Cal Dive Still Waiting For That Offshore Recovery

| About: Cal Dive (DVR)
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Cal Dive's backlog is at a multiyear high and utilization levels are low, suggesting meaningful margin leverage potential.

There is a real risk that business migrates away from Cal Dive's established areas of expertise.

Relatively low coverage, a high short interest ratio, and a relatively undemanding valuation could propel the shares on good news.

There are more than a couple of ways to make Cal Dive (NYSE:DVR) look cheap. If you look at the book value of the company's vessels, it might be tempting to call the stock undervalued on the basis of its liquidation value. Likewise, if you look at past utilization rates and EBITDA margins, it can be tempting to base a strong bull argument on the basis of substantial earnings leverage once Gulf of Mexico activity levels recover.

I'm not nailing down the coffin lid on Cal Dive, but I do see this stock as a more speculative play on better offshore activity levels in the Gulf. The nature of offshore support functions is changing, and I believe it favors companies like Oceaneering (NYSE:OII), Chouset, Subsea 7, Saipem, and Technip (TKPPY) as more work goes to ROVs and deepwater projects. Projects are starting to move forward, though, and Gulf rival Tetra Technologies (NYSE:TTI) has sounded relatively bullish on near-term prospects. If Cal Dive can get more of its fleet working in FY 2014 and continue to move back toward mid-teens EBITDA margins, a substantially higher share price is possible.

Fourth-Quarter Results Showed Some Progress

Cal Dive reported fourth-quarter earnings about five weeks ago, and though the company missed on the top line, there were still a few encouraging data points. Revenue rose 9% on a yoy basis and the 3% sequential improvement was quite a bit better than the performance in Tetra's Offshore business (down 22% from the September quarter). Overall utilization on a calendar basis was only 44%, not improving much at all from mid-2013, as saturation diving utilization dropped from 75% to 60% and surface diving and construction utilization remain in the mid-to-high 30%'s.

EBITDA improved more significantly, rising 27% from the year-ago level and ending the year with a 10.7% EBITDA margin against a full-year margin of 6.6%.

Backlog Firms Up, Helped By Pemex

Cal Dive has been benefiting from more work at Pemex's Mexico's state-owned energy company. Cal Dive had six assets working on Pemex projects, and the company announced that it has completed about 60% of the work on $290 million in awards. Looking ahead, I do not believe it is unreasonable to think that Cal Dive could pick up more work here; the Mexican government has gotten a lot more serious about repairing Pemex and restoring some of its luster (and cash-generating capabilities). A lot of that process is going to revolve around offshore activities in the Gulf of Mexico and with Cal Dive's strong share in the region (50% by some estimates), they should be in play for picking up more business.

All told, Cal Dive reported that its backlog rose about 45% to close 2013, reaching the highest level in five years. The good news in a higher backlog is usually pretty self-explanatory, but I would observe that even at 15% EBITDA margins, that backlog only gets the company to about half of the Street's EBITDA target for 2014.

Long-Term Challenges Remain An Issue

One of the concerns I have about Cal Dive is similar to a concern I have about Parker Drilling (NYSE:PKD) - whether key parts of the business can remain competitive over the long term. In particular, I'm worried about the long-term competitiveness of manned diving and the company's leverage to shallower waters.

It is true that there are things that Oceaneering's (and Chouset's) ROVs cannot do today, and it's probably always going to be true that there are things that an ROV cannot do, or do as well as a diver. That list of "can't do" tasks is shrinking for ROVs, though, and Cal Dive may face increasing price pressure in that market.

I'm also worried about the migration of offshore business to deeper waters. The further E&P companies go offshore, the more that fits the capabilities of Technip, Saipem, and Subsea 7. There's likely to be ample opportunities for decommissioning work in shallower water, but this is an area where Tetra has been focusing more of its attention lately.

What's It Worth?

It's tempting to look at Cal Dive's fleet and see value. After all, new-build diving support vessels can sell for well more than $150 million and pipelay vessels are worth even more. The problem is in the details. These new vessels have considerable advantages in terms of where they can operate and what they can do, and that pushes the value of older, less capable vessels down quite a bit. To that end, I'd note the asset impairments that Cal Dive has been recording over the last two years - they're not big, but they do suggest some caution in approaching Cal Dive from the perspective that its vessels are seriously undervalued.

I do believe management deserves credit for the recent improvements in EBITDA margins. If activity continues to improve in the Gulf of Mexico in 2014 and 2015, that should pave the way for ongoing improvements and better cash flow generation. My current assumptions are for 13% and 16% EBTIDA margins in 2014 and 2015 and better utilization would likely improve both the revenue and margins for Cal Dive.

The Bottom Line

If Cal Dive can do around $70 million in 2014 EBITDA (annualizing the last quarter would lead to $68 million), $2.50 to $3.00 seems like a fair valuation range for the shares. Going a year further out, mid-teens EBITDA margins could at least theoretically support a fair value close to $4.

Even a $2.50 fair value suggests a stock that is 50% undervalued, but a few words of caution seem appropriate. Activity levels in the Gulf have been skewed to deeper-water projects and there are credible bearish arguments as to why shallow water activity won't pick up as much (if at all). Likewise, there are ongoing threats that competitors like Technip, Tetra, and Oceaneering will beat Cal Dive for business. All in all, Cal Dive is an interesting speculation, and one where the 25% short ratio could mean some big moves on good news, but there is more than enough execution risk here to merit the label of "speculation".

Disclosure: I 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.