That certainly sounds exciting; but this unfortunately is not the end of story. You could be greatly disappointed when you find out that its goodwill stands at $102.20/share out of its book value of $118.11. In other words, 86.5% of its book value is goodwill.
Much (90%) of this monstrous goodwill was originated from the recent acquisition of the former Houston based Veritas DGC to form CGG Veritas. However, the purpose of this article is not to assess the quality of the goodwill. Rather, my major intention is to figure out the worth of the entire CGV enterprise from a value investor’s perspective.
CGV’s debt-equity ratio stood at 0.65 as of end of first quarter (March 31 2007). Using another measure, the debt is 175% of market cap as of Friday’s close. Due to this high degree of leverage, some value investors would simply stay away from this stock. I happen to be a value investor who believes in the added benefit of flexibility (now that it is not overdone). So I would take a shot at valuing this stock.
I will apply Greenwald’s valuation approach to this stock. The Greenwald approach values stocks using three elements, the reproduction cost, earnings power value, and the growth value. Let’s assess each element for CGV now.
I. CGV’s Reproduction Cost
The reproduction cost is simply the cost a competitor would need to incur in order to reproduce CGV’s business in a (hypothetical) level playing field, i.e., when there is no barrier of entry to new competitors or no competitive advantage on CGV’s side.
To come up with reproduction cost for CGV, we would mainly adjust for the CGV’s goodwill and the value of R&D and marketing investments, which are off the balance sheet.
As mentioned above, 90% of the goodwill is attributable to the recent acquisition of Veritas DGC. The $3,513M cash/stock combination paid to Veritas shareholders represents a 67% premium to Veritas’ market value of $2,099M back in August 2006. Based on Veritas’ reported book value on Oct. 31 2006, CGV has paid at a P/B ratio of 4.34, which was pricey yet likely a typical valuation for acquisition in the energy sector.
To have a built-in margin of safety, however, a value investor should not take the management’s valuation doctrine at face value. Instead, one should make major adjustment downward in this type of expensive business acquisition. The right approach is one that values the business being acquired at a discount to its market value instead of premium. That means valuing the acquired business as if we the value investors were buying the business ourselves.
In valuing the acquisition, we will take clue from Veritas DGC’s historical financial performance and the industrial business cycle.
The seismic or geophysical industry was stuck in a cyclical trough from 1999 to early 2004. The second half of 2004 through 2006 has seen robust recovery. And the robust growth appears likely to continue going forward.
For a cyclical business, it appears reasonable to approximate long-term ROC using the ROC achieved in the first two recovering years following a trough. Since Veritas’ fiscal year (before being acquired) ended July 31 and the recovery started from the second half of 2004, this means that we can use the ROC achieved in FY 2005 and FY 2006. Veritas achieved ROC of 12.01% and 11.36% for FY 2005 and 2006, respectively. So we would take a conservative round number of 11%.
The other elements needed for evaluating the worth of a firm’s long-term growth are the growth rate itself and cost of capital. Veritas’ revenue growth from FY 2003 through 2006 was 10.98%, 12.48%, 12.32%, and 29.68%, respectively. But since we are looking for a sustainable long-term growth rate, we would use a conservative, mid single-digit rate of 6%.
Regarding cost of capital, one can use either practical estimate or the WACC (weighted average cost of capital) derived from CAPM (Capital Asset Pricing Model). Good enough for us, CGV’s management has made public the WACC numbers they use in valuing goodwill. Depending on business segment, the company uses WACC in the range 8.29% (for multi-client library) to 9.06% (for products). For Veritas, it appears reasonable to use 8.5%, which is the mid value between multi-client library business (8.29%) and processing business (8.67%).
Finally we need to know the initial invested capital, which we take the average of FY 05 and FY 06, or $724.046M.
Simple math then places Veritas’ worth at $1,448M or €1,114M at the rate of $1.3 per euro. Remember this is the result of valuing Veritas based on initial capital outlay of about $724M, long-term growth rate of 6% at an ROC of 11%, and a capital cost of 8.5%.
Compare this to the purchase price €2,725M ($3,513M) the company paid, this is a 59.1% discount. With this, we have essentially written €1,611M (or 85.9%) off the estimated total €1,878M of goodwill. Had we the value investors bought Veritas at $1,448M or €1,114M, we would have received a 31% discount relative to Veritas’ market value in last August (at $56.16 per share). And we would have paid only 1.93x Veritas’ book value ($749.8M) as of Oct. 31, or 1.79x its book value ($810M) at the completion of merger in early January. Since Veritas had a high quality balance sheet (with zero goodwill and reasonable amount of intangibles) we can feel really happy to have paid only 1.79x book.
With Veritas’ value adjusted to our satisfaction, the only thing that remains is the valuation of CGV’s other subsidiary, CGG. The company’s account on CGG seems to be largely fair. But we do want to add the values of R&D and marketing, which are not reflected in the balance sheet.
For the value of R&D, we follow Greenwald’s simple 5-year (FY 2002 through FY 2006) straight-line depreciation approach, which gives €96.04M. For marketing value adjustment, we first find the SG&A expense per revenue euro during the last six fiscal years (FY 2001 through FY2006). Then we calculate the smoothed-out SG&A expenses incurred in the last three fiscal years (FY 2004 through 2006). We take 50% of the smoothed-out SG&A expense as the marketing value adjustment. This gives €157.68M . The R&D and marketing value adjustment together amount to €253.72M.
After our immense goodwill “write-off” and R&D/marketing value adjustment on the CGG unit, we arrive at an adjusted book value of €1,049.83M, which also approximates the reproduction cost of CGV’s asset at the end of first quarter ended March 31 2007.
Again using €/US$ ratio of 1.3, this translates to a per-share adjusted book value of $50.08. CGV was trading at 88% of the adjusted book value (adjusted P/B=0.88) as of Friday’s close. Although this does not look as exciting as a P/B of 0.37, it certainly still represents a good bargain.
II. The Earnings Power Value
The reproduction cost represents the cost a new entrant needs to incur in order to mimic CGV’s business when there is no barrier of entry. According to our estimate above, CGV is worth about $50 a share under this free-entry business environment. However, for a well-respected leading global provider of geophysical services and equipment manufacturer that has been in existence since 1931, one would be tempted to ask if this reproduction cost has reflected CGV’s franchise value.
The answer is clearly no. And that is why there are two other elements in Greenwald’s valuation approach.
The first elements reflective of the franchise value is the earnings power value, which evaluates the present value of a firm’s future distributable cash flow assuming a zero growth rate.
We are to assume that CGV maintains earnings forever at the level of FY 2006 (zero growth) for both the CGG and the Veritas subsidiaries. Note again that (the old) Veritas’ FY ended July 31 while CGG’s FY ended Dec. 31.
To determine the present value of future cash flow, we adjust the FY06 earnings of each subsidiary to arrive at a base cash flow. Greenwald calls this base number adjusted earnings.
Because we are assuming no growth, the firm will only need to invest at a level that can maintain its current (FY 06) earnings. That means the capital expenditures, R&D and SG&A expenses need to be adjusted downward to a “maintenance level.” Following Greenwald, we can call these maintenance capital expenditures, maintenance R&D expenses, and maintenance SG&A expenses.
For all three maintenance costs, we find respective cost per revenue euro (or dollar) for the past few (6 for CGG and 5 for Veritas) fiscal years and use this to determine the investment level for prior year’s revenue, which means FY 05’s revenue. This way we are stripping out the growth component out of the FY 06 result.
For amortization and depreciation, we simply add the reported numbers back. For acquisition we simply account for it euro for euro. This is because “current” (FY 06) year’s revenue contains the acquired businesses’ full contribution. For one-time charges, we average them out over the past five (Veritas) or six (CGG) fiscal years.
After going through all these, we arrive at a combined adjusted earnings figure of €314.31M, which consists of €228.12M contributed by CGG with the balance from Veritas.
Under the zero-growth condition, the present value of the future cash flow is simply the adjusted earnings divided by cost of capital. Again, for weighted average cost of capital the maximum value used by the management was 9.06% (for its products business). But we will settle on a more conservative 10% instead. This leads to €3,143.1M in the present value of future cash flow.
To arrive at the earnings power value, we need to account for debt and excess cash (beyond 1% revenue). After subtracting the debt (as of March 31 2007) of €1,573.5M and excess cash (relative to FY06’s revenue) of 363.18M, we finally arrive at the earnings power value of €1,932.82M. This translates into €70.92 per share or $92.2 per share (at $1.3 per euro), which is more than double Friday’s market close of $44.04!
We have not made any adjustment for the business cycle. As pointed out above, FY 2006 was about the second year into the seismic industrial recovery. So we take that as the midpoint of business cycle, which sounds reasonable if not conservative.
CGV’s franchise value can be found by simply subtracting reproduction cost from its earnings power value. The result is €882.99M or $1,148 M. So the franchise value alone is €32.50 or $42.12 per share, close to CGV’s current market value.
Since the adjusted book value is about $50 (13.7% above current market value), at current market price we are getting the franchise value for free! This is precisely the type of margin of safety a value investor seeks.
III. Value of Growth
A firm’s growth creates shareholder value only if it can maintain an ROC that is greater than its cost of capital, a condition achieved only by firms that enjoy competitive advantage (or franchise value). As in II, we are still going to use 10% as cost of capital. Referring to CGG and Veritas’ historical data and factoring in seismic industry’s business cycle, it appears 11% is a sustainable ROC for the combined firm (CGV). For a sustainable long-term growth rate, we are going to use 6%.
For initially invested capital, since we are already aware of the excessive goodwill in the corporate balance sheet we will use our adjusted book value (€1,049.83M, see I) for the equity portion. After debt is added, we come up with an initial capital outlay of €2,633.13M.
Using this set of parameters, the present value of CGV’s assumed growth amounts to €3,291.42M. This translates into €120.77 or $157 per share. Obviously this extra $64.81 per share franchise value of growth (beyond zero-growth value of $92.2/share) serves as yet another level of safety protection for value investors. The total franchise value under the growth assumption is $106.93 (beyond the firm’s reproduction cost of $50.08).
IV. A Brief Note on Business Environment
Although the seismic industry will remain cyclical in nature, the industry has been greatly strengthened in recent years mainly for two reasons.
First, the strong long-term global demand on energy has resulted in a negative net reserve replacement rate in the oil and gas industry. This means reserve replacement has not been able to catch up with consumption. To alleviate this problem, oil and gas companies will need to maintain a high level of exploration expenditures going forward. And this will benefit both drilling and seismic companies.
Second, technological advances in recent years have increased fidelity, reliability and scope of the seismic technologies. These technologies are now not only used in exploration, but can also be used in development and production by oil and gas companies. This means new revenue opportunities for the industry.
CGG Veritas’ commitment in R&D has enabled it to capitalize on the recent technological advances. It has firmly secured competitive advantage in high-end growth markets such as data acquisition in transition zones and difficult terrain or deepwater sub-salt reservoir delineation and discovery.
Overall, CGV’s business is going strong. As of May 1, 2007, the company’s backlog was €1,213M (or US$1,650M). This represents about 62% of the combined CGG – Veritas revenue in FY 2006 (although the two units had quite different FY end dates).
Given CGV’s franchise position and overall industrial strength, its high leverage level and aggressive expansion strategy is likely not a cause for alarm. And if management proves the monstrous goodwill’s worth one day (which is likely), investors will be hugely rewarded.
CGG Veritas’ current market value is below our adjusted book value of $50.08. Its earnings power value (based on FY 06 result) puts its worth at $92.2 per share. When long-term growth is also taken into account, the stock is likely to be worth well above $100 a share. So its current stock price ($44.04 as of Friday’s market close) represents a bargain with huge margin of safety. At the mid-40 price level, one is paying for less than its adjusted net worth and getting franchise value (as a leading global geophysical player) for free. The franchise value is worth some $40 to $100, depending on how much of CGV’s future growth is taken into account.
Disclosure: The author owns CGV as of this writing.
CGV 1-yr chart: