Policy Uncertainties Keep ION Geophysical's Growth On A Leash

About: ION Geophysical Corporation (IO)
by: Badsha Chowdhury

Energy policy ambiguity in some of the Latin American geographies are blocking ION Geophysical’s growth.

Crude oil price volatility and upstream operators’ capex uncertainty are also hurting the company’s prospects.

2D and 3D re-imaging programs have been increasing in Brazil offshore.

The company’s cash flow is weak.

Its relative valuation multiples are not cheap.

IO is still not out of woods

ION Geophysical (IO) provides geoscience products, services, and solutions that allow upstream energy companies to obtain the earth’s subsurface images. I do not think IO will be able to keep its momentum going in the short run because of several industry headwinds. Unless offshore capex starts picking up and the crude oil price stabilizes, sustained growth for the company remains doubtful.

Ion Geophysical will look to improve its revenues when the upstream operators increase capex investment and the company’s new venture programs gain momentum. IO’s 3-D reimaging program in Picanha in offshore Brazil should also boost growth. Its software-based products have found progressively higher usage in the U.S. military sector, which can turn out to be a huge market. However, the company’s traditional offshore-based business in Mexico and Panama has continued to suffer from policy uncertainties.

In the past year, IO stock price has gone down by 43.5% and underperformed the VanEck Vectors Oil Services ETF (OIH), which declined by 35% during this period. OIH represents the oilfield equipment & services (or OFS) industry.

Looking through IO’s drivers in 2018

Ion Geophysical invested $28 million in the multi-client data library in 2018, sanctioning seven new programs. Of these, three were 2D multi-client programs and four were 3D multi-client reimaging programs. IO’s area under the 3D data library increased by 36% in 2018 compared to 2017. The most remarkable growth came from its Picanha 3D reimaging program in offshore Brazil. IO initiated this program in August 2017 to understand the complex petroleum systems in the Campos and Santos basins in Brazil. During 2018, the company was able to keep pricing firm in that program, despite the general lack of investment in the offshore projects. The other significant improvement for IO was the success in its new technology offerings, which includes Full Waveform Inversion data processing technology and OBS acquisition systems. These technologies offer betterment in image quality and productivity. Recently, IO received three awards for such projects. As a result, its imaging services backlog increased by $9 million after January 2019. Let us now see how these factors affected the company’s revenues and margin in Q4.

Analyzing IO’s Q4 performance

From Q4 2017 to Q4 2018, IO’s E&P Technology & Services segment revenues increased by 26%, while the Operations Optimization segment saw 43% revenue growth. Both these segments also witnessed strong gross profit improvement. Year over year, gross profits for the E&P Technology & Services and the Operations Optimization segments increased by 53% and 47%, respectively. Now let us check out the drivers for each of the segments to understand where IO is going at its current state.

IO’s ocean bottom activity and Marlin deployments increased in Q4 following higher command and control software systems sales. The company received two new contracts and tree extensions for its Gator technology systems. IOs Gator software is the central hub that integrates and manages data and helps perform complex multivessel ocean bottom operations. On top of that, IO’s Marlin operations optimization software doubled in 2018 with 60 new deployments. The application helped upstream operators avoid various operational conflicts and associated downtime, thus saving costs for them. As of December 31, IO’s backlog for Marlin was $2 million.

IO’s new technology-based offerings

IO’s other new technology-based initiative is SailWing, which can be used as an alternative to the conventional marine diverters. With IO’s growing presence in the source vessel performance market, this product can add $3 million to $5 million in revenues with a healthy margin. What could turn out to be the company’s vast potential market is its application for the armed forces. In 2018, IO sold its compass technology for use in military GPS to provide precision navigation applications. It has a second similar project in the pipeline. It also has initiated a field trial for the acoustic communication system that enables communication for naval divers.

In the ocean bottom system market, IO is offering 4Sea components more broadly to service providers, which will launch a stream of recurring revenues. IO’s 4Sea is a fully integrated ocean bottom system. The company expects 4Sea to be commercialized in 2019. The 4Sea integrated QA-QC system is scheduled to be delivered in 1H 2019.

IO’s negative drivers

Despite robust growth in Q4 2018, IO’s full-year 2019 revenues decreased by 9% compared to FY2017, while its net loss deteriorated to $71.1 million in FY2018 versus a net loss of $65.1 million in FY2017. What caused the headwind was offshore drillers’ budget constraints and deals being pushed out due to geopolitical challenges. Because of geopolitical issues and policy uncertainties, IO could not realize revenues of around $30-40 million in Panama and Mexico in 2H 2018. Delays in license round announcements have negatively affected the company’s new venture programs. In a new 2D multi-client program offshore Panama, the license round announcement has been delayed further. These programs were already suspended in Q2 and were expected to be commended in Q3. However, no such action has taken place yet. IO’s management expects the next license round in Panama to be announced in 2H 2019.

The situation has been further complicated by the E&P companies’ spending cut on new acreage and seismic data in Mexico. The situation will remain so until the prospects of investment in those areas become clearer. There is a growing trend in Mexico of restricting exploration spending pushing deals into 2019. IO’s management observes that many of the company’s upstream customers wait to purchase data until the government makes a formal public announcement. In December 2018, Mexico’s new President Andrés Manuel López Obrador ordered a 3-year moratorium on new license rounds in the country. This can significantly reduce IO’s growth prospect in that region.

During Q4, IO took a $37 million impairment charge. The company assessed that customers’ shift in the OBS market to nodal systems limited opportunities for its legacy cable-based technologies. Overall, the crude oil price weakness affected upstream operators’ capex, which also limited OFS companies’ revenues. In December 2018, Brent oil prices declined by 18%. In this environment, when growth opportunities can be limited, E&P operators are prioritizing cash conservation over reserve replacement. A case in this point would be IO’s non-materialization of the year-end multi-client purchases.

IO’s industry outlook

Company management expects short-term-term volatility in the crude oil prices in the near term following upstream investors’ cautious E&P spending in 2019. The short-term impact of the crude oil price volatility on the capex budget is not easy to ascertain. However, IO’s management considers the long-term oil and gas fundamentals to remain strong. The upstream capex may increase by 8% in 2019 compared to 2018, as management commented in the Q4 earnings call.

In 2019, IO anticipates significant improvement in revenues after the upstream operators increase capex investment, the company’s new venture programs increase, and the benefits of the 2018 new venture programs are realized in 2019. IO’s software business and commercialization of several offerings will drive growth in 2019. To increase the number of newly sanctioned programs, the company has recently approved a fourth 15,000 square kilometer phase of the Picanha 3D reimaging program offshore Brazil. This leaves ~25% of the total program to be completed in the future. In February, IO received a new 2D multi-client reimaging program in the deepwater Campos basin in Brazil. The program is expected to be completed in May 2019. The program can also supplement the Picanha 3D program.

Current status of IO’s lawsuit against SLB

Since 2009, there has been litigation between Schlumberger (SLB) and IO regarding a patent infringement regarding marine seismic streamer steering devices. On June 22, 2018, IO announced that the US Supreme Court reversed a Federal Circuit Court's determination that lost profits Schlumberger’s WesternGeco sought against IO were not available. In July, the Federal Circuit ordered the parties to submit briefs on the damages, if any, to which WesternGeco is entitled.

In January 2019, the Federal Circuits Court has joined together the two fronts. The Federal Circuit court also ordered that the lost profits award could only be reinstated if it was found that the technology covered by the last remaining patent claim was essential for performing the surveys for the lost profits. Although the long-standing case is likely to have been priced into IO stock, an unfavorable verdict on the matter can reduce the company’s margin.

Debt and cash flow

IO’s long-term debt has decreased by 22% from FY2017 to FY2018.The majority of its contractual obligations are due between 2019 and 2022 ($180 million). The company’s 2018 capex budget was $28-22 million. In FY2019, it expects to spend $40.0-60.0 million, which includes investments in the multi-client data library.

In February 2018, IO raised $47 million from an equity offering. A part of the fund raised was used to de-leverage its balance sheet. The offering also included warrants to purchase additional shares. The warrants expire on March 21, 2019. If the warrants are exercised in full before their expiration, IO will receive additional proceeds of $61.2 million. So, the company can repay a significant part of its debt from these proceeds, if the warrants are exercised.

IO’s cash flow from operations in FY2018 was $7.1 million, which was a significant decrease compared to FY2017. This was driven by lower activity compared to 2017, the WesternGeco lawsuit payment, an increase in accounts and unbilled receivable balance, and reductions in accounts payable and accrued expenses. IO’s cash & cash equivalents were $33 million as of December 31, 2018. The total liquidity (revolving credit facility plus cash) available is $75 million. Sans further refinancing, the company needs to increase cash flow from operations significantly. Else, it will need to dip into its cash balance or revolving credit facility to finance its capex and meet financial obligations, even if the company’s deleveraging is complete.

What do IO’s relative valuation multiples suggest?

IO is currently trading at an EV/EBITDA multiple of 14.8x. Its forward EV/EBITDA multiple is 3.7x, according to sell-side analysts’ estimates. The lower forward multiple compared to the current EV/EBITDA multiple implies higher EBITDA in the next twelve months. Despite the deceleration in the margin the next quarter, the company is expected to turn around in 2019. Margins may improve following the return of the license rounds in Panama, higher license activity in Brazil, and as margin from IO’s new products start to reflect. Between FY2013 and FY2018, the company’s average EV/EBITDA multiple was ~8.0X. So, IO is currently trading at a premium to its past six-year average.

The company’s forward EV-to-EBITDA multiple compression versus its adjusted trailing twelve months EV/EBITDA is steeper than its industry peers’ average, as noted in the table above. This is because sell-side analysts expect the rise in IO’s EBITDA in the next four quarters to be higher than the peers’ average. This would typically reflect in a higher current EV/EBITDA multiple compared to the peers’ average. IO’s TTM EV/EBITDA multiple is higher than its peers’ (SPU, CGG, and SLB) average of 6.0x.

Analysts’ rating on IO

According to data provided by Seeking Alpha, one sell-side analyst rated IO a “buy” in February (including strong buys), while one sell-side analyst rated the stock a “hold”. None of the sell-side analysts rated it a “sell”. The analysts’ consensus target price for the stock is $19, which at IO’s current price yields ~54% returns.

What’s the take on IO?

Ion Geophysical will look to improve its revenues when the upstream operators increase capex investment, the company’s new venture programs grow, and the benefits from the new venture programs initiated in 2018 get realized in 2019. IO has a robust new product pipeline, which keeps customers engaged and opens up new markets. The company’s 3D re-imaging program in Picanha in offshore Brazil will also likely boost its growth. Its software-based products have found progressively higher usage in the U.S. military sector, which can turn out to be a huge market.

However, IO’s traditional offshore-based business in Mexico and Panama has continued to suffer from policy paralysis. Mexico’s moratorium to ban new oil blocks for the next three years can significantly affect the company’s prospects in that region. IO’s lawsuit with Schlumberger is still pending. The company plans to allocate more capital in capex in FY2019. With higher capex, its low cash flow from operations can translate into negative free cash flow, unless growth picks up significantly. With significant debt repayment due in the next 1-3 years, IO’s balance sheet reflects financial risks.

The company’s relative valuation multiples are higher than its past average after the stock price shot up by 34.5% in the past month. I do not think IO will be able to keep its momentum going in the short run because of several industry headwinds. In the long term, the company may be able to increase its market share and inflate its margin. Unless offshore capex starts picking up and the crude oil price stabilizes, sustained growth for IO remains doubtful.

Disclosure: I/we 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.