Unique Business Model of Norwegian Oil Service Firm Has Long-Term Value

TGS-NOPEC Geophysical Co. ASA (TGSNF, Financial) recently posted fully diluted losses of 28 cents per share for 2015, and the price is down around 30% since late 2015. The unique business model seems to provide some long-term value.

TGS-NOPEC is a Norwegian oil and gas service company that provides multi-client seismic data. Seismic data is the only 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.

Therefore, 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 choose 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 (the multi client model).

TGS's business follows the multi-client model.

This business caught my eye as it has one attribute that is vital to sustaining a competitive advantage: low costs and expenses relative to the customer's 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 (PLSDF, Financial), claims that the price of the survey is around 1% the total cost for E&P firms.

Warren 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 emphasized the value of their business model on page 10 of their 2008 annual report, explaining how they have an asset light balance sheet, unlike competitors, as a result of following a multi-client driven model. They have been following this model strictly since inception, and there are no signs of deviation when times get tough.

The multi-client model is flexible. It allows TGS to scale back operating expenses facing falling demand or 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 the data is near zero.

Before TGS embarks on a project, it gets "pre-funded"Â by a group of customers who wish to use the data. This is normally pre-funded 50%. 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 (CGG, Financial) have a combination of the two business models stated above and, therefore, their balance sheets limits the returns on capital possible:

However, there have been a couple of other entrants following TGS' model such as Spectrum ASA (SPTFY, Financial), set up by a former TGS guy, and Pulse Seismic. We will look at barriers to entry later in this article.

TGS’ ROIC has been consistently higher for the last 10 years, indicating a possible sustainable competitive advantage over its competitors.

Let's just run through a few factors that could possibly explain these excess returns. First, the company enjoys great pricing power. By serving hundreds of E&P firms who need access to seismic data before they begin operations, this expenditure is crucial for their business. When you also account for the fact the cost of the data purchased from TGS amounts to around 1% of total E&P costs, plus the savings in time and efficiency they achieve from the data, TGS enjoy considerable pricing power. This asset base can then be licensed years after the survey is completed at no extra cost.

TGS has an ultra asset light balance sheet relative to competitors. They lease vessels and do not need to outlay a huge amount of capital apart from underwriting a percentage of the project along with the E&P customers, historically around 50%.

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.

Also, there are always opportunities to reinvest these earnings back into the business, most notably inorganically. E&P companies constantly need better, more efficient ways to replenish depleting reserves and TGS has the ability to reinvest into more advanced technology, machinery or make bolt-on acquisitions to enhance growth. These bolt-on acquisitions are acquired following a counter-cyclical approach from management. They look to acquire cheap surveys and assets from struggling firms when underlying oil price falls through the floor as today, or other firms are struggling.

Counter-cyclical capital allocation

Management has 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 and 2011, management increased capex, snapping up cheap surveys from struggling competitors. In the 2015 Q3 release was the following:

“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… 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.” (Page 7, TGSNF 2015 Q3 Results)

The graphs below show TGS' capex relative to competitors.

Management not only talks the talk, but actually walks 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 to measure this precisely, though I have attempted.

The chart above shows the obviously highly volatile one-year ROIIC but a fairly high and consistent three-year ROIIC. For example, the one-year ROIIC in 2011 was -2%, but the following three-year rolling ROIIC from 2012 to 2014 were 77%, 67% and 29%.

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 Charlie Munger (Trades, Portfolio) likes to say, is the power of being market leader. The quality of TGS' library is crucial. The location, interpretation and efficiency of the data are key to maintaining their advantage.

The quality of the multi-client data library is clear. The 10 and five-year CAGR of the library is 18.5% and 11.5%, growing from $145 million to $839 million 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 has been in the game nearly 20 years and therefore has experience and knowledge of interpretation of the data. 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 the market leader is a no-brainer, and low-cost providers cannot exactly compete.

The only reason they would go with a competitor, such as SPTFY, 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 understands the most valuable areas and have a hold on many geographies.

Risks and what the market might have missed

I believe the market is underestimating the long-term value of TGS's MC library. I first invested in TGS towards the end of 2015 and was far too early. I underestimated the supply side cycle of the industry and should have realised that 2016 will be a huge slowdown in terms of E&P capex.

When calculating maintenance capex for the FCF, I add back increases in the change in the value of the MC library stated on the balance sheet and take this as growth capex. Backing this out gives FCF from 2012 to 2014 of $225 million, $250 million, $330 million and losses of $23 million in 2015. TGS' OCF was $566 million in 2015 and they spent 82% of revenue on acquiring data. You can buy TGS for 2.38x OCF or around 5x to 6x normalised FCF. I feel 2016 will provide a good opportunity to buy TGS and any supply side improvement in upstream confidence could be an entry trigger.

One obvious risk and assumption one makes when investing in TGS is the price of oil. Any company's assets in the energy industry is basically a derivative on the underlying commodity price. This year is certain to be a tough year for TGS and everyone in the industry, but the survivors will no doubt emerge stronger. Upstream firms are cutting back capex over 50% year over year, and although everyone will shudder at the thought of E&P expenditure today, this is almost certain in the future. I cannot forecast the price; maybe it will go to $20 in the short term, but the one assumption I am willing to make is the future value of TGS' asset base, and the fact E&P firms will still need to utilise the data to drill in the future.