As investors develop throughout their careers, they invariably develop a certain investing style; certain characteristics they look for in companies before they invest. Warren Buffett prefers companies with strong free cash flow, low debt and simple business models. Bill Ackman prefers to invest in companies where he can accumulate a large block of shares and through doing so influence company management. It pays to have a certain style due to the avalanche of information currently available in the stock market; by developing an investment style and staying within your circle of competence, the average investor is able to filter out much of the noise of Wall Street and find successful investment opportunities.
From a personal perspective, I prefer small-cap companies with strong free cash flows whose earnings are "hidden" by large non-cash charges such as depreciation, impairments etc. These non-cash charges are backwards looking and not always indicative of future company performance. I find that companies that fit this criteria are generally passed over by mainstream Wall Street due to their small size and the fact that their earnings appear to be weak. Pulse Seismic (OTCQX:PLSDF) is one such company.
Pulse Seismic is a Canadian-based company that licenses out 2D and 3D seismic data to oil & gas companies in Western Canada. The library mainly covers the Western Canada Sedimentary Basin, which contains one of the world's largest reserves of oil and natural gas. The company makes money by licensing out its data library and through participation surveys whereby it develops new seismic data with customers. In these instances, at the end of a survey, the customer receives a license for the new seismic data while Pulse Seismic receives all proprietary rights. The lion's share of the company's revenue comes from licensing out its existing library with participation surveys representing a much smaller, albeit growing, slice of the revenue pie.
Seismic data is used by the oil & gas industry to better understand geological formations in order to determine where the highest potential areas are for hydro carbons. Accurate well placement is a crucial aspect of exploratory drilling and high quality seismic data helps customers gain a better idea of the most attractive areas to begin drilling. For example, in the developing liquids rich Duvernay Shale play in Alberta, a single horizontal well costs between $10M-$15M. Pulse Seismics central business model premise is that with such high capex costs at stake, customers are well served to better understand the geographical formations in which they operate.
In the 2011, Pulse Seismic generated $51M of revenue and net earnings of $5M. On the face of it, these would appear to be very poor results based on Pulse Seismic's market cap of $140M, implying a 28x P/E multiple. However, the amortization of the company's seismic library was $32M, accounting for 70% of its total 2011 costs! Pulse Seismic has a particularly aggressive accounting treatment of the data library in which it amortized the value of a data set to $0 over a 7-year period. However, you can see from investor presentations on its website that it sells data from all the way back to the 1960s, demonstrating that the amortization treatment should be considered extremely conservative and not indicative of the business environment the company operates in.
Total 2011 free cash flow generated was $24M, which equates to a respectable yield of 16%. This is even more impressive when you consider that we are currently in the midst of the biggest market decline of natural gas in history. Free cash flow is one of my favorite valuation metrics as I believe it is the most shareholder friendly. As a part owner of the business, I want to know how much cash I can take out while still being able to run operations. Management incentive compensation is based in large part on its ability to grow free cash flow, ensuring that its interests are aligned with shareholders.
From a capital allocation perspective, company management has three main choices; expand the seismic data library, increase the dividend or repurchase the stock. As of now, management has chosen a combination of the three; the dividend was raised 60% in the 1st quarter of 2012 to $0.08 (4% yield), it is purchasing 10% of the outstanding float and actively looking to expand the data library, especially in the Duvernay Shale play either through outside purchases or participation surveys. The share repurchase plan is especially encouraging to see as 10% of the outstanding shares is the maximum amount it is allowed to repurchase under the current normal-course issuer bid (NCIB), indicating management would have liked to repurchase more if allowed. Management teams that understand the importance of effective capital deployment is are extremely valuable. You can have a great operationally performing company but if the free cash flow is not allocated properly then the investment will most likely prove to be fruitless, something I have had negative experiences with in the past.
Pulse Seismic's long-term future is tethered to the future price of natural gas. With gas prices currently hovering around historic lows, oil and gas companies are lowering their capex programs as many drilling areas have become uneconomical. However, I believe that we have reached the trough of the cycle. Gas rigs are being shut down at an increasing rate due to low sustained gas prices. The latest Baker-Hughes report shows 541 gas-directed rigs currently operating in the United States, the lowest number since 1999. I believe this demonstrates that energy companies are becoming serious about lowering the record supply that is currently on the market. Of course, this does not affect the liquid plays that produce gas as a by product but if the rig count continues to shrink, natural gas prices at some point have to respond. If the price of natural gas rises to around the $4.50 level, I believe there would be a tremendous impact to Pulse Seismic's revenue generation.
Even in today's depressed environment, there is still a market for Pulse Seismic services. During this trough in the natural gas cycle, companies are currently utilizing seismic data to pinpoint low-cost, low exploration properties and to increase their prospect reserves for the inevitable future rise in the market. Combining this with the increased liquids drilling in the WCSB, Pulse Seismic should have no trouble surviving the current market downturn.
In conclusion, I believe Pulse Seismic to be an attractive opportunity to play the eventual rise in the natural gas market. Unlike other pure natural gas plays, Pulse Seismic still has attractive valuation metrics (16% FCF Yield) even at the bottom of the cycle. By purchasing Pulse Seismic, you are able to take advantage of any upside in the future price of natural gas while having your downside protected by the company's strong balance sheet and conservative management. Even if it takes years for the price of natural gas to recover, I believe that company management will adapt accordingly, making this company an attractive investment for potential shareholders.