CGG (XPAR:CGG), an integrated Geoscience company, has lost 37% of its value year to date. Given the dearth of opportunities in the market, I decided to look at the company under the lens of a long term investor.
All figures in USD
Cash = $320M
Debt = $2,682M
Pension = $57.3M
Shares/Price/Cap = 176.8M/$19.76/$3,497M
EV = $5,916M
FCF 2012/2011/2010 = $63.1M/$94.2M/-$108M
A geoscience company can be thought of primarily as a service provider for the Oil & Gas industry. An oil and gas company needs data to estimate or discover oil/gas fields. This is done by gravity, magnetic, passive seismic and reflection surveys. The idea is to get relevant data and then try to reconstruct the situation beneath the surface of the earth. Ideally, one can estimate the size of the reservoir, where to best dig for the well and how to manage it well over time.
Additionally, prospecting for oil has caught on and it is being done in harsh environments of deep sea, icy regions of the North Pole and under other hazardous operating conditions.
CGG provides a complete package in this area. They make the equipments which are used to generate and record the data (operating segment: Equipment), acquire and storage of the data (operating segment: acquisitions) and interpretation of the data (operating segment: Geology, Geophysics & Reservoir). The following is a split of their revenues according to the segments and geography. The marine, land and multi-client, all come under the purview of acquisitions segment. Thus, the company derives 57% of its revenue from its acquisitions segment.
The company has a long and varied history since its foundation by Conrad Schlumberger in 1931. In its current form, it is result of a merger between CGG and Veritas DGC -- which was completed in 2007. Veritas DGC itself was a result of merger between Veritas (founded in Canada in 1974) and Digital Consulting Inc (founded in Texas in 1965). The company employs 10,000 people across 70 countries.
CGG has been a serial acquirer and as a result is has significant amount of goodwill ($3,125M, Sep 2013) and debt ($2,529M, Jun 2013) on its balance sheet.
This is especially surprising given that the company has not been very profitable over the years.
Reading the annual report, I was grappling with the issue. Why is the company, which is making losses, continues to leverage its balance sheet and acquire company after company. It was clear that the incentive of the management needs to be checked. The following is how the variable pay is decided for the management (CEO and CFO).
:A word of caution here, the Morningstar data on FCF of the company is wildly inaccurate. For some reason they do not include the capital expenditure in acquiring the multi-client data.
The financial objectives are related to the Group revenues (weighted 30%), operating income (OPINC) (weighted 35%), EBITDAS less capital expenditures (weighted 20%) and Group free cash flow (weighted 15%).
The acquisition segment is one of the most interesting and deserves to be looked into. CGG acquires data in two different ways (i) by specific request from a company, in which case the data remains private and accessible only to the company which requested it, and (ii) multi-client data, where a group of companies pay partial costs of the acquisition and CGG is free to license the data to other users, for a fee.
The multi-client data is a gold mine and should offer fat margins for the company. It is much cheaper for a company to license the data, rather than arrange a private acquisition at significantly higher costs. The license fee forms a very small part of the clients overall costs and so he willingly pays for quality.
CGG has been investing a lot in its multi-client data library, year after year. As a result, its multi-client library has over 300,000 Km^2 of 3D coverage and more than 1M km of potential field data in the most prospective regions of the world. The company also provides data management services and experts to interpret the data.
The investment is one of the reasons why the company is not wildly profitable. Each of the individual surveys eats significant amount of money and has a limited book life based on its location. So, a survey may be subject to significant amortization even though the sales of license associated with the data is weak or non-existent. This will result in lower net income but higher operating cash flows.
At the end of 2012, the multi-client library in North America has more than 60,540 Km^2 of 3D surveys, primarily along the Rocky Mountains, Alaska, Oklahoma, South & East Texas, shale gas basin and Bakken field (shale oil). This market has high level of pre-funding and limited overlaps with other geophysical contractors. In 2012, the company invested $117M for the multi-client data with pre-funding of 96%.
The data acquisitions in the marine world has similar business model. The company has 522,000 Km^2 of multi-client data, primarily in Gulf of Mexico, Brazil, North Sea and deep waters in Angola. Unfortunately, this market is competitive with significant overlaps in the libraries of other contractors. They invested $302M in marine multi-client surveys in 2012 with prefunding level of 62%.
The company operates five state of the art processing centers, located in Houston, London, Singapore, Paris and Calgary and 25 regional centers. There are 12 dedicated centers located within clients offices, which makes CGG the leader in this sector. The GGR segment has sticky customers and sees less competition compared to other two segments.
The company’s main equipment division is called Sercel. Sercel develops a complete rang of geophysical equipment for data acquisitions. It competes with Ion Geophysical (NYSE:IO) in the marine products and Inova (joint venture between BGP and Ion) and Geospace Technologies on land. Sercel has grown through acquisitions and a result owns 60% of the equipment market.
A detailed discussion of risks follows.
The company has a fleet of 17 seismic vessels for marine acquisitions. These incur significant fuel costs circa $198 in 2012. An increase of 20% in the fuel price will result in a negative effect of $25M on the operating income. The company has invested significant sums of money on its fleet and as a result has the most technologically advanced marine data collection fleets in the world.
The company obtains most of its contracts through very competitive bidding processes. While no single competes with them in all segments, in each of their segments they face intense competition. Additionally, the business volume depends on the level of capital expenditures by the oil and gas industry. After the Deepwater Horizon incident, for example, the stock of the company fell 24%, eclipsing the drop in the share price of BP in the near term. The revenues derived from land and marine data acquisition also varies significantly during the year.
The company does not have a very good balance sheet. It has revolving credit facilities in the US and France which are contingent upon financial metric that the company needs to maintain. If these metrics are broken, the company may need to pay within a short time span.
As a byproduct of acquisitions, the company has nearly $3.1 bn in goodwill. Most of the companies in this area are asset light. They have data libraries which are amortized year after year but are more valuable than the book value. For example, the Fugro acquisition in 2012 resulted in an increase of $725mn in goodwill. This is stark, given that the total price paid for the Fugro geophysical division was around $1.6 billion. A writedown in the goodwill will result in loss for the company. With so many acquisition, the company is bound to be wrong often.
The management has not taken a conservative view towards the number of shares outstanding. The shares have gone from 59M in 2003 to 177M in the most recent quarter. This is a compounded annual growth of 12%.
The combination of significant debt, huge goodwill, growth through acquisitions, management incentives, and share dilutions stops me from investing in this company. It is especially disappointing because this company has an opportunity to be a wide moat, cash generating behemoth. Unfortunately, the management seems incapable in recognizing it.