August is the Time to Buy Odyssey Marine Exploration

Company Description

Odyssey Marine Exploration, Inc. (NASDAQ:OMEX) is engaged in the archaeologically-sensitive exploration and recovery of deep water shipwrecks that contain treasure throughout the world.

Odyssey’s May 2007 recovery of the estimated $500M Black Swan treasure and subsequent legal dispute with Spain has made headlines worldwide. Odyssey utilizes innovative methods and state-of-the-art sonar technology to conduct extensive deep ocean search and recovery operations on high value shipwreck targets.

Industry Overview

Sea exploration has dramatically changed due to state-of-the-art technologies that enable the search, discovery and recovery of shipwrecks that were previously beyond reach. Odyssey is transforming activities long associated with "pirates and treasure hunters", into a serious and legitimate commercial industry founded on strong business practices, a commitment to the environment and high archaeological standards. There are well over 1,000 high-value shipwreck targets ($50 million - $2+ billion).

Investment Thesis

Odyssey is our favorite “lottery ticket” play for the next 6 months given its massively outsized risk/reward profile. August is the time to buy OMEX. Odyssey has been operating in the English Channel this season. The recovery season in the Channel runs from May - October due to weather. Hence, announced recoveries usually come August - October. Odyssey arrested 2 shipwrecks on May 29, 2008 in the English Channel. It is logical to conclude that Odyssey has been working on recovery operations on those 2 sites.

Odyssey’s combination of the best research department, superior sonar technology, and the most operations experienced team combine to generate a steady flow of identified and arrested high-value shipwreck targets. In order to have a successful and sustainable business in the shipwreck recovery business, 3 requirements must be met…

1. FINDING: Can the company consistently find the high-value shipwreck targets?
2. RETAINING: Can the company retain the majority of the value of the recovery?
3. MONETIZING: Can the company effectively monetize the value of the recovery?

1) Finding High Value Targets

Odyssey has a team of 8 archeologists that have identified the most attractive shipwreck targets and have reviewed literally hundreds of thousands of historical documents to provide the most likely areas to conduct the searches.

Odyssey owns and employs state-of-the-art technology, including both search and recovery vessels, side-scan sonar and magnetometer equipment, remotely operated vehicles ("ROVs") and other advanced technological innovations. Over the past 10 yrs, OMEX has markedly improved side-scan sonar and magnetometer technology. A ship with traditional commercial side scan sonar can cruise at approximately 2 knots, where OMEX’s ships can now travel at up to 8 knots while towing a side-scan sonar buoy. This allows Odyssey to cover up to 4 times the research area over the same period of time. Odyssey has also significantly improved the search resolution and data analysis which creates more precise vectors leading to massive efficiencies and time savings by reducing false positives.

2) Retaining the Recovery

In order for the salvor to legally retain the value of the recovery, the shipwreck must not be subject to “sovereign immunity.” Below is a brief primer on the relevant law.

Legal

There are two important subject areas connected to any shipwreck. The Law of the Sea Convention establishes the rights of a country based on location and Admiralty and Maritime Law governs maritime questions and offenses.

The Law of Sea Convention establishes three separate zones off the coast of any country:

• Territorial Water (<12 miles)
• Contiguous Zones (12 - 24 miles)
• Exclusive Economic Zones [EEZ] (24 - 200 miles)

A shipwreck in Territorial Water (within 12 miles) is considered to be the property of that country if the shipwreck is not deemed to be sovereign immune (see “Sovereign Immunity” below for definition). Commercial wrecks in Territorial Water are only eligible for arrest or a salvage award when permitted by that country’s laws or if there is a pre-existing agreement in place between Odyssey and the country.

Sovereign Immunity

Under international law, warships and other vessels or aircraft owned or operated by a country and used only on government non-commercial service ("State vessels and aircraft'') may continue to enjoy sovereign immunity after sinking, wherever they are located. This typically makes any sovereign vessel immune from arrest, salvage claim and salvage award.

However, if a military ship is on a mission that has any commercial business, the ship is no longer considered a sovereign immune vessel. Commercial vessels and mail ships are also not considered sovereign immune vessels. Odyssey only targets vessels that are deemed to be non-sovereign vessels. The only exception is if Odyssey has a pre-existing agreement in place with that country (similar to Odyssey’s agreement with the U.K. for the sovereign vessel, the HMS Sussex).

Salvage Law

“Salvage” is the reward given to persons who voluntarily assist a ship or recover its cargo from impending or actual peril or loss. If a shipwreck is not subject to sovereign immunity, it is deemed to be a “commercial vessel” and comes under maritime and admiralty salvage law. Under maritime and admiralty salvage law, a salvor is typically entitled to 90% of the recovery. Thus, if a country or another claimant has a legitimate claim on a commercial ship, in a best case the country or claimant is awarded 10%...leaving 90% to the salvor. Hence, Odyssey is likely to receive at least 90% of any find to which they are granted salvage regardless of who the claimants are.

3) Monetizing the Recovery

To maximize the value of the recovered coins and artifacts, the coins should be well promoted and packaged.

Discovery Channel Series

In May 2008, Odyssey and Discovery Communications (owner of the Discovery Channel) announced a significant production deal. Similar to the show “The Deadliest Catch”, Discovery intends to air a series based upon Odyssey’s shipwreck recoveries. There will be a 2 part episode on the Black Swan (currently slated for November 2008) and the regular series is slated to air either near the end of 1Q09 or the beginning of 2Q09. Filming started at the beginning of June 2008. Odyssey receives a fee per episode that covers a significant portion of the operating budget of the recovery ship.

Marketing Partners

We expect Odyssey to announce relationships with top-tier public companies that specialize in the packaging and sales of collectible coins and artifacts. This will markedly increase the speed of monetization of the recoveries.

The Black Swan Litigation with Spain

The company has already recovered approximately 500,000 coins (estimated by at least one external expert to be valued at $500M) from a site code-named the Black Swan. We believe that it is likely that Odyssey will be granted rights to 90% of this find by the Admiralty Court of the United States.

On August 8, 2008 the stock price was $4.75, which is the same level that the shares were at BEFORE the announcement of the recovery of the Black Swan treasure in May 2007. That implies that the market is giving Odyssey zero chance to keep any of the Black Swan treasure. Spain has been quite vocal in the press talking about how Spanish galleons are part of Spain’s heritage and therefore, Spain demands the return of the coins and artifacts from Spanish shipwrecks. Oddly, Spain seems to neglect to acknowledge that the gold and silver coins and gemstones from the Black Swan were coming back from the New World where Spain enslaved and killed countless people in South America during its colonial period. Grand standing aside, what actually will dictate the outcome of the trial is admiralty law (as discussed above).

Spain can only refuse salvage on a vessel that is “sovereign immune.” In order for a vessel to be sovereign immune, it must have been a Spanish warship that was 100% engaged in non-commercial activity at the time of its sinking.

Spain has several severe challenges with its legal case in the Black Swan. First, Odyssey Marine did not recover a single item from the site to indicate that there was a ship at that site. The Black Swan recovery site is just a debris field. There is not a canon, a ship’s bell, moorings, the ship’s spine, or anything else to indicate that the site is that of a shipwreck. One possible explanation is that during battle, if a ship was taking on water or needed to lighten its load so that it could better escape, it would throw the heaviest items overboard. Odyssey Marine recovered 17 tons of coins and artifacts from the site.

Even if Spain is successful in proving that the Black Swan site is that of a shipwreck, Spain has the burden of proof to prove which shipwreck it is. Spain claims that it is the Nuestra Senora de la Mercedes which sunk in 1804. Odyssey claims that there are some pieces of data that support that conclusion, but other pieces of data that do not support that conclusion.

Even if Spain is able to prove that the Black Swan site is (1) that of a shipwreck and (2) that the shipwreck is the Mercedes, Spain must then prove that the Mercedes was subject to sovereign immunity. There is no debate that the Mercedes was a Spanish warship. However, on the return voyage from the New World upon which it was sunk, documentation exists that demonstrates that approximately 72% of the cargo on the ship was commercial. Given that the Mercedes was not on a 100% non-commercial mission, the shipwreck site cannot be subject to sovereign immunity. Instead, if Spain is successful in proving that the site is that of the shipwreck of the Mercedes, the recovery would come under salvage law. Under salvage law, approximately 90% of the recovery is typically granted to the salvor. In this case, the salvor is Odyssey Marine. The remaining 10% would be shared among any legitimate claimants.

The next step in the litigation with Spain is that the presiding magistrate has asked Spain to lay out its entire case to establish its claim that the Black Swan is subject to sovereign immunity. Spain's dispositive motion is due on or before September 22, 2008. A victory by Odyssey in the Black Swan case will establish firm and wide-reaching precedent regarding the “commercial” status (vs. “sovereign immune”) of all State warships that were transporting some commercial cargo or non-military passengers at the time of the sinking.

Upcoming Catalysts

4 major events will likely act as positive catalysts for Odyssey’s shares….

1) Settlement or Legal Victory in the Black Swan Case

a. Settlement - any settlement would likely be in the form of a split (50/50) of the Black Swan treasure and the terms would extend to any other Spanish shipwreck that Odyssey recovers regardless of whether the ship is commercial or sovereign immune. Additionally, in order to ensure that the market for the coins and artifacts is kept in balance, if Spain ever wanted to sell a portion of its percentage of the recoveries, the sale would be managed by Odyssey. We believe that a settlement is unlikely until sometime after September 22, 2008. This is the date when Spain’s response is due in

Admiralty Court

as to why it believes that the Black Swan is subject to sovereign immunity. If Spain’s support for its position is not legally compelling, it is possible that the court could signal to Spain that it feels that it is Spain’s best interest to settle the dispute or risk establishing a very negative precedent against Spain.

b. Legal Victory - If Spain declines to settle the Black Swan case and Odyssey prevails, then Odyssey would be granted a salvage award on the Black Swan and likely retain over 90% of the recovery. More importantly, direct legal precedent will have been established and it is open season on the 100s of Spanish mixed-use shipwrecks (warships that had some commercial goods on them at the time of the sinking) that are in international waters. It is believed that the vast majority of the high-value ($200M - $3+ billion) Spanish shipwrecks were mixed-use.

2) Recovery of another high-value shipwreck – As mentioned above, we believe that Odyssey is currently engaged in at least one recovery operation in the English Channel. Given that the recovery season in the Channel is from May – October (due to weather), we would not be surprised if there were meaningful developments before the end of this year’s English Channel recovery season.

3) Airing of the Odyssey series on Discovery Channel – the series on Discovery will bring worldwide attention to the company. It is expected that the Discovery Channel will air a 2 part episode on the Black Swan in late 2008, which will lead into the series that will air in late 1Q09 or early 2Q09.

4) Announcement of wide-sweeping country agreements – we believe that it is likely that Odyssey is working on partnership agreements with various countries that would cover numerous shipwrecks of the country in question.

Valuation

These are the major sites that Odyssey Marine may have already discovered:

1. Black Swan

500,000 silver and several hundred gold coins have been recovered and it is estimated that this is only half of the cargo. Odyssey will be returning to the site to conclude recovery operations.

Estimated Value: $500M - $1 billion

2. HMS Sussex

HMS Sussex was an English warship lost in a severe storm in 1694. Historical documents and other evidence suggest that there was approximately 10 tons of Gold aboard the vessel when it sank. If the research is correct, then the numismatic value estimates for the cargo range from several hundred million to a billion dollars or more, depending on whether the cargo referenced in historical documents is gold or silver, the condition of the coins, which denominations may be represented. Odyssey and the Government of the United Kingdom have signed an exclusive partnering agreement for the shipwreck of the British warship HMS Sussex. This is the first time in history any government entered into an agreement with the private sector for the archaeological excavation of a sovereign warship.

Estimated Value: $300 - $1+ billion

3. Merchant Royal

The Merchant Royal set sail in late August 1641, trailed by her sister ship, the Dover Merchant. But during the journey she began to leak and rescuers were unable reach her in time. The loss of the treasure made headlines. Back in 1641, the ship’s hold was equivalent to one-third of the national exchequer. There are reports of anywhere from 100,000-400,000 pounds sterling, and 100,000 gemstones.

Estimated Value: $500M - $2 billion

4. SS Ancona

The SS Ancona, an Italian passenger liner torpedoed by a German U-boat in 1915 off the southeastern coast of Sardinia, taking 12 barrels of gold and a shipment of silver bars with it to the bottom.

Estimated Value: $60M.

5. Undisclosed (but suspected to be the El Salvador) - According to historical records it was carrying 16 chests of silver and four of gold when it went down in the area of Cape Lookout during a 1750 hurricane.

Estimated Value: $125M

6. Undisclosed (but suspected to be the La Vierge du Bon Port) - On July 9, 1666, the ship was attacked by an English corsair and sunk off Guernsey.

Estimated Value: $100M - $400M

A silver coin wholesales for $200 - $2,000 depending on the scarcity, condition, and the “collectibility” of the coin. A gold coin wholesales for $4,000 - $100,000 depending on the scarcity, condition, and the “collectibility” of the coin. Odyssey management believes that several items of worked gold and silver will wholesale in the millions.

We value the company by first looking at the value of the 6 targets listed above and then consider the pipeline of the business beyond these 6 sites.

The mid-point of values of the 6 shipwrecks is $3.5 billion. Assuming 2 full-time recovery vessels, we estimate that it will take 3 years to recover these 6 sites. It is likely that Odyssey will add an additional recovery vessel or 2 in the near future. The sales cycle for collectible and numismatic coins can be 4 - 5 years, depending on demand. With the interest and demand that will likely be generated by the Discovery series, we have conservatively assumed a 4 year sales cycle. We assume that 40% of the wholesale revenue goes to sales, marketing and channel partners. Assuming 12% discount rate, we estimate the current value of the above listed shipwreck projects to be $17.00/sh. Again, this portion of the valuation is based just on the 6 identified and arrested sites.

Odyssey is adding 2- 4 new arrested shipwreck sites annually. It has already identified what it believes are 7 potentially high-value targets in the Channel and the North Atlantic. Additionally, there are numerous sites along the Mexican coast and in the Caribbean that have been identified. We estimate that Odyssey will be able to recover 3 wrecks per year past 2011 with an average value of $150M per wreck, producing EBITDA of $216M. The NPV of this cash stream is $22.60/sh. The combined value of the two cash flow streams generates a total value of $39.60/sh. Hence, we believe that if Odyssey continues to execute that the shares could appreciate 10x.

Recent Trading Sets Up for a Short Squeeze

The company is not covered by the sell side and there are now 6.9M shares short (15.3% of the float). An additional 1M shares were shorted in the first 15 days of July 2008. Why? From late June through July 15th, the financial stocks were breaking down very hard and it looked like the market was setting-up for a massive decline. Many of the quant funds needed to lay out new short positions with little time for deep company-specific analysis. This is what happened with Odyssey and the incremental 1M shares that were shorted during June 30 – July 15.

Given that most of the short holders are “low-conviction” shorts, they have done little fundamental work on the company. In the face of evidence that they badly misread the situation, that they will look to quickly cover. Hence, there are 6.9M shares that will have to be bought in very short order in the event that one or more of the above catalysts take place. The vast majority of OMEX’s float is held by high-conviction long institutional holders and insiders. High-conviction long institutional owners believe that we are at the beginning of a 3 – 5 year bull run for OMEX. There are very few shares available for the shorts to buy and the price will move quickly higher. Therefore, this is setting-up for a MASSIVE short squeeze.

Conclusion

There are issues that carry high uncertainty and require a significant time investment to gain conviction around. We believe that this causes the shares to trade at a steep discount to baseline value. It is likely that several of these uncertainties will be removed in the coming months and that the company will trade up significantly to better reflect intrinsic value. We feel that Odyssey Marine presents a unique investment opportunity.

Full Disclosure: The author manages a hedge fund that is long Odyssey Marine (OMEX).