TGS Nopec Geophysical ASA (OTCPK:TGSNF)(OTCPK:TGSGY) is a Norwegian oil data provider that is the result of a merger with U.S.-based TGS and Norwegian Nopec in the year 1998. The company's main product is refined data covering land or sea-based oil reserves (the latter being the main focus), which it sells to customers involved in oil exploration. Oil companies have two alternatives for obtaining data from TGS. Customers can either directly contract TGS, which in turn acquires the data, performs the post-processing and then transfers the right of ownership to the client.
This model is more expensive for the customer, as they pay the full price for the job performed by TGS and in addition they have to store and maintain a database. Alternatively, they can opt for a multi-client solution, in which the company finances a fraction of the total project costs upfront. The total investment is thus smaller, but the customers do not get full ownership of the acquired data. Ownership is retained at TGS, which then sells this same data to other interested parties.
Figure 1. The extent of TGS Nopec's data library ((Source: TGS))
TGS Nopec is specialized in the second alternative, the so-called multi-client business model, as it allows the company to generate more return on investment by selling the same data to multiple customers. Only 3% of the total revenue is derived from the proprietary model; the rest is multi-client data. The company employs a strict ROI discipline in its multi-client investment projects, by following the stated goal to only undertake projects that are able to earn a sales return of 2 to 2.5 times' investment.
The figure below reveals that this target has almost been reached and that the long-term trend is approaching a 2x return on investment. However, the recent cyclical downturn due to lower oil prices have of course had a negative impact on sales and consequently ROI, as seen in 2015 and 2016.
Figure 2. TGS historical sales return on investment (company filings)
The future of the oil industry is constantly clouded in uncertainty and it is currently perhaps even more uncertain than ever before. The dates for peak oil have been predicted on multiple occasions – and subsequently revised as new data became available. The current worry is that of peak demand, as acceptance of the climate change theory becomes more mainstream and society faces a greater pressure to shift towards more environmentally friendly sources of energy.
Some major European cities have recently introduced plans to ban diesel cars, either right away or at least by the year 2040. It is not unreasonable to assume that a ban on gasoline engines follows closely behind as alternative methods of propulsion become more sophisticated.
The industry itself (here represented by The International Energy Agency) expects oil demand to continue increasing with more than 10% by the year 2040. However, this institution is not completely oblivious to changing paradigms and has set out different scenarios, which I present here in Figure 3.
The IEA base case is the one I just described and the efficiency case takes into account increased levels of engine automation that attempts to run engines as often as possible at the optimal operation point, thus reducing waste of fuel. The electric vehicle case assumes that battery-driven cars will play a large role in the future and the last case, fuel switching, represents an industry-wide shift towards alternative source of fuels (such as biofuels).
The long-term trends for oil demand and thus the future oil prices are not easy to estimate and presents a large uncertainty. However, short-term trends for exploration of oil is somewhat possible to anticipate. The cost of sea-drilling has shrunk marginally over the years and the break-even price for companies involved with this activity are currently at profitable levels – even with the currently depressed oil prices (Figure 4).
For example, in an article by Financial Times (8 Sep 2017), the journalist writes that the Norwegian state-owned oil company and TGS customer Statoil (NYSE:STO), had a break-even price at $80 a few years ago for its Johan Castberg fields.
Today, the break-even for the same field is down to $35, driven by technological advancement, which makes ocean drilling more profitable. Statoil even claims a break-even price of $25 for another of its oil fields in the Barents sea. The company representatives said in the latest conference call that most customers have a planning price in the range of $50 to $60 a barrel.
This means that we can expect investment activity to pick up again, which will benefit companies like TGS. If the price of crude oil starts to rise even more in the near future, then the ROI (return on investment) for new oil fields would become even more attractive, which is sure to drive more customers to TGS and its peers in the oil exploration data industry.Brent Crude Oil Spot Price data by YCharts
Figure 4. Brent crude oil price.
There is a lot of competition in this field, as the barriers to entry are not high enough to ward off new players. However, the latest cyclical downturn of this industry hit the existing competitors hard and some of these are on the verge of bankruptcy, which leaves more of the pie to the remaining companies. I gathered some data about the listed competitors that I was able to find.
These are: French company CGG (NYSE:CGG), Norwegian peer Petroleum Geoservices (OTCPK:PGSVY)(OTCPK:PGEJF), Norwegian Spectrum ASA (OTC:SPTYF), American ION Geophysical Corporation (NYSE:IO), Norwegian EMGS and Norwegian Seabird exploration (OTC:SBDXF). In Figure 5, I present 10 years’ worth of EBITDA for these companies, in order to provide a rough overview of historical market shares and trends.
I also gathered some information about the current credit rating for each of these companies and a measure for the debt servicing capacity, here represented by the EBITDA to Interest Expense from the last filing. These serve to strengthen the hypothesis that this industry will undergo a radical change, which would create great prosperity among the survivors. This data is presented in Table 1, below, and as we can see from this Table, CGG is in fact bankrupt.
This once mighty company suffered greatly from the cyclical headwinds, and the debt carried on the balance sheet caused the company to file for Chapter 11. PGS and ION are also in trouble, having the sub-investment grade rating of CCC+. If the bondholders are doubting whether they get their investment back, how can the equity holders stand any chance?
Seabird and EMGS are two other companies that are suffering and are close to bankruptcy. The only companies that have solid balance sheets are Spectrum (SPU) and TGS. It is not just the event of bankruptcy that is negative for the company in question and positive for the competitors; near bankruptcy is itself also very costly as assets held on the balance sheet must be sold at discount to service interest expenses. This presents an opportunity for savvy competitors to take advantage of a desperate peer and acquire quality assets at a discount.
What makes TGS Nopec different?
5 out of the 7 companies that I have identified in this industry are not in good shape, but TGS has a solid balance sheet and is ready for a cyclical upswing. One of the major reasons for TGS Nopec’s survival is the fact that it avoids financing by interest-bearing debt, which in retrospect has turned out to be the right strategy.
The other major factor is the company is very asset light. TGS does not own any data acquisition vessels, but has instead opted to lease these from other operators as the need arises. This solution leads to slightly higher hourly costs, as the company essentially has to pay the subcontractors profit margins, but it also means that there are no ongoing service costs and other expenses related to ownership.
Furthermore, the company does not have to concern itself with utilization rates for its vessels and deploy these to low-yielding prospects just to keep the boats busy. Instead, TGS can focus only on the low-hanging fruits, which is exactly what it is doing by only performing projects that have a 2-2.5 return on investment. The company has in the past not had any problems getting vessels and currently they have 8 boats (representing 1/3 of the total market) in operation performing 3D surveys on their behalf.
Financials and valuation
A strong earnings model and small asset base have given this company an average return on capital employed (ROCE) in the mid-double digits for the lifetime of the company. The recent years’ ROCE has been significantly lower, which is of course related to the cyclical downturn, but as business picks up the pace again so should the ROCE. Value creation takes place when ROCE exceeds the cost of capital (which is usually in the range of 5-15 %), which is why this measure is important.
I believe this number will increase substantially in the next few years, conditional on oil prices remaining stable or even increasing. The other financial figures are also favorable, for example, the EBIT margin is usually in the mid-40s (but 15% last year) and the company continues to generate positive free cash flows.
On a trailing 12 months basis, the P/E is 83, which might initially seem expensive, but is caused by the denominator being unusually low ($22.2 million USD) in 2016, compared to a more normal $269.1 in 2013). This is again caused by the headwinds that this sector faced in 2015-2016. If normalized earnings are used, based on the assumptions that headwinds turn into tailwinds and earnings return to mid-cycle levels, then the forward P/E ratio becomes 11.4, which is a more reasonable number.
The bankruptcy or near bankruptcy of TGS Nopec’s competitors means that the company's market share could grow, possibly by +50%, which could lead to a substantial increase in valuation, and possibly an upside price of 276 NOK ($36 in the ADR) in the next 2-3 years.
Some of these factors are already playing out. In the latest conference call, management reported a 24% YoY increase in the backlog and heavy acquisition activity is planned for Q3, most of which is prefunded by the customers. The management themselves have been eager buyers of TGS stocks at the current market price. Table 2 below summarizes the year to date insider buying (which excludes stock options). TGS currently (6 Oct 2017) trades at 184.6 NOK at the Oslo stock exchange.
Table 2. Insider buying 1 Jan 2017-7 Oct 2017.
|10 Feb||SVP EU & Asia||2250||190.0|
|20 Feb||VP Operations||1100||189.2|
|10 Mar||SVP Geological products||2500||185.6|
|10 Mar||SVP Onshore||2000||183.8|
|10 Mar||VP HR & Communications||2000||183.8|
|10 Mar||VP Operations||5000||185.0|
|10 Mar||VP Imaging services||2800||186.1|
|10 Mar||VP General council||1575||186.1|
The valuation thesis is mainly based on either rising or flat oil prices. If the prices would, for some reason or another, go down again then this investment would not turn out to be a good one. The company seems immune from bankruptcy due to its equity-only financing and low overhead costs, but a lack of earnings would nevertheless punish the stock price.
The data that the company owns may also turn out to be unfavorable for the industry, which would lead to less late sales. The data will also eventually become obsolete. The company amortizes its data library on a four-year basis, which indicates that this is the useful economic life of the data.
There are plenty of signals that indicate a prosperous future for this company and consequently its stock price. A lower break-even price for ocean drilling will lead to increased exploration activity even at depressed oil prices. Cyclical tailwinds that weed out the weak competitors leaves more business for the survivors when the winds change. Lastly, plentiful insider buying indicates that the management has confidence in the industry and the company while simultaneously signaling that the stock is not overvalued.
Disclosure: I am/we are long TGSNF.
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.
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