Seitel (SELA) Earnings

We finally got a chance to review Seitel´s (SELA) latest earnings report, 10K, and conference call. Overall, the report was very good, as evidenced by the company´s strong cash generation. However, the key to valuing the company lies of course in the future expectations of free cash-flow, which for a variety of reasons are quite unpredictable in the case of (SELA). In our estimation, the valuation of SELA is somewhat high and is based on various best-case growth assumptions, and as such  we do not believe the stock offers above-average risk/reward at the current price, which has appreciated by nearly 50% in the last few months. Nevertheless, we are holding on to our shares, since we think that the seismic business will continue to perform strongly throughout 2006, and we see no real operational risks on the horizon that would prompt a sustained sell-off in the stock. That said, we think it is probably clear that oil and gas stocks in general, and SELA in particular, have slowly started to price in higher crude and gas prices, making many of the shares less attractive from a value standpoint. So if you are looking for good odds, its getting difficult to find in the oil and gas sector.

Now on to the earnings report...

Seitel (SELA) is a difficult company to analyze, primarily because due to various aspects of its business it has all sorts of non-cash revenues and expenses. To sort it all out, we therefore like to focus on the balance sheet and what the company calls, "cash margin", the cash generated by the company minus any cash SG&A expenses. We then subtract from the cash margin any cash capital expenditures (a signifcant portion of Seitel´s capital expenditures are not paid by Seitel, but rather by customers) and debt obligations to arrive at a free cash-flow number for the company.

Employing the above method, in 2005, by our best estimates the company generated about $30 million in cash or $0.20 per share. In 2006, SELA estimates $24 million in debt payments, and $34 million in cash cap-ex (out of a total of $93 million total). In order to estimate cash-flow in 2006, one would have to have a good estimate of the cash margin in 2006. This is obviously difficult, given a lack of sufficient data. However, it is important to note that SELA´s SG&A is relatively fixed, so that any increase in cash revenue can drop to the bottom line. My wild guess for SELA is $90 million in cash margin in 2006 (representing 25% growth). That would imply $30 million in cash generation in 2006 or $0.20 per share. Obviously this projection implies zero growth in cash-flow in 2006, which is why we are lukewarm on the stock. The reason for the low cash-flow growth is the 50% growth in cap-ex estimated for 2006. On the upside, it is possible that our estimates of future cash margin are too low. But in our best case scenario we have the company generating $0.30 per share in cash in 2006.

So in the best case we see upside to about $4 per share in 2006. On the downside, given that the company´s customer base is comprised of many small to medium-sized O&G companies, which probably have much more risk relative to o&g prices than larger companies, it´s easy to see how SELA´s cash-flow can evaporate quickly in the event that o&g prices collapse. Since we don´t like to bet on future commodity prices, it´s probably sufficient to just assume that an investment gamble on SELA at current prices is at best a 50/50 bet based on currently available information. It is puzzling to us why ValueAct Capital purchased so many shares recently, and were it not for their purchase (which makes us wonder whether our revenue expectations and valuations are too low), we would be more likely to take some money off the table at this time. Instead, we´re holding on, as mentioned at the start of this post.