 2008 share prices, OMEX (according to the article) "could appreciate 10x."

To be worth "net present value," some assumptions need to be made about the time required to produce value from a wreck. In Mel Fisher's case, the answer was not just a few months. It was years. In the case of some of OMEX' targets, the answer may be never. Changes in US law governing US warships means changes in US law governing Spanish warships. US law declares unpermitted salvage illegal, and Spain is so politically opposed to private salvage that it is party to a treaty that criminalizes sale of artifacts that have spent a long time underwater, even if it's by a museum de-accessioning an artifact because it can't afford to maintain it properly.

Don't expect reason from Spain on wrecks. And don't expect under existing law to confidently place a non-negative "net present value" of something like a Spanish warship full of ill-gotten gains looted by Spain from the New World. (On the other hand, the British ship for which OMEX has a salvage license from the UK may be entirely different -- assuming it turns out it isn't located in Spanish waters where it is subject to Spanish law.)

Assuming the authors of the prior article were discussing the supposed prospects for a 10x gain in the price of shares instead of the balance of the corporation's bank account (which swells with each public offering), it'd be hard to see how the 10x gain should be expected. A look at OMEX' financials show that despite the success it has actually achieved in finding things at the bottom of the sea, the only real treasure it's recovered from investors' pockets. A glance at OMEX' heinously negative cash flow quickly assures readers that its negative earnings aren't a result of some sort of tax-motivated accelerated depreciation occurring while money is rolling in the door.

Let's have a quick look at the 10-Q from the period ended 9/2011. The current assets - that's what OMEX owns that has positive value that can be realized within a year - were worth $12 million on 9/30/2011. This, after OMEX raised over $15.6 million in a common stock offering in June of 2011 (at a 2.2% discount to the stock price the day before the pricing was announced). Don't think that OMEX only lost $3.6 million, though: its operating cash flow was a $9 million hemorrhage for the nine months ended September 30, 2011, which was a few million worse than in the year-previous period. And it wasn't making money investing, either: Investment activities lost over half a million bucks. The only place OMEX netted cash was from financing activities -- selling stock.

Meanwhile, OMEX's personnel have the greatest treasure of all: they get to chase their lifelong dreams of finding sunken treasure while being paid a fat salary from someone else's money. What could be better?

If you'd like an investment that makes money employing skilled offshore operators with expensive equipment doing something more financially productive at the bottom of the sea, consider an oil company like Royal Dutch Shell or Exxon Mobil (NYSE:XOM) or an offshore services company like Oceaneering International or Subsea 7 (OTCPK:SUBCY).

Americans don't seem to have heard of Subsea 7, though it's got thousands of employees and ongoing operations in the Gulf, Brazil, the North Sea, and Africa. However, there is a US-traded ADR and solid profits; while its ROI trails Oceaneering, its earnings per share are a lot cheaper at its lower P/E. The fun part is that by picking between XOM, OII, RDS.A, SUBCY, and others of their ilk, you can pick from companies that are doing something loftier than standing in a cold shower tearing up £50 notes while a camera is running.

Hunting Your Own Treasure

Recall Warren Buffett's advice for making money? "The first rule of investing is don't lose money; the second rule is don't forget Rule No. 1." You can't lose short-term and expect long-term excellence. When you see an "opportunity" like OMEX, which is driven by hope rather than math, run. Grab your valuables first, of course, but run.

I'm always hesitant to bet against the idiocy of people inspired by the media, but there's a more attractive way to play this than a straight short. For a long/short idea, consider investing in a company in the energy industry that uses the same (or better) technology as OMEX, but has a strategy that creates profit. Both OMEX and its opposing investment will enjoy a similar asset lifespan, and a similar operating cost for each well-equipped vessel full of costly, skilled personnel. The compliance overhead of the energy business is substantial, but so is the compliance and litigation budget of salvors seeking title to Spanish warships.

The place where the companies will truly diverge is in strategy: OII and SUBCY will thrive with growing energy demand, and will sell services whether oil and gas producers are in the news for disasters (in which case they need experienced contractors) or are in the news for their record profits (in which case business is booming for support companies). Consider one (or both) for the long leg, and pair against an OMEX short. Given the timeline for litigation and OMEX's long track record of going nowhere while burning investors' cash seems unlikely to enjoy a short-term reversal.

Over the long run, what's the likelihood of OMEX producing outstanding returns in comparison to a business with a track record of raking in cash from customers needing essential services provided in an industry the world cannot do without? That's what makes OMEX/OII or OMEX/SUBCY an attractive long/short: even if OMEX goes up a bit for some reason, you only lose if it goes up more than a company that's making lots of money with a strategy that ensures it continues.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.