The Buy Thesis
Deep Sea Supply (DSSPF.PK) is an offshore supply company servicing the offshore drillers with its fleet of 12 platform supply vessels and 15 anchor handling tug supply vessels. The company's vessels currently operate in the North Sea spot market, West Africa, Mediterranean, South East Asia and Brazil. For 2012, the company had revenue of $124.1 million and an EBITDA of $50.7 million. However, the company trades at a market capitalization of $205 million, which is just 1.6 times 2012 revenue. This thesis investigates the reason for a low market capitalization and the reasons for believing that Deep Sea can be an acquisition candidate, a factor, which will trigger significant stock upside. Acquisition apart, the thesis also discusses the growth factors that can translate into higher stock price.
A Recent Industry Event To Support The Acquisition Story
Tidewater (TDW) is a relatively larger player in the offshore supply vessel industry with a current market capitalization of $2.78 billion. The company has embarked on an aggressive growth strategy with 18 new vessels added in the last fiscal and a commitment to purchase or construct 32 vessels at a cost of $836.6 million. Besides the organic growth, the company has also taken the inorganic route to expand into new geographies. In May 2013, Tidewater announced the acquisition of Troms Offshore Supply AS for $395 million. The acquisition includes five large PSVs and one deepwater PSV, which is under construction. A consideration of $395 million for six PSVs implies an acquisition value of $66 million per vessel. The acquisition was important for Tidewater in two ways - It marks the entry of Tidewater in the Norwegian North Sea and it provides the company with the harsh environment operating fleet. Tidewater has sufficient financial flexibility (discussed later) and another equally good opportunity in the Norwegian region would be an acquisition candidate to create further inroads in the North Sea.
Deep Sea's ! Brazilian Joint Venture Underlines The Need For Funding
A potential acquisition candidate would be one, which is trading at attractive valuation multiples and has limited financial flexibility. In January 2013, Deep Sea and BTG Pactual agreed to establish a joint venture in Brazil. As per the acquisition terms, Deep Sea transferred 9 AHTS and 6 PSV vessels to the joint venture. The JV would also acquire 6 new PSVs under construction and for delivery in 2H13 and 1H14.
The primary reason for the JV was to fund growth in the Brazilian OSV market. The reason is clear when the company's first quarter 2013 balance sheet is analyzed. Deep Sea had a debt to EBITDA of 8.2 and a loan-to-value of 86% based on the book value of vessels. High leverage was restricting growth and the company needed cash infusion to expand in prospective markets.
After the completion of the 50:50 JV, the company's leverage has declined to 5.3 from 8.2 and the balance sheet looks relatively robust with cash (including 50% from JV) holdings of $106 million. With increased financial flexibility, Deep Sea is now considering acquisition of 10 new PSVs. What is noteworthy is that the company has a market capitalization of just $205 million and this makes it a good acquisition candidate.
An Attractive EV/EBITDA Multiple Makes Deep Sea An Acquisition Target Besides Providing Stock Upside Potential
The chart below gives the EV/EBITDA multiple of some of the major OSV players in the Norwegian region and the multiple for Tidewater.
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The EV/EBITDA multiple is most attractive for Deep Sea. If Tidewater were to consider another acquisition in the Norwegian region, Deep Sea would therefore ! be the be! st bet. A market capitalization of just $205 million also looks attractive from an acquisition perspective.
It is important to mention here that a low EV/EBITDA multiple is not because of inferior assets or sluggish growth. The financials have been improving after bottoming out in 2011 and I have discussed the long-term EBITDA margin trend later in the article. The reason for the low EV/EBITDA multiple is the high leverage and the restricted financial flexibility that Deep Sea had before the joint venture. A low financial flexibility would mean slower expansion and as stock prices discount the future, the EV saw limited upside. As the chart shows, the company's stock price has been moving sideways for almost three years. During these years, the company's financial flexibility remained very restricted.
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As mentioned earlier, Deep Sea had a leverage of 8.2 and a loan-to-value of 86% before the joint venture deal. Currently, the leverage stands at 6.6 and the loan-to-value at 72%. The EV/EBITDA multiple will trend higher as the JV starts delivering positive results. A relatively higher financial flexibility for Deep Sea and its plans to acquire new PSVs will also support higher valuation multiples. The company is therefore at an important inflection point with supportive industry dynamics.
Valuation Consideration For An Acquisition Scenario
Tidewater's acquisition of six PSVs was for a valuation consideration of $66 million per vessel as discussed above. Deep Sea's information memorandum related to the JV also states that the cost of construction of six new PSVs is $282 million, which implies a cost of $47 million per PSV. A ballpark estimate for the current value of a PSV would therefore be anywhere between $47 million to $66 million. For Deep Sea PSV valuation, I would consider an average price of $56 million per vesse! l. This i! s fairly realistic as most of the current PSV fleet has been built on or after 2007 and the fleet age is not high.
Considering 50% (three) of the JV PSV and the remaining three PSVs fully owned by Deep Sea, the value of six PSVs would be $336 million.
I will also try to arrive at a ballpark estimate for AHTS vessels based on some recent transactions in the industry. In March 2013, Ocean Yield acquired two AHTS vessels from Farstad Supply AS for a total cost of $204 million, implying a value of $102 million per AHTS. However, the acquired vessels are high-end vessels with 24,371 BHP. In another transaction, Indonesia-based PT Pelayaran Nasional Buana Bina Raya TBK (BBR) has acquired a 9,000-bhp AHTS for a consideration of $18 million against a market value of $24 million for the vessel. Therefore, the acquisition cost depends on the AHTS vessel specification. The table below gives the total value of AHTS vessels owned by Deep Sea based on the vessel specification and a ballpark estimate from the above transactions.
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Combining the PSV and AHTS vessel value, the valuation consideration in the case of an acquisition is shown in the table below.
Even if we take a relatively stressed scenario arguing that some of the AHTS vessels are built in 1999, the valuation consideration would still imply a potential 50-90% upside from the current market capitalization in the event of an acquisition. This will also make Deep Sea's valuation in line with the EV/EBITDA multiple of peers discussed earlier.
Industry Recovery Would Support Growth
The day rates impact the EBITDA margin in the offshore supply vessel industry. The day rates are indicative of the demand factor and the tr! end in EB! ITDA margin can tell investors about the recovery or decline in the industry. After the EBITDA margin bottomed out at 27% in 2011, there has been a gradual rise with the margin for the first quarter of 2013 at 43%. If the recovery continues in the industry, Deep Sea can get back to the peak EBITDA margin of 69% witnessed in 2007.
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A steady recovery in the industry is very likely as the offshore oil & gas market spending is expected to grow at a CAGR of 8-10% in 2013-17. The highest capital expenditure will be seen in Brazil and Norway. Deep Sea has presence in both the markets and should continue to win term contracts as exploration activity remains robust.
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Revenue Visibility Would Also Support Growth
Deep Sea has a total contract backlog (including 50% JV backlog) of $164 million as of July 2013. The backlog gives the company revenue visibility and stability. A steady income flow from term contracts, as indicated in the chart would mean that the company will not face any significant issues in the near term from a debt servicing perspective. The stability in earnings is evident from 4Q12 and 1Q13 earnings trend where the company reported an EBITDA of $16.6 million for both quarters with an EBITDA margin of 43%. Considering the steady revenue inflow, Deep Sea is in line to witness a revenue growth of 24.8% and an EBITDA growth of 31.4% for the financial year 2013.
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Deep Sea also has $106 million of cash as of 2Q13 and this can be used for buying a new PSV fleet. This, in my opinion, would be! another ! upside trigger for the stock. I must mention here that a positive result in 2Q13 and the other factors discussed have resulted in a positive impact on the share price with the stock trading higher by 6% in today's trade.
Ambitious Expansion Plans After The Joint Venture
Before discussing the company's growth plans after the JV, I would quickly mention here that the Deep Sea has been looking to expand into new markets through JVs as it would give them access to funding. Back in 2011, Deep Sea entered into a strategic partnership in Malaysia with a 25% stake in the JV.
Coming to the recent transaction, the main rationale for the partnership with BTG Pactual is the company's local presence coupled with the fact that BTG has nearly $21.4 billion of assets under management and a JV with a major investment vehicle would give relatively easy access to funding the growth. After the transfer of 15 AHTS and PSV vessels and the delivery of six new PSVs, the JV will be the third largest OSV provider in Brazil. The BTG brand name would also help Deep Sea make its presence significantly felt in an attractive offshore market. Besides the current newbuilds, the JV also plans to acquire additional AHTS and PSV vessels. Therefore, the growth strategy in Brazil is aggressive and is backed by a strong funding partner.
Apart from the JV, the company plans to leverage off the excess cash ($103 million) and increased financial flexibility to boost growth. While the strategy might seem generic, the company is growing at the right time as indicated in the industry recovery trend above. In the immediate term, the discussion with PSV Holdings (as per 2Q13 presentation), a company affiliated with Hemen Holdings, for the purchase of 10 PSV vessels might provide earnings visibility boost along with stock upside. I have specifically mentioned Hemen Holdings as the entity has 35.05% stake in Deep Sea. It is therefore very likely that a final agreement is reached for 10 new PSVs. Therefore, the growth plans for ! the near ! to medium-term are ambitious and it is backed by the right strategic moves.
Risk Factors
Risk Factor 1 - Deep Sea operates in a highly cyclical industry and the sustained global economic uncertainty is a big risk for a small company with relatively high leverage. The global economy might have however passed its worst phase with the first signs of recovery in Europe besides sustained economic resilience in the United States.
Risk Factor 2 - The stock is relatively illiquid in terms of trading in the OTC exchange. This risk is mitigated by the fact that investors can directly invest in the stock in the Oslo exchange.
Conclusion
Deep Sea is an attractive stock at a current price of $1.63 and a current market capitalization of $205 million. The recent closure of the joint venture and a higher financial flexibility coming from cash inflow from the JV supports the growth story and is the first reason for a stock upside. An attractive EV/EBITDA multiple supports the acquisition story and provides another stock upside trigger. Investors can consider the stock at current levels for significant medium to long-term upside.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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