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. 

Berkeley Group Holdings: London's NVR

Berkeley released interims today showing continued strong performance with adjusted profit before tax up 10%, increased forward sales and estimate future land bank gross margin. They increased the dividend return programme the introduced in 2011 from £13 to 16.34 per share, with £12 to be distributed over the next 6 years.

I mentioned in a previous post about Berk's unique operating model and the favourable macro fundamentals that are certain to provide tailwinds in the coming years, however I didn't touch much on management or the ability of this company to create value.

Is this a value creator? Does the company create value throughout time? How can we even measure this?

Michael Mauboussin explains how value creation stems from the ability of company to earn returns on capital above their cost but throughout time. Consistently. This is the test, Can Berkeley continue to generate ROIC's in the 20s and if not what is the long run average ROIC for such a business.

                                   

Berkeley has consistently generated high ROIC, well above it's cost of capital. This is simply due to their operating model. They buy plots of brownfield land, land previously used for industrial or other commercial purposes, to redevelop and sell residential homes on in the South East and London.

Competition for brownfield sites is considerably lower than standard green belt plots which are chased by all UK builders. Berkeley's management has skill in choosing land, placemaking. They have purchased land at 10-15% of the final selling price.

The unique operating model is very similar to NVR, the US Homebuilder who purchase options on land rather than outright purchasing plots. Berkeley also do this and claim they have around 'we hold a pipeline of strategic long-term options for in excess of 5,000 plots'. This keeps the capital required to run the business minimal to maintain those high ROIC's.

How can we prove management have skill in choosing brownfield sites and gaining planning permission?

One way is to use Buffett's value add measure of $1 of retained earnings being greater than a nominal $1.

Berkeley Market cap 2011 - £1.35bn 

Sum of Net Income (inc 2015 H1) - £1.314

Sum of Dividends - £0.5954bn

Retained Earnings = £718m 

Mkt Cap 2011 + Retained = £2.068bn 

Current Market Cap = £4.89bn 

Total Value Added = £2.828

From 1996 the record is even more outstanding:

96 Mkt cap - £32m 

Retained earnings April 1996 - Oct 2015 = £2.398bn

Total Value added = £4.89bn - £2.43bn = £2.46bn 

Berkeley has created £2 of value for every £1 retained over a 20-year period. Clear value creation. 

OK, yeah, some of this value has come from the huge increase in house prices in these areas. The House price index shows a CAGR of around 8% over the 20 year period in question. So Berkeley management have definitely added some value from operations.

How long can this continue?

Macro factors tailwinds:

• Continued, sustainable for London and South East property 
• Constrained supply in housing 
• Continued support, and increased pressure, of government pushing the redevelopment of brownfield sites in London
• Increasing approvals of planning applications
• Help to Buy scheme improving mortgage approvals. 

Seems like its here to stay at least for the next couple of years. 

Hargreaves Services Asset Valuation

Interesting links this week

Sanjay Bakshi - Bayesian thinking piece - Must Read

The most recent Howard Marks memo

Recent podcast of Julia Gatlef on Phil Tetlock's Superforecasting book - great site and Julia has some very good videos on youtube for understanding cognitive functions and scientific stuff.

After Amazon's recent earnings result I found re-reading this great post on their business model

And of course, Andrew Left of Citron Research on Valeant - this is a good introduction for anyone who, like me, has zero knowledge of the biotech world

Pebbles of perception: Book review

Pebbles of Perception by Laurence Endersen is a little big of wisdom and, not surprisingly, stemmed from the author's reading of Poor Charlie's Almanack and his resonation with Mungers thinking. It is a very easy read and gets you to stop and think about all aspects of choice within life and steps to take to ensure you do the best to make the best choice.

Life is about decisions and this book gets you to think more about perception, incentives and emotion in order to go through life making good decisions. I have highlighted a few main points from the book that really made me think:

1. Incentives - 'the rabbit runs faster than the fox, because the rabbit is running for his life while the fox is only running for his dinner'. The chapter on incentives is great and immediately made me think of a bit of advice I got from a former colleague that 'every decision and problem in the real world stems down to incentives and expectations of the parties involved'. The author links incentives to the 'eat what you kill' culture in finance and how there is nothing more dangerous tan underestimating incentives.
2. Perspective - ' too far east is west and too far west is east'. Understanding perspective and contextual differences in decisions will help understand outcomes.
3. Fear and uncertainty - The future is uncertain. The author uses a great analogy of fear of the future in life. 'We are the captain of our own ship. Fear of the future is the anchor that holds us in the harbour. Fear-ruled ships stay in safe harbours, but what use is a ship that won't set sail?' Uncertainty is forever present in all decisions. But without risk there is no return. Understanding the forever presence of uncertainty can not only help us calculate or imagine probable scenarios but also help us strive to eliminate as much uncertainty as possible. This point also resonates with Seth Klarman's comments on uncertainty which can be found in the link in my previous blog post here. 

Munger, MITMCo and Klarman: Interesting links from this week

First link is from Munger on Coca Cola and one of the best examples of 'inverted thinking'. No explicit mentions of basic valuation metrics we would see in most analysts' work and is a must read for anyone attempting to think differently:

Charlie Munger: Coca Cola Analysis

The following link is an interview by Manuel of ideas with MIT's Investment Company MITMCo. Great insight into what they look for in managers and how they analyse the thinking process and characteristics of managers. Great read for money managers and aspiring investors.

MITMCo: Perspectives of Aspiring Superinvestors

The third link is an article by Seth Klarman on uncertainty written in Feb 2009, the midst of the crisis. I think this piece resonates well with recent spouts of high volatility and uncertainty in markets today. Understanding uncertainty and the limits to your analysis helps understand the risk of the investment and also spurs you on to eliminate as much uncertainty as possible.

Seth Klarman: The value of not being sure

Lectra - earnings power of a quality business

Lectra – Free growth in a quality business.  

Lectra is the world leader in integrated technology solutions dedicated to industries using soft materials. The firm designs, produces and markets full-line technological solutions – compromising software, CAD/CAM (computer aided design and manufacturing) equipment and software and associated services such as PLM. This mainly covers automakers, fashion and apparel and furniture amongst other industries. Two founding brothers have a combined 30% ownership of the business own the company.

They have been heavily spending on R&D recently, planning to benefit from the longer term trend of brands modernising their manufacturing processes, using seamless data and technological solutions to improve cost efficiency and product quality. Lectra estimate they have around 25-30% market share in CAD/CAM (computer aided design and manufacturing) software and equipment business. This company is not statistically cheap on basic valuation metrics, although the quality and earnings power of the company provide value.

Business

In 2011 they decided to invest for the long term and transform the company. They have committed €50m to spend on innovation, research and marketing in the years 2012-15. This is a company that is investing for the long-term future of the business and is noticing the rapidly changing requirements of the sector. They have actually spent around €20m per year since 2012 on R&D, although French taxation and research credits mean the net spend is actually around half this value. The company sells machinery with software, which is then contracted annually, providing Lectra with recurring revenues. Revenues from deploying new systems for new clients is the growth revenue of the business.

How much of a margin of safety does the recurring revenue give and what are reasonable growth rates of the growth revenue?

As always, lets think safety first. The recurring revenues are from contracts of existing systems, spare parts and consumables. In 2014, Lectra earned €122m in recurring revenues, which just about covers the fixed overhead costs of running the business entirely. This fixed cost, which is mainly salaries for the engineers and brains behind the solutions, amounts to around 75% of gross profit for the last 10 years. This recurring revenue has also been around 55-60% of total revenues consistently and provides some safety, although obviously subject to some risk.

How reliable are these revenues? How replaceable are they for consumers, i.e. what is the replacement cost of the service and product Lectra provides?

Lectra has around 23,000 customers from all industries, and although they do not equally contribute to revenue, it would take many small or a few large customers to literally shut down operations for Lectra to lose a huge chunk of revenue. FY2014 – no single customer represented more than 7% of revenue, the 10 largest customers account for less than 20% and the 20 largest less than 25%. The sales are fairly evenly spread geographically with 46%, 24% and 23% coming from Europe, Americas and Asia respectively and are evenly spread between both automotive and apparel sectors, with a small portion in aeronautical and furniture. This provides some sustainability in revenues and predictability in the underlying business.

I believe the replacement cost of the machinery Lectra provides is fairly high. I am assuming here that once Lectra do employ a system (machinery and software) for a client, like Oracle and other back office operating systems, it takes huge cost and efficiency incentives for the client to change. A brand is not going to replace all their systems, plus educate and teach their employees to use a new system, with a new competitor once Lectra have installed their software into the brand’s processes. Therefore, Lectra benefit from great first mover advantages and the innovation and R&D provides high barriers to entry. The main issue is recruiting and educating the clients on the solutions they provide.  

Growth

Selling new systems, the machinery and the software with it, is the growth driver in this business. They have COGS made up of purchase and freight costs which amount to around 25% of revenue giving a 5-year average gross margin of 75%. Operating costs are c55-60%, which involve fixed overheads and fixed and variable wages. This gives operational leverage to the business and if they begin to sell many new systems, a large amount of marginal revenue flows to bottom line. FY2014 the firm had operational leverage of 2.27 (fixed costs / variables) and therefore for every 1% change in revenue, operating income will increase 2.2x. These fixed costs have been around 55% of revenue for the last 10 years consistently. The company has negative working capital requirements as they receive payments for their software and equipment and then shift the goods/service. As long as gross profit from recurring contracts cover personnel costs, a security ratio management refer to, the risk of this investment is reduced. Lectra benefit from 30% R&D tax credit and employment tax credits from French government enabling them to literally spend all cash generated on growth.

Instead of asking the obvious questions around growth; why/how will they sell these new systems and what kind of growth rates can we expect, I am going to invert the question and say how is it possible they will not grow and in what scenario would this happen?

Lectra estimate they have around 25-30% market share in their core business of CAD/CAM equipment and services. I have mentioned before about the replacement cost of their services and that it would need a seriously highly efficient, low cost service provider to take Lectra’s clientele. Another way to not grow is to implode and this would cause a global crisis to halt all manufacturing in the fashion and apparel and automotive industries. 

The company’s cost base is largely in euros in France, which has given Lectra an edge over its US competitor for the last year. Adjusting for Lectras intangible strength, mainly customer relationships and brainpower in this niche field, and the remaining assets shows the reproduction asset cost of business is around 1.5x book value. The value of the assets actually needed to start a competitor in this niche field is around €160m. The earnings power and reproduction cost show the company have a competitive advantage. The majority of the assets are intangibles and therefore the main risk is a large competitor entering the market with greater innovative solutions. This is a risk, although the niche nature of the business makes it highly inefficient for a large player to spend as much time as Lectra to enter a small market. 

I feel there is definitely spare capacity in the demand on the micro level for Lectra’s services as global brands move towards using technology and data in all processes. I am confident in the long-term growth in new systems as it is clear more and more brands will need to adopt systems that enable the full use of seamless data and technology to maintain their brands cost efficiency and quality. The business is sustainable on recurring revenues and operational leverage is going to accelerate earnings once new systems are employed. Also, Lectra have publicised a 10-year plan to speed up China’s product development and add value to their design and manufacturing activities. Their strategy to targeting growth seems to be adequate although valuing this growth is difficult. To attempt an estimate of the value of growth I use the basic Greenwald method:

Lectra have spent c€20m a year on innovation, engineers, marketing and revamping the business. This R&D is fully expensed each year and actually only amounts to 70% of the total value due to tax credits.

Assuming 5% growth rate and 10% WACC:

Future cash flow = (ROC – g) * Capital invested

                                          = (.35 - .05) * 55m = 16.5m

Value of a growing firm = 16.5m * 1 / ( .1 - .05) = 330m or this can be proven by:

(ROC – g ) * Capital / (r –g).

This value of future growth gives 25% upside to the current value of the firm.

Valuation

Greenwald states that ‘when earnings power is above market value, growth comes for free’, and Lectra seems to provide this. The firm has great potential to evolve into a high growth stock. Average operating margins for the last 5 years have been around 11-12% and the operational leverage in the business provides space for expansion as they grow.

Management claim to have around 25-30% market share in the CAD/CAM software and equipment sector, and they have patents running until 2022 that protect this share and therefore margins. The power of these patents were recently proven when Lectra won a battle with a German manufacturer claiming they had infringed on Lectra’s airbag cutting system. I feel there is a high chance Lectra will remain global leader in the CAD/CAM sector and I do not consider any growth in the PLM market as this is a very competitive service. 

The current price of Lectra is not cheap by any means. Trading at around 9.8x EBIT and 16.8x FCF with a PE of 16.8 with all metrics higher than their 5 year averages. However, it’s clear you are paying for quality here. Insider ownership, 35% 5-year average ROIC and consistent cash flow proves the quality of this company. Lectra's main competitor is a private company called Gerber. Vector Capital bought Gerber Scientific, in 2011, for $282m. This price was at around P/S 0.5 of the last 4 years total revenue, and a huge PE of over 40 but no recent data is available on Gerber.

I have calculated the earnings power value of Lectra to be around €12.09, giving an 11.5% margin of safety to the market price. This is using a 10% cost of capital and being conservative with adding back only 10% of SG&A and R&D. This current earning power eases some of the uncertainty against future growth in new systems. I am happy to pay for quality here. Also, looking plainly at the facts of the firm investing over €60m in the last 3 years, with an average ROIC of around 35%, this has a high probability of returning at least €21m in cash in the coming years.