TGS NOPEC: Long term value opportunity

Would you believe me if I told you there's a company that has a 10 year average ROIC and ROE of 32% and 25% respectively, has their customers pay around 50% of capital expenditures and has pricing power over these customers? 

Because this is a long post, quick summary:

• Negative sentiment around oil has created an opportunity in a well managed, asset-light oil service business.
• Company allocates capital counter-cyclically, similar to Berkeley Group which I have spoke about here and here
• Enjoys significant pricing power, high ROIC and operating margins consistently 35-40%

TGS NOPEC is a Norwegian oil and gas service company that provides multi-client seismic data. The 2008 annual report briefly explains the business:

Seismic data is the only rigorous way to physically map sub-surface geology in order to determine where to drill for oil and gas. Oil companies can obtain seismic data either by hiring a seismic contractor and paying the full cost and profit to the contractor, or by purchasing a license to use multi-client data already acquired by a contractor.

So there are two main business models in the industry where E&P companies can either pay full cost for the entire survey and own the data on a propriety basis, or go the cheaper route and pay a fraction of cost and let the seismic company own the data and license it on a non-exclusive basis. 

TGS follow the Multi-Client (MC) model entirely.

This business particularly caught my eye as it has one attribute that is vital to sustaining a competitive advantage: low cost/expense relative to the customers overall cost base. Seismic data firms have pricing power as they save costs in dollar terms and in time for E&P companies. A quote from a competitor, Pulse Seismic, claims that the price of the survey is around 1% the total cost for E&P firms.

Also, Buffett tried to buy a similar firm in 2004, called Seitel, in which he claimed the market undervalued the MC library asset. Anything Buffett looks at is surely worth a look!

TGS Business Model

TGS claimed in their 2008 annual report that they are 'doing things differently' from competitors and following the MC model entirely giving them a very asset light business. Throughout the cycle this allows them to scale back operating expenses facing falling demand and easily meet higher demand by hiring vessels and crew to collect the data. Once this data is collected and owned, the marginal cost of selling this is near zero. 

Before TGS embarks on a project, it gets 'pre-funded' by a group of customers who wish to use the data and TGS themselves. This is normally funded half and half. Making your customer pay for a product you then license back to them seems like a good business to me. 

TGS's main competitors PG and CGG have a combination of the two business models stated above and therefore their balance sheets limits the returns on capital possible:

2014 Numbers ($)	TGS	CGG	Pet Geo
MC Library	818	947	695
PPE	42	1,238	1,663
Total Assets	1767	7,061	3,563
Debt	0	2,778	2,400
Equity	1339	2,693	1,901

However, there have been a couple of other entrants following TGS's model such as Spectrum ASA, set up by a former TGS guy, and Pulse Seismic. I will come onto barriers to entry later. 

Do the numbers prove TGS'S model has an advantage over their competitors? 

                              

TGS share price performance seemed to decouple from the industry in the last few years as the oil price has nose-dived and their ROIC has been consistently higher for last 10 years.

So what are the factors that enable TGS to maintain these higher numbers?

• Pricing power – the company serves hundreds of customers. All E&P firms need access to seismic data before they begin operations and it is crucial to saving costs, working efficiently and maximizing extraction rates. The cost of exploration is hundreds of millions and the relative small cost of buying seismic data gives TGS considerable pricing power.
• Asset light balance sheet – leases vessels and doesn’t need to outlay a huge amount of capital apart from underwriting a % of the project along with the E&P customers
• Asset base (data) can be licensed years after the survey is completed at no extra cost.
• Market share in this business is vital. If I am an E&P I am not going to buy data from a small player, I am going to go to the leader to ensure everything is correct and trustworthy. Therefore there is a huge positive feedback loop with market share here.
• Ability to reinvest these earnings back into the business – E&P companies constantly need better, more efficient ways to replenish depleting reserves and therefore TGS have the ability to reinvest into more advanced technology or machinery in order to better process data or make previously uneconomical places to drill viable. 
• TGS management follow a counter-cyclical capital allocation process where they look to acquire cheap surveys and assets from struggling firms when underlying oil price falls through the floor. 

Counter cyclical Capital Allocaton

Management have continually reiterated during times of struggle that they will continue to follow their counter-cyclical capital allocation process. After the Gulf oil spill in 2010/11 management increased capex, snapping up cheap surveys from struggling competitors. In the 2015 Q3 release was the following:

0. The company has taken advantage of the slow market to secure adequate land and marine crew capacity for planned projects at favorable arrangements. The acquisition cost per unit has come considerably down and multi-client investments in 2016 are likely to be lower than in 2015. The weak market conditions have also led to an increasing number of M&A opportunities. Earlier this year, TGS announced the acquisition of the majority of Polarcus’ multi-client library and the company is prepared to continue investing inorganically in order to further increase the basis for long-term profitable growth, provided that return requirements are met. 

Proof of this?

In 2008 TGS increased capex 60%, in 2011 20% and in 2015 are set to increase it around 22%.

So management not only talk the talk, but actually walk the walk. They seem to be true capital allocators.

My question now becomes how effective is this allocation and can they maintain this competitive advantage they seem to have?

Return on incrementally invested capital is said to be a fairly good indicator of the sustainability of a moat, i.e. if the ROIIC is decreasing through time, this moat is not sustainable. It is very hard and to measure this precisely although I have attempted.

                                  

The chart above shows the obviously highly volatile 1yr ROIIC but a fairly high and consistent 3-year ROIIC. For example, the 1-year ROIIC in 2011 was -2% but the following 3-year rolling ROIIC from 2012-14 were 77%, 67% and 29% respectively. 

What stops an entrant gaining market share and what factors help sustain the moat?

One factor I think is crucial in this business that enables TGS to benefit from a ‘virtuous circle’, as Munger likes to say, is the power of being market leader. The quality of TGS’s library is crucial. The location, interpretation and efficiency of the data is key to maintaining their advantage. 

The quality of the multi-client data library is clear. The 10 and 5-year CAGR of the library is 18.5% and 11.5% respectively, growing from $145m to $818m today. These assets are worth notably more than book. The replacement cost exceeds book value and the ability of some competitors to replicate the library is very expensive and time inefficient.

In what situation would a customer choose a smaller competitor over TGS? 

TGS have been in the game nearly 20 years and therefore have experience and knowledge of interpretation of the data and therefore a younger company cannot exactly compete here. New revolutionary technology to interpret the data, maybe. 

If you’re an E&P company, you are not going to pay for data that is not the most efficient or valuable. The total cost of paying a company like TGS is so small in relation to their business that paying for market leader is a no-brainer and therefore low cost providers cannot exactly compete. 

The only reason they would go with a competitor, such as Spectrum, is the intricacies of the data, mainly location. I do not understand or know the best places to run surveys to drill oil and don't intend to, but I am sure that TGS understand the most valuable areas and have a hold on many geographies.  

What has the market missed?

The market seems to be underestimating the power of the MC library in the future. EPS will come in around $1.2 for 2015 and revenue will continue to fall into 2016 and therefore the market will most probably sell everything related to oil E&P as this is the first capex to be scaled back.

When calculating maintenance capex for the FCF I add back increases in the change in the value of the MC library stated on balance sheet and take this as growth capex. Backing this out gives FCF from 2012-14 of $225m, $250, $330m and an estimated $270-300m for 2015. With a market cap of around $1.55bn you are getting TGS at around 5-6x FCF, 9.5x EBIT and and 12x E2015 earnings. I think for a company with these numbers this is a good price, however no doubt the stock will be a sucker to oil price movement in the short term.

One obvious risk and assumption one makes when investing in TGS is that of the price of oil. I cannot forecast the price, maybe it will go to $20 in short-term, but I the one assumption I am willing to make is the future value of TGS's asset base and the fact E&P firms will still need to utilise the data to drill in the future.