TGS-Nopec (TGS) Valuing a Commodity Company

TGS-Nopec is a norwegian geophysical company which provides of marine seismic data for E&P companies. The firm could be classified as a commodity company as oil price impact not only in revenues and earnings but also reinvestment and financing costs.

Valuation

When valuing this type of companies, the danger of focusing on the most recent fiscal year is that the resulting valuation will depend in great part on where we are in the cycle (oil price). If the most recent year was a boom (or down) year, the value will be high (or low). Consequently, normalization with commodity companies has to be built around a normalized commodity price.

So, what is a normalized price for oil? We will use expected oil prices from the forward and futures markets. We know that these forward and futures prices only offer the illusion of forecasts, because they are tied to the current oil price. The advantage of this approach is that it comes with a built-in mechanism for hedging against oil price risk. An investor who believes that a company is undervalued but is shaky on what will happen to oil prices in the future can buy stock in the company and sell oil price futures to protect herself against adverse price movements.

Figure 1 shows TGS´s EBIT as a function of the oil price (Real Brent ($/barrel)) each year from 2002 to 2018.

The EBIT clearly increases (or decreases) as the Brent increases (or decreases). We regress the EBIT against the Brent over the period and obtain the following:

To get from EBIT to equity value at TGS, we make the following assumptions:

• TGS´s EBIT will grow at 2% in perpetuity from next year.

• We estimate a bottom-up beta of 1.08 for TGS. Then we use the treasury bond rate of 2.61% and an equity risk premium of 6.63% to estimate a cost of equity:

Cost of Equity = 2.61% + 1.08 (6.63%) = 9.79%

• TGS has a market value of debt of $55.27 million (after operating lease adjustment) and a market value of equity of $2,769.89 million, resulting in a debt ratio of 98%. Its cost of debt is expected to be 8.72%, reflecting a default spread of 6.11% over the risk free rate. Using a marginal tax rate of 23% (rather than the effective tax rate), we estimate a cost of capital of 9.73% for the firm:

Cost of Capital = 9.79% (0.98) + 6.72% (0.02) = 9.73%

• TGS will continue forever with same ROIC and cost of capital currently estimated in the base year.

TGS reported EBIT of $230.0 million in 2018, but that reflects the fact that the average oil price during the year was $70.94. Actually, the expected oil price (future Brent) has dropped to $66.86, and the EBIT for the coming year should be lower. Using the regression results, the expected EBIT at this oil price is $172.42:

EBIT (Normilized) = -92.08 + 3.956 ($66.86) = $172.42

This EBIT has to be adjusted to operating leases reported in 2018, resulting $170.95 million. This EBIT translate into a ROIC of 12.54% and a reinvestment rate of 15.94%, based on a 2% growth rate.

Reinvestment Rate = g/ROIC = 2%/12.54% = 15.94%

Adding the current cash balance ($273.53 million), subtracting debt with the operating lease adjustment ($53.90 million), subtracting the value of options ($6.44 million), and dividing by the number of shares diluted (102.3 million) yields the value per share of:

At its current stock price of $27.79, the stock looks highly overvalued.

Simulation

Because the earnings, cash flow, and value of TGS are determined to a great extent by what happens to the oil prices, probabilistic approach could works here. We can use simulations of the oil price to derive the value of TGS. The trickiest part of this simulation is to establish how the inputs to the valuation (earnings, reinvestment, and cost of financing) will change as the price of the oil change.

We will make several steps:

1. Determine the probability distribution for the oil price: Because the value per share is so dependent on the oil price, it would make more sense to allow the oil price to vary and value the company as a function of this price 

2. Link EBIT to oil price: We used the regression results from earlier

3. Estimate the value as a function of EBIT: As the EBIT changes, there two levels at which the value of the firm is affected. The first is that lower EBIT, other things remaining equal, lowers the base FCFF, and reduces value. The second is that ROIC is recomputed, holding the capital invested fixed, as the EBIT changes. As EBIT declines, the ROIC drops and the firm will have to reinvest more to sustain the stable growth rate of 2%. While we could also have allowed the cost of capital and the growth rate to vary, we feel comfortable with both numbers and have left them fixed.

4. Develop a distribution for the value: We ran 10,000 simulations, letting the oil price vary and valuing the equity value per share in each simulation. The results are summarized in Figure 2:

The average value per share across the simulation was $12.80, with a minimum value of $0,46 and a maximum value of $41,27. The current stock price is $27,79 and there is 96% chance that the value will be less.

Conclusion

Commodity companies are hard to value because the uncertainty and volatility are, at least for me, greater than in any other type of companies.

As many investors try to make pricing (multiples) with TGS-Nopec that probably yield an undervalued company, my faith in valuing (discount cash flows) is stronger than pricing and 

I would not buy shares in a firm overvalued.

Knowing that this is a firm with great advantages that we have not analyzed in this post, I would be patience and wait until the opportunity arises.

Gym Group Plc (GYM) should cut pay dividends

Since IPO in 2014, GYM is a public company traded in LSE with a current market capitalization about ₤269 million. Founded in 2007 by the current CEO John Treharne, the company provides 147 low cost gyms across the UK and is considered as a high growth firm by many investors (as well as by me).

If GYM is in a growth stage of its life cycle, as we see in the figure above, I would not expect neither dividends nor buyback stocks because it is highly probably that the company need the cash to great investment opportunities, but GYM don’t follow this expectation: the firm initiated a token dividend in 2016 of ₤0.32 million, increasing it to ₤1.35 million in 2017 and all seems that it´s going to increase again in 2018 as we see in the last TTM ₤1.54 million (we don´t have yet the results of 2018).

Is GYM right about this dividend policy? The acid test to answer this question is estimation of how much cash a firm can afford to return to its stockholders (or the Free Cash Flow to Equity).

In order to come to a conclusion, I will begin with the P&L statements reported by the company in the last four-five years, including the last TTM:

The next step is the adjustment and normalization of this statement, and several adjustments are needed:

1. One-time charge from other income in year 2015, is eliminated.
2. Amortizable Intangibles is non tax deductible item and should be added back to the revenues. Only tax deductible depreciation and amortization counts.
3. Our tax should be in accordance with a normalized effective tax rate

With all these pieces, we come to our Net Income adjusted and normalized:

My next step is estimations of incremental in non-cash working capital, difference between debt issued and debt repaid, and computation of capital expenditures:

1. The Change in non-cash working capital year by year is described as follow:
   
2. For the difference between debt issued and debt repaid, I will take a proxy through the incremental book value of debt reported in the balance sheet
   
3. In estimating capital expenditure I will not distinguish between internal investment (maintenance capex) and external investment (growth capex). The capital expenditure of a GYM, therefore, need to include all purchases, business combination, etc, reported as cash flow from investing activities.

Finally, with all these pieces attached, the result is as follow:

As we see in the table above, the Free Cash Flow to Equity is negative and some years (e.g. 2015) very negative. Thus, GYM don´t have capacity to return cash to stockholders and should stop what it is doing.

But, why GYM pay dividens, as it should not do it? a possible answer could be that high growth firms are sometimes advised by the banker to initiate dividends because it increases the potential stockholder base for the company and, by extension, the stock price .. and that´s true, for example look at pension funds, pension funds cannot buy stocks that do not pay dividends. Thus, the banker makes the suggestion to pay a token dividend, a small dividend that increase the demand of the stock and push up stock prices. It sounds awful good, but that is the way the problems get started. When the stockholders receive for the first time dividends, what investors expect the next year?, of course more dividends!, the firm can´t blame investors.

In summary if the firm cannot pay dividends, the firm should not get start this process, it seems easy to say, but hard to stick with this rule.