Seismic Sector Is Sizzling (PGS, SELA, SLB)

 |  Includes: PGSVY, SLB
by: Envoy Global Research

If you've been following my oil and gas stock picks, you know that I've been bullish on the seismic sector for quite some time. I remarked in late 2005 that seismic would be a key investment theme in 2006 and recommended purchases of Seitel Inc. (OTC: SELA) and Petroleum Geo-Services (NYSE: PGS) for the best exposure to the sector. On Friday, the whole seismic sector got a huge boost when Schlumberger Ltd. (NYSE: SLB) announced the purchase of its remaining 30% stake in WesternGeco, the leading seismic data company in the world, from Baker Hughes for $2.4 billion.

There's nothing like an acquisition to get Wall Street's speculative juices flowing, and the news sent Seitel and Petroleum Geo-Services, up 14% and 10%, respectively, leaving both stocks up way more than 100% since I first recommended them.

My current feeling is that these stocks (especially Seitel, which still languishes on the bulletin board), can still go up alot more in 2006 and so I'm holding on. Admittedly, as is generally the case, I've been quite conservative on my price targets for these stocks, especially with Seitel, but with the Schlumberger acquisition alot of business and valuation risk has been removed from the sector. And a perceived reduction in risk is always good for stock prices.

Without getting into the nitty gritty valuations, which I am quite frankly too lazy to do, I think a key reason to hold on to the stocks can be summed up qualitatively. Specifically, Schlumberger CEO Andrew Gould, had this to say about the conditions in the seismic market:

The industry exploration cycle that has now clearly begun is likely to be longer and more sustainable than anything seen in recent years. Targeted reservoirs are likely to be smaller and will be more complex, with ultimate recovery factors being key to project economics. Our decision to purchase the minority interest of WesternGeco reflects our confidence in the seismic market and our belief that greater reservoir complexity will require more accurate reservoir characterization.

In short, growth in the seismic sector will be stupendous for several years. And that is the key factor for any stock: Sustainable Cash-Flow Growth Not As Yet Factored Into The Stock Price. In the case of the seismic companies, I think it is it the growing realization of the sustainability of the current cash-flow boom, not the growth in cash-flow per se, that can keep the stocks chugging along for quite some time.

Therefore, given the small supply of leading seismic companies with sustainable business models (i.e. PGS, SELA, VTS), and given Wall Street's propensity to chase performance and momentum, one can expect that shares in these companies will continue to perform well for quite some time. Of course, at some point expectations will outpace the reality of the underlying seismic business, but for now I don't believe that is the case, since valuations are nowhere near nosebleed levels.

Incidentally, I think Mr. Gould's quote is also significant because it actually touches upon a concept which it would seem the vast majority of people miss when investing. The only reason why a stock has any value whatsoever is because of the businesses underlying future cash flow growth and the sustainability of that growth. Of course, there are other details to consider such as whether the market is already factoring in that the cash flow growth and sustainability, but without some concept of sustainable cash-flow growth there is simply no way of approaching an investment in the stock market. In fact, in these instances you probably do have better odds playing craps in a real casino.

It simply amazes me how people just gamble on stocks because a price hits a new high or they sell because a stock goes beneath some sort of moving average. There is simply no analysis of the business so as to ascertain the sustainability and growth of cash-flow. For instance, the other day, someone recommended to me a stock that had not had one financial filing since 2004. Now how can you even consider investing in a company if you can't see the financials?

Or consider the case of another tip on a PKI security company. Sounds exciting you may think, maybe I'll jump in. However, a cursory glance at the company's 10K, reveals a weak financial position and a business model centered around government contracts in what amounts to a highly competitive industry (despite the fact that, not surprisingly, the company suggests that they face no competition). Little cash, chasing government contracts, massive competition from larger well-financed competitors, and a valuation of 10X sales (double that of much more capable competitors) are hardly the recipe for sustainable cash-flow growth and a reasonable expectation of continued stock price appreciation. It's one thing for Google (NASDAQ:GOOG), a dominant company with almost unbelievable cash flow and billions upon billions of cash (I think it is up to $8 or so billion now, not sure), to trade at a high price to sales multiple, but it's quite another for a tiny company with no cash to do the same.

In all these cases and more, what clearly drives investors to make ludicrous gambles which can in no way work out over the long-term are two factors: Liquidity and Past Performance. Since silly stocks, with no real sustainable business to speak of, do in fact go up dramatically at times to valuations that defy any rational explanation (we'll leave the reasons to an SEC investigation), and since shares of a stock are easily bought and sold, people make the general assumption that its OK to buy any stock irrespective of any business and/or financial analysis. However, this type of reasoning will most likely lead you to the poorhouse because it is a mathematical certainty that in the long-run (i.e. after many "investments") you are gauranteed to lose money if you gamble in situations where the odds are against you, which they are if you invest in companies with no sustainable cash-flow growth at nosebleed valuations.

From my perspective, the key to success in the stock market is to improve your odds by investing in situations that because of a reasonable business and financial analysis can be said to have a greater than expected chance of showing a profit, i.e. you face limited downside risk and may expect significant upside gains. At times, for various reasons, these investment gambles will fail, but ideally over the long-term you will have a history of wins and losses, with the wins dominating if you invest in situations where your expected gain is positive and the risk/reward is favorable. The worst thing that can happen to you in the stock market is to be making money, using a strategy that simply must fail over the long-term.

PGS, SELA 1-yr Performance