With oil prices ramping up over the past two years, it's been a great run not only for companies that drill for and sell oil, but also for those in supporting industries. Veritas DGC
Oil companies purchase information from Veritas that they use to find the most promising places to drill. Skyrocketing oil prices mean that there has been more incentive to pay up for exploration. The company's fleet of six ships collects offshore data (61% of revenues in 2004), while its 13 crews collect data on land.
As evidence of the good times, in yesterday's third-quarter conference call, management reported that the price of incoming contract bids had increased 30% over similar quarterly levels in 2004. This higher demand increased the company's third-quarter operating margin by 5 percentage points to 17%, which in turn helped propel operating income to $29.2 million, up 36% over Q3 of last year.
Despite these exciting results, the stock dropped 12% yesterday because of a weaker-than-expected fourth-quarter outlook. This news, though, may lure some investors into taking the plunge. The P/E of 21 seems low, given the recent margin expansion and double-digit earnings growth.
This Fool, however, will look elsewhere. My lack of interest in this business comes down to this: It's unpredictable, and it's difficult to value on a cash flow basis. The price of oil exceeded $59 per barrel on Monday, and some analysts think it will eventually climb to more than $100. On the other hand, ExxonMobil's
Along with unpredictable demand, another problem with the business is that it eats cash. Veritas must keep plowing earnings back into equipment and technology upgrades to stay competitive. Look at the historical cash flow statements and you'll see an alarming trend. To get an estimate of the company's free cash flow for the period, take total operating cash flow and subtract out capital expenditures (including investments in the multi-client library), and then add back any proceeds from the sale of property and equipment. Unfortunately, this number has been positive in only four of the past 15 years. While the past two fiscal years are among the positive, the company's FCF could easily sink back into the red because of excessive capital needs or weak demand.
Given these issues, I can't value this company with any reasonable degree of certainty. The company has performed well over the past few quarters and will probably continue this performance in the near future. But I have no idea what the growth rate will be over the next five to 10 years. Today's offering price is low relative to current prospects, but a change in the environment could lead to depletion of the company's value.
Fool contributor Matt Thurmond has no financial interest in any company mentioned in this article.