Analysis of Oyo Geospace
I first purchased OYO Geospace for Two Roads Diverged in December of 2006. After further research, I decided that I wanted OYO to be one of my top holdings. This decision has rewarded me well. In this analysis, I will summarize Oyo’s different lines of business, examine their earnings history, and try to determine a range of values for their shares.
About the Company
Oyo Geospace (NASD: OYOG) designs and manufactures scientific instrumentation and equipment used by the global petroleum industry to acquire more seismic data in new and better ways. They provide their services through four subsidiary companies: Geospace Technologies, Geospace Engineering Resources International (GERI), Geospace Offshore and OYO Instruments.
First, I’ll describe the subsidiary that doesn’t seem to fit. OYO Instruments is a manufacturer of professional-quality thermal imaging equipment and film products. Our products provide unique, reliable, affordable and chemistry-free thermal image solutions to an array of graphic display industries requiring large-format (12 to 54 inch wide) images with image resolutions ranging from 200 to 1,200 dpi. This company may provide some steady cash flow, but it is likely not the reason one would purchase Oyo.
A big part of Oyo’s recurring growth has been from their seismic equipment businesses. Geospace Technologies is a manufacturer and supplier of recording instrumentation solutions, precision sensors (geophones, hydrophones,vibration detectors and seismometers), and custom seismic cable assemblies and connectors for land and marine oil and gas exploration. Their sensor solutions also play integral roles in the security, industrial sensor, and geotechnical engineering markets, which are gaining importance in an increasingly security- and safety-conscious world.
Geospace Offshore designs and manufactures cable and umbilical products for the oilfield and remote operated vehicle (ROV) service industries and for specialty cable markets. Their manufacturing facilities in Houston, Texas, produce technically sophisticated and highly reliable cabling and umbilical solutions for electrical, fiber optic, electro-mechanical and electro-hydraulic applications.
The company’s Geospace Engineering Resources International, known industry-wide as GERI, is the the subsidiary that could really provide transformational growth to the company. GERI develops and deploys sophisticated seismic reservoir monitoring solutions. These solutions are characterized by very large channel counts, fault tolerant operations, and real time acquisition. Data collected by their permanent and retrievable sea-floor and wellbore seismic solutions allow oil and gas engineers to actively monitor critical changes inside the reservoir. Through acquisition of more and better data, engineers dramatically enhance their operational and production decisions over the life of the reservoir.
The company’s Reservior Characterization Systems (RCS) provided from the GERI subsidiary is a big part of my thesis for this company. They have announced several sales of these systems to date, but not within the last nine months. This may be because the company overall has been severely capacity constrained, and customers could not receive the systems in a timely fashion. They have since built a new production facility and are in the process of transitioning to this facility. This may take a couple of more quarters. After that, we’ll see if the RCS contracts start flowing. If they do not, it may mean that the company’s RCS have not gained traction.
Still, their seismic equipment should remain in high demand as oil hovers between $90-$100 per barrel. In addition, the company recently announced a wireless seismic recorder called the Geospace Seismic Recorder (GSR), which will be in production by early 2008. I’m not sure how much this new device will impact sales or if this product has the potential to transform the industry.
History
Oyo has become a new company in the last few years as they have exited the research and development stage and entered the production and implementation phase of their life as a company. Because of this, I have only covered the past two years of history.
| (in millions) | 2007 | 2006 |
|---|---|---|
| Revenues | $138.1 | $103.7 |
| Cost of Goods Sold | $87.6 | $67.4 |
| Gross Profit | $50.5 | $36.3 |
| Operating Expenses | $24.1 | $21.8 |
| Adjustments | -$1.8 | $0.2 |
| Taxes | $8.6 | $4.5 |
| Net Earnings | $19.6 | $9.8 |
| Depreciation & Amortization | $3.7 | $3.9 |
| Capital Expenditures | $17.0 | $4.8 |
| Growth Capex | $13.5 | $4.8 |
| Owner Earnings | $19.8 | $8.9 |
| Shareholder Equity | $102.4 | $78.8 |
| Shares Outstanding | 6.06 | 5.96 |
| Owner Earnings Per Share | $3.26 | $1.49 |
| Gross Profit Margin | 36.6% | 35.0% |
| Net Profit Margin | 14.2% | 9.4% |
| Return on Equity | 24.9% |
Future Earnings Estimates
Here is where things start to get difficult. In 2007, Oyo booked $16.2 million in RCS revenue in the first quarter. Earnings for that quarter were $1.30 per share. This represents the last RCS contract the company received. Two things are possible, and maybe both of them are possible. The company’s technology is obsolete, causing this business to decline, and/or their constraints on capacity have prevented them from meeting demand. Oyo has been moving in to a new production facility. It seems to be dragging on, but they are trying not to disrupt business too much during the move. Over the past year or so, the company has been capacity constrained.We have yet to see an earnings report that doesn’t include the impact of these constraints on capacity or a move to a new facility. Their fiscal fourth quarter, announced about a week ago, provides the best baseline that we have. In that quarter, they announced earnings of $0.60 per share, excluding one-time gains on equipment sales. I have annualized this number to and made some other assumptions to achieve a baseline below.
| (in millions) | Proforma |
|---|---|
| Revenues | $123.2 |
| Cost of Goods Sold | $80.1 |
| Gross Profit | $43.1 |
| Operating Expenses | $21.1 |
| Adjustments | $0.0 |
| Taxes | $7.7 |
| Net Earnings | $13.3 |
| Depreciation & Amortization | $4.0 |
| Capital Expenditures | $15.0 |
| Growth Capex | $11.5 |
| Owner Earnings | $13.8 |
| Shareholder Equity | $116.2 |
| Shares Outstanding | 6.11 |
| Owner Earnings Per Share | $2.27 |
| Gross Profit Margin | 35.0% |
| Net Profit Margin | 10.8% |
| Return on Equity | 16.9% |
Again, this proforma does not include the full impact of the completion of their expanded capacity. I will build this, as well as future demand into my growth rates below.
Impact of RCS
As noted above, RCS contracts can have a huge impact on future earnings if they materialize. For every contract, I estimate $0.70 per share in earnings. Their last completed contract resulted in $1.30 in earnings during a period when they were producing $0.50 per share per quarter. Note that they earn this revenue when the system is installed. So the announcement of a contract may not juice earnings for several quarters. I do not think, at this point, RCS contracts should be relied upon when purchasing this company, but they could still provide tremendous upside.
Valuation
There is still a great deal of demand for Oyo’s other products. Their expanded capacity could still result in a great deal of steady growth. In addition, Oyo is an inventing company. They recently introduced wireless seismic recorders that could be very beneficial to earnings in 2008. Other products may follow. Based on this, I’ve estimated 20% growth for the first 5 years, 12% growth for 5 more years, then a reversionary PEG of 1.5 times a 12% growth rate. I use a 10% discount rate applied to the cash flow stream.
I’ve also created a second column that assumes RCS becomes an adopted technology, meaning two contracts per year growing to five contracts per year.
| - | $/Shr | RCS Earn. | Total |
|---|---|---|---|
| Year 1 | $2.70 | $1.40 | $4.10 |
| Year 2 | $3.30 | $1.40 | $4.70 |
| Year 3 | $3.90 | $1.40 | $5.30 |
| Year 4 | $4.70 | $2.10 | $6.80 |
| Year 5 | $5.60 | $2.10 | $7.70 |
| Year 6 | $6.30 | $2.10 | $8.40 |
| Year 7 | $7.00 | $2.80 | $9.80 |
| Year 8 | $7.90 | $2.80 | $10.70 |
| Year 9 | $8.80 | $2.80 | $11.60 |
| Year 10 | $9.90 | $3.50 | $13.40 |
| Reversion | $178.30 | $335.10 | |
| IV @ 10% | $95.70 | $12.70 | $163.30 |
A 25% discount to intrinsic value results in a price of $72 per share, which may still represent a good entry point for this stock. As a way to test a range of values, a 25% 5-year growth rate followed by 12% growth results in a value of $116, and a 12% 10-year growth rate results in a value of $69 per share. To determine a value including RCS contracts, it works to add about $60 per share to the intrinsic value. Based on this, the top end of the valuation range is about $170.
Conclusion
The story has not yet played out at Oyo Geospace. They are still transitioning to an expanded facility and there is still potential for future RCS contracts. Because Oyo already comprises a major part of Two Roads Diverged, I will likely not add any shares even if it drops below $70. I think the recent sell-off is premature, but we shall see how Oyo looks after getting their operations stabilized.
January 9th, 2008 at 5:27 am
[...] Oyo Geospace (NASD: OYOG) over the past couple of days decline to the low 60s. As noted in my previous post about Oyo, a price of $69 per share represents 12% earnings growth over the next 10 years. I think [...]
January 9th, 2008 at 9:53 pm
Hi,
Nice Analysis! I am trying to understand you mean by a reversionary PEG of 1.5 times growth rate and how do you come up with Revesion value of 178.30 $. Your answer is appreciated.
Thanks
January 10th, 2008 at 5:59 am
Thanks for the comment, Amit.
There are many different ways of assembling a discounted cash flow of future earnings. Sometimes you will see an analyst use one growth rate for five or ten years and then a “terminal” growth rate going out 30 years.
I would rather keep control of that “terminal” growth. I assume that I sell the company after a certain length of time. To determine the value upon sale, I assume here that I can sell Oyo for 1.5 times its growth rate. So I’m applying 1.5 times 12%, then multiplying this by 100. This then equals the P/E ratio of 18. I multiply year 10 earnings by 18 to get a market capitalization. Above I am working in per share amounts, so I multiply year 10 earnings per share by 18. This then becomes added to year 10 of the cash flows. I discount the cash flows back at 10% for $95.70 per share.
The $178.30 value is not discounted. So it is possible that Oyo would be worth $178 in 2018. Still you wouldn’t pay $178 today, so you discount it back. I hope that makes some sense.
February 13th, 2008 at 8:38 pm
[...] baseline earnings as calculated in December are still relevant for Oyo Geospace. I have included them [...]