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ION Geophysical Corporation (NYSE:IO)

Q1 2008 Earnings Call

May 7, 2008 10:00 am ET

Executives

Jack Lascar – Investor Relations

Robert P. Peebler – Chief Executive Officer, President

Brian Hansen – Chief Financial Officer, Executive Vice President

Analysts

James West - Lehman Brothers

Terese Fabian - Sidoti & Company

George Gaspar - Robert W. Baird

[Tamara Monuchin] - Greenwood Investments

Operator

Welcome to the ION Geophysical first quarter earnings conference call. (Operator Instructions) I would now like to turn the conference over to Jack Lascar, with DRG&E.

Jack Lascar

Welcome to the ION Geophysical Corporation's first quarter earnings conference call. We appreciate your joining us today. Your hosts today are Bob Peebler, President and Chief Executive Officer, and Brian Hansen, Executive Vice President and Chief Financial Officer.

Before I turn the call over to management, I have a few items to cover. If you would like to be on an email distribution list to receive future news releases or experienced a technical problem and didn't receive your news release yesterday, please call us and provide us with that information. That number is 713-5296600.

If you would like to listen to a replay of today's call, it is available via webcast by going to the Investor Relations section of the company's website at www.IONGEO.com or via a recorded instant replay until May 22. The information was provided in yesterday's earnings release.

Information reported on this call speaks only as of today, May 7, 2008, and therefore you're advised that timesensitive information may no longer be accurate as of the time of any replay.

Before we begin let me remind you that certain statements made by management during this call may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

These forward-looking statements are based on management's current expectations and include known and unknown risks, uncertainties and other factors, many of which the company is unable to predict or control, that may cause the company's actual results or performance to differ materially from any future results or performance expressed or implied by those statements.

These risks and uncertainties include the risk factors disclosed by the company from time to time in its filings with the SEC, including in its annual report on Form 10-K for the year ended December 31, 2007. Furthermore, as we started this call, please also refer to the statement regarding forward-looking statements incorporated in our press release issued yesterday, and please note that the contents of our conference call this morning are covered by those statements.

I'll now turn the call to Bob Peebler.

Robert P. Peebler

We had several highlights for the quarter, including significant earnings growth compared to a year ago, with our earnings per share doubling as compared to Q1 2007 even with the decline in revenues for the same period.

Brian will give more detail, but our revenue decline is an example of the lumpy nature of our business, where last year we recognized revenue of the BP Apache FireFly system that was delivered in the fall of 2006 and the delivery of the remaining part of the third VSO system to RXT. When we back out those two large sales, we get a better understanding of the underlying growth of the business, which grew 9% year-over-year.

We did see a slowdown in our Gulf of Mexico processing business during the quarter which appears to be an anomaly as the pipeline and backlog for our Houston center has picked back up. We should be back on our plan by the end of the year.

We had a very strong start with a multi-client business that includes continued diversification away from the Gulf of Mexico and into West Africa, Latin America, the Far East and the Arctic. We are particularly pleased to have a solid position in the Arctic, where there is a strong and growing interest from oil companies and spans the entire regions of Alaska, Canada and Russia. We believe this is a frontier that is in its early stages of growth and will provide ION with many future opportunities for our high-end technical products and services.

Related to our processing business in the Gulf of Mexico, part of the slowdown was driven by much of the industry's processing jobs being dedicated to [inaudible] surveys and GXT has been locked out of that market due to the contractual obligations of oil companies to use the processing services of the acquisition companies. This first phase is now coming to an end, and we are getting the opportunity to bid on reprocessing of [inaudible] surveys due to the need to further increase quality, including using reverse time migration and the recognized leadership of GXT. We expect this trend to continue, and that is being borne out by our visible pipeline of potential business for the remainder of the year.

Some of the slower-than-planned Gulf of Mexico processing business was offset by a record quarter in our Denver office for our Land processing business and non-conventional resource plays in North America has been growing rapidly. Our Denver GXT technology business is ideally suited for many of the fractured shales that are strategic to several of our oil company customers.

We are also continuing to expand our processing business around the world, including the recently announced joint venture with LARGEO in Russia. We expect that processing in Russia, Eastern Europe, North Africa and the Middle East will continue to grow as a percentage of our total processing business due to our globalization strategy.

In our Land business we saw a slight decline in the total number of vib truck sales but an increase in total margins, reflecting a stronger pricing environment. We still see a strong vib market in the east, including Russia, North Africa and the Middle East and believe that we should have a solid year for vib sales.

The best news for our Land division was improvements in our system margins, which are primarily due to our cost reduction program.

Once again, we had strong performance in our Marine business. The primary driver was continued strength in our positioning technology, including both DigiBIRD and DigiFIN and our marine software from Concept Systems.

We're also building the fifth VSO system with expectations for delivery to ArchT beginning the end of this quarter or early in Q3 with the full system being delivered by the end of the year.

I will now turn the call over to Brian.

Brian Hansen

As Bob mentioned, we had a very strong first quarter. Starting with revenues, we generated $140 million compared to $165 million during the first quarter of 2007.

Revenues for the first quarter of 2007 included the first systems sale of FireFly for $20.8 million and the balance of the third VectorSeis ocean system sale to RXT for $15 million. Excluding the $36 million impact of these two large sales, the first quarter 2008 revenues increased 9% to $140 million compared to $129 million for the first quarter of 2007.

Our gross margin in the first quarter of 2008 showed a dramatic increase of 11 percentage points to 35% compared to 24% in 2007. This increase is due to increased margins of at least 5 percentage points across all of our segments.

In our ION Solutions division, strong multi-client data library sales in the Artic region combined with robust prefunded multiclient surveys off the coast of South America led to significant margin increases compared 2007. Additionally, increased Marine positioning product sales and Marine imaging systems and increased software sales and data management solutions contributed to our overall margin improvements.

Finally, margin improvements occurred in our Scorpion cable systems and in our VibroSeis vehicle sales in our Land Imaging Systems segment.

Overall, this significant increase in our consolidated gross margin percentage shows our continued focus on cost improvements, process optimization and a more profitable product mix.

In the Land Imaging Systems segment, revenues remained stable at $50 million compared to $53 million excluding the sale of FireFly in 2007. Gross margins in our Land business grew in 2008 to 24% compared to 16% in 2007, including the first FireFly system sale. This increase is a combination of not having the low margin FireFly sale in the mix in 2008 as well as our continued focus on cost reductions in our Scorpion system and a stronger pricing environment for our VibroSeis vehicles.

Marine Imaging Systems finished the quarter with approximately $34 million in revenue which represented a 19% increase over the $29 million in revenue, excluding the VSO sale in the first quarter of 2007. Demand for our positioning systems remains strong, which includes increased sales of our new DigiFIN system.

With introduction of DigiSTREAMER this quarter, continued sales of DigiBIRD and DigiFIN, and the continued introduction of new seismic boats, we continued to expect our Marine business to experience another solid year in 2008.

Gross margin in the Marine group continued to expand, reaching 46% in the first quarter of 2008 compared to 39% in the first quarter of 2007. This increase is primarily due to product mix, with stronger positioning system and source product sales.

Our Data Management Solutions segment revenues increased 40% to $9.2 million in the first quarter of 2008 from $6.6 million in the first quarter of 2007. The increase reflects strong industry demand for marine seismic work and for our GATOR and Orca product line, towed streamer navigation and data management applications.

Continued strength in our Orca sales demonstrates the full market acceptance achieved by this newly offered product, which is proving itself to be especially valuable in commanding and controlling complex acquisition geometries involving multiple vessels and streamer passes, a type of survey that is becoming more and more common around the world.

In our ION Solutions division, net revenues increased 14% to $47 million in the first quarter of 2008, primarily driven by increased multi-client data library and new venture sales, especially off the coast of South America.

Overall, consolidated operating expenses for the first quarter of 2008 as a percentage of revenue increased to 27% from 20% in the first quarter of 2007. The increase as a percentage of revenue is primarily a function of the first quarter traditionally being the lowest revenue quarter for the business. On a full year basis we expect operating expenses as a percentage of revenue will improve from 2007 levels in line with our guidance.

We continue to invest heavily in research, development and are expanding our operations internationally, including the opening of our international headquarters in Dubai. We incurred an income tax expense of approximately $2.1 million in the first quarter of 2008. The income tax expense represents an effective tax rate of 19.4% for 2008 as compared to 24.7% in the first quarter of 2007.

We generated strong first quarter net income of $8 million, which is over 145% increase from the $3 million earned in the first quarter of 2007. For the first quarter of 2008, our diluted EPS doubled to $0.08 compared to 2007's $0.04.

Turing to the balance sheet, inventories rose by $35 million as we continued to build the fifth VSO system Bob mentioned earlier and ramp up inventories for FireFly Version 2.0. Accounts receivable decreased by $28 million from year end 2007, and overall our working capital increased 14% over prior year. We expect this trend to continue into the third quarter of 2008 as we invest in inventory in anticipation of the commercialization of FireFly.

CapEx excluding the investment in our multi-client data library for 2008 was $4 million. Year-to-date investment in the multiclient library totaled $27 million, an abnormally high amount for any one quarter. We expect the capital demand of our multi-client business for the remaining three quarters on average to be significantly lower than the first quarter of 2008.

Cash remains stable at $36 million from the fourth quarter of 2007. The largest inflow of cash for the quarter related to Fletcher International exercising their last remaining option granted during the original funding in 2005 to invest a further $35 million into ION in the form of convertible preferred stock. The total preferred stock purchased by Fletcher since 2005 is $70 million. This last round of funding was primarily used to support our current working capital needs.

Due to the release of new accounting guidance related to embedded derivatives, the last two tranches of our preferred stock, our Series D2 and Series D3, contain an embedded derivative related to the redemption feature. Because this guidance is for transactions occurring after its effective date in 2007, we are required to bifurcate the Series D2 and Series D3 redemption features and fair value them on a quarterly basis.

As of March 31, 2008, the fair value of the redemption features is $9.4 million and is recorded as a liability on the balance sheet. The value of these features decreased by $200,000 from their purchase dates, therefore we recorded the change of $200,000 on its own line item on the income statement. At the end of each quarter, the changes in fair value will be reflected as a separate line item in other income and expense in the income statement.

Fair value calculation is sensitive to changes in our stock price. For example, holding all other inputs constant, a 10% decline in our stock price would increase the fair value of the redemption features and result in a charge of approximately $1.6 million.

For 2008 we are reiterating the earnings guidance we provided last December. We continue to expect 2008 consolidated revenues to be between $780 and $830 million. Accordingly, we anticipate 2008 earnings to be between $0.70 and $0.85 per diluted share.

Similar to the past two years, we anticipate 2008 to be backend loaded. This is mainly due to the natural budget planning cycle of our larger contractor customers who formulate capital spending plans during the first quarter each year, as well as the anticipated timing of the commercialization of our FireFly cableless system. As a result, we anticipate that the revenue and earnings cycle of 2008 will be very similar to that of 2007.

With that, I'll turn the call back to Bob.

Robert P. Peebler

In general, the seismic market looks strong for both Land and Marine, and with the current high commodity prices, we don't see any practical reason that this trend will not continue into next year and likely beyond.

We believe the strongest markets will be in the East, including Russia, China, North Africa, India, and the Middle East, but are also seeing a strengthening market for higher end technology in North America, including the various unconventional resource plays, the Arctic and the continued emphasis on subsurface salt in the Gulf of Mexico. I continue to be bullish about the market for our products and services and expect another strong year, as our guidance suggests.

I would like now to update you on FireFly. We are currently testing Version 2.0 in our engineering labs and at our outdoor test facility in Sealy, Texas and expect that to continue through May. Our current plan is then to move into acceptance testing, where we would be moving equipment to a loaned oil company property that is much larger than Sealy, and we could do much more extensive and large-scale testing.

Assuming this goes well, we have lined up a commercial multi-client job that will be managed by our GXT Integrated Solutions group, who will subcontract with a land acquisition contractor to provide the crew. The job is expected to start in mid-July. The project is a fractured shale play, so not only are we going to have the opportunity to fully test FireFly Version 2.0 on a commercial job, but we are also going to have the opportunity to demonstrate the value of full wave on an unconventional resource play that has many analogs in North America.

So far, we are very pleased with Version 2.0 and have not had any major technical issues. The only manufacturing issue we have encountered is the delivery of [inaudible] batteries that has been slower than expected as a result of very high global demand due to rapidly expanding consumer products that use similar battery technology. We view this as a very short-term issue that will be resolved by the time we get to full commercialization during the second half of the year.

As for FireFly sales, we have significant interest by various contractors and oil companies, both domestic and international. We expect the oil companies' interest in full wave but also their strong concerns for environmental and safety issues to be the main driver of our initial sales. We do not expect to make any sales until we have proven that 2.0 works as expected and can be demonstrated on a real job, and this is why we are excited to have the multi-client opportunity in July as it gives us the opportunity to demonstrate the full utility of the system and the many, many improvements made since our early Version 1.0. I am pleased with our progress in FireFly Version 2.0 and look forward to an exciting second half of the year.

Related to full wave, it's worth mentioning we are doing some very interesting pilots in cooperation with both supermajor and large independents related to deepwater subsurface salt and imaging in the Artic. For me this illustrates both a growing understanding of the value of recording the full-wave field by oil companies, but also how they are aggressively pursuing new technologies to unlock the geological puzzles of the more complex imaging problems. I believe ION is uniquely positioned to take advantage of this trend.

With that, I will turn the call over to the operator for questions.

Questions-and-Answer Session

Operator

(Operator Instructions) Your first question comes from James West - Lehman Brothers.

James West - Lehman Brothers

On the FireFly project that's upcoming, you mentioned it was multi-client. Could you let us know who the oil companies are that will be using the data?

Robert P. Peebler

I can't at the moment mainly because we are in the process of putting that project completely together. We do have one major underwriter, but we don't want to expose it until the thing's completely papered. There's a lot of people play in that world.

James West - Lehman Brothers

At this point you guys are generating a significant amount of cash. You've talked about the funding of the data library is kind of trending down as we go throughout the year which would suggest that cash would continue to build. What's the most appropriate use of cash in your mind? Are there technology M&A opportunities out there?

Brian Hansen

James, when we look at the cash, I think it's important to sort of recognize that our business in the next couple or few quarters is going to be fairly cash intensive because of the build in inventories and also the build in consequential receivables as we ramp up commercialized FireFly, so I'm not sure that that will be an issue for us in 2008 but it's probably something we'll revisit in '09.

Robert P. Peebler

James, I think just on M&A, obviously that's something that we are constantly looking at. We hardly go a month or a week that someone doesn't serve up some kind of an idea. For me, it's just as simple as we look at bills and we look at our strategy. And obviously if we find something that fits, then we'll get serious about it. But we're not really building the business through an M&A approach. But that doesn't say we don't constantly look at opportunities, and as we grow in both scope and size, we're presented with those kinds of ideas.

James West - Lehman Brothers

Any update on what your competitors are doing relative to the FireFly technology?

Robert P. Peebler

I don't think there's any real change. I think the ones that are out there, the ones we know about  and I think that they're at various, certainly at various stages - but there's really no visible change that we're aware of.

Operator

Your next question comes from Terese Fabian - Sidoti & Company.

Terese Fabian - Sidoti & Company

You said that your Denver processing center was growing rapidly because of work processing in fractured shale. Are your technologies either in the processing segment or data acquisition more applicable to certain types of reservoirs than others?

Robert P. Peebler

Yes, the reason our Denver office is quite good in that area is that one of their technologies that actually came through the company that we had there called Axis that PFT was folded into JXT, that's what's called asMutable processing. That's where you have sort of a wide area shoot and you're looking for lateral variations, and if you in these stratigraphic plays and also to a certain extent with fracture detection, you can use that to better find the fractures and also the lithological changes and variations. Those are very subtle stratigraphic plays, and they also tend to be fractured plays.

It's also an area that we believe that will have quite an interesting application for full wave, and that's why, like I mentioned in this job we're lining up, that it will be in a fractured shale play so it'll give us a really good opportunity for us to, since we're controlling the job and we'll have the processing on that job, we can really see what we can do with full wave in these resource plays.

Terese Fabian - Sidoti & Company

On FireFly, do you have any indication, either from BP or Apache, that they will using the system again?

Robert P. Peebler

Yes, they will. In fact, we're talking to both of them and sort of coordinating. It'll likely be as late as out into late fall, I think what we're sort of shooting at right now. But yes, they both are quite interested. And obviously they both have co-ownership in the current system, and so they do plan on deploying it again. That's a good thing.

Terese Fabian - Sidoti & Company

Will they be using an upgraded version, too?

Robert P. Peebler

Yes, they likely will. That's one that we're working on right now, on how to see if we can make that happen.

Terese Fabian - Sidoti & Company

Do you see in the international market, I know you have a lot of contacts there, a lot of travel, much of an impact on oil prices per barrel, whether they're $120 or $100 or $90, in terms of the amount of seismic work they're planning?

Robert P. Peebler

I think the theme is the same everywhere, whether it's Saudi Arabia or Russia or Kazakhstan or North America, everyone is finding the exploration and even redevelopment more complex. It's that old deal that the easy stuff has mainly been found, with the exceptions of a few places that are just getting access because they've been shut out on technology. And so I just think that you're going to see - and obviously higher oil prices give them more money to do technical work - so I think it's almost a given that we'll see strong seismic activity in all those places.

Operator

Your next question comes from Terese Fabian - Sidoti & Company.

Terese Fabian - Sidoti & Company

Can you talk about the new venture sales that you mentioned in your press release from, oh, I guess off the coast of South America. Is that a multi-client data library sale or how is that described?

Brian Hansen

It is a multi-client project. There are two projects that we have ongoing off the coast of South America right now, Terese, and they're both multi-client. But we don't typically announce the names of the projects until we get the shooting completed.

Terese Fabian - Sidoti & Company

Do you see any possibility of there being over capacity of multi-client data in the near future?

Robert P. Peebler

I think there's that possibility in some style, but if you look at what we do with our spans, it's quite unique. You know, there's some wide azimuth multi-client going on, which is quite unique. So I think that everybody is sort of carving out niches.

I don't see a lot of what I just think of very basic 3-D spec shooting. In fact, I don't know if any of that's really going on. So I would say that there's a lot of exploration [inaudible] and a lot of interest in exploration all around the world, so I don't see that as a problem, at least in the near term.

Terese Fabian - Sidoti & Company

And your work is still pretty much 100% pre-funded?

Brian Hansen

That's correct, Terese. If you look at of all the projects we launched and executed in 2007, they were 100% prefunded. There's typically at any one point in time we may have, you know, $10 or $15 million of our own cash in just from sort of a funds flow timing, timing of expenses versus timing of prefunding coming in, but in general our portfolio operates at 100% pre-funded levels.

Terese Fabian - Sidoti & Company

On your gross margins, that was a pretty significant rise in the Product segment, up to 36%. Is this, do you think, a run rate going forward or is it due to a product mix as well as to the cost improvements that you're getting?

Brian Hansen

Yes, there's a few things going on there, obviously, but a lot of it's product mix. So we definitely had good margin improvement on the Land business, and I think that that's probably indicative of the trend for the full year.

But if you look at the Marine business, the Marine business was really a product mix issue. We had a lot of positioning products in there. As we start pushing the VSO sales through that segment, you're going to see probably a little bit of pressure on margin there.

Operator

Your next question comes from George Gaspar - Robert W. Baird.

George Gaspar - Robert W. Baird

You discussed the seismic library buildup. Can you give us a perspective of over the last three years where you are now in terms of what has been the inventory in the library, how much have you spent annually, and what's the turnover rate, what are you getting back from this on an earnings basis? Can you delve into this a little bit more for us?

Brian Hansen

Outside of reporting the Solutions segment, we don't report at that level of granularity.

George Gaspar - Robert W. Baird

So there's nothing you can say about the size of your library on an annual basis and what monies you've put into it?

Brian Hansen

Well, we do report what we invest in multi-client. For example, it was roughly - rough math - it was $55 or $65 million in 2007. I haven't got the exact numbers in front of me. And I think you would have seen that step up. The year prior I think it was like $35 million. It is broken out.

George Gaspar - Robert W. Baird

And specifically, in terms of your international operations [office to office], can you indicate what the interpretive, seismic interpretive work consists of in terms of revenue count?

Robert P. Peebler

We don't do much interpretive work. What we do is processing. We do have a small services business, but it's really in the noise, is the way I would describe that. We don't break that out separately. But mainly, the main revenue for us is processing revenues itself. And I don't believe we do give the mix, we just give the total revenue number.

The one thing I will say and I said it in my script is that the trend for us, obviously, more and more of our business is away from North America as we open up centers around the world. And the business is growing more in the East, so things like our joint venture in Russia; we'll start getting revenues from that. We have a joint venture in Nigeria. That's a very strong business for us.

And so over time we think the processing business will continue to grow, and the percent of that business will come more and more from outside of North America.

George Gaspar - Robert W. Baird

And can you give an update on where the new seismic boat construction sits today? How many new boats are still to be outfitted that you can see in the world construction market, and where do you envision your equipment getting on percentage wise, those ships that are still being completed.

Robert P. Peebler

George, I think there are places you can find that information. We have our own internal analysis, and obviously we're bidding on jobs and so we just don't make that data public.

You can go out there. There are people that are in those businesses that you can get that information from.

George Gaspar - Robert W. Baird

On FireFly in terms of Version 2.0 relative to 1.0, some of the changes that have been made in the system, I don't know if you want to go into that in any detail, but are you still working on the same type of number of geophones that were deployed in the first version or have you learned something from Version 1.0 that has suggested that there's got to be more deployment of geophones in the package? Or is it just more in terms of how the data is derived and brought into a central area?

Robert P. Peebler

Well, the system is designed to scale. So it can handle, in theory it can handle one or it can handle 20,000 or 50,000 or whatever. So the trick in the system is, as you scale up and the - if you want to think of it in a broad sense, the data management becomes more complex. Obviously, your radio system, your data management system, your tracking system, all the things that - it's a very large, integrated system and so what the field tests helped us to understand was that when you scale these things up and when you give them to very large [station] counts, how you manage all that.

And the changes to the system are firmware, software, hardware; it's a very substantial improvement to many areas. Some of the learnings we got from the job, we probably have probably 40 man years that we put into the system over the last year and a half or so. But there's way too much detail to get in on the call.

Operator

Your next question comes from [Tamara Monuchin] - Greenwood Investments.

Tamara Monuchin - Greenwood Investments

My question is about Marine segment. I was wondering what is the main driver for the Marine sector. Is it number of vessels that come online or there a retrofit market that you are targeting?

Robert P. Peebler

Yes, it's a bit of all of the above. Obviously, when a new vessel comes on, that's quite substantial because you're outfitting the complete boat. And so that drives all of our suppliers' businesses, all the way from people who do compressors [inaudible] so there is quite a nice business that we've all enjoyed just having new vessels coming out, and that's going to continue looking out at least another couple years.

In addition to that, there's a very substantial trend towards more complex shooting and that requires all the way from more streamers in the water to more complicated software, like our product Orca that can handle multi-configurations of boats that work together. And then you have, as the size of the operating fleet increases, you get into  things happen out there, and so you get into replacement due to damaged equipment, needs for repairs, and you would expect that to be the case.

So there's really multiple drivers being driven by not only the complexity of what they're doing but the sheer volume of the business.

Tamara Monuchin - Greenwood Investments

So if we look at your Marine revenues during the last couple of years just qualitatively, is it half and half in terms of new vessels versus retrofit and do you see any trends?

Robert P. Peebler

Actually, I don't know that. I don't want to speculate, because I just don't have that off the top of my head. Our guys in the Marine division could probably recite that pretty quickly.

But the trend, the one thing that's new to us is that we're also entering new products. So, for example, our DigiFIN product is a new product, and so that gives us another whole revenue stream. Our DigiSTREAMER that we just currently made our first sale really is almost a new product line for us because we've had a very small market share. We also have new products within the mix to address the market.

But I don't have the number off the top of my head on what that [percent] is.

Operator

I'm showing that there are no further questions.

Robert P. Peebler

Well, thank you for taking the time to attend this conference, and we look forward to talking to you during our next earnings call. Thank you.

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