Sunday, March 16, 2014

Computer Modelling Group ( Toronto - CMG ) -- The Big Frack Attack

Computer Modelling Group ( $27.50) is the leading provider of simulation software used to maximize the economic potential of hard to recover oil and gas reserves.  The company dominates the tar sands market in Western Canada.  It also has strong positions in deep offshore and other heavy oil applications.  Most large pools of petroleum and natural have been found by now.  The ones that remain have become difficult to monetize, moreover, because they exist out in the ocean or in arctic locations.   New land-based discoveries increasingly are being made in shale deposits which require a high degree of technical ability to exploit.  Computer Modelling entered that market a few years ago as U.S. drilling activity accelerated.  The number of customers employing its simulators now is expanding at a rapid pace.  Most have been trying out the technology on a limited basis.  Success has encouraged them to purchase additional licenses and apply the technology to a larger percentage of their overall drilling programs.

The core business remains solid.  Computer Modelling added seven shale customers in the December quarter, bringing the total to 37.  But that segment still represents a small portion of the total business.  The tar sands segment flattened out over the past year due to pipeline shortages, which made it more difficult for smaller operators to acquire financing.  That forced output to be moved by railroad, a more expensive option that itself was capacity constrained.  A series of accidents caused the Canadian government to tighten safety rules on rail car shipping, moreover, exerting further pressure on drilling activity in Western Canada.  Despite all that the major producers have kept up production, and most of those companies are heavy users of Computer Modelling's systems.

Expansion in South America and the Middle East is reinforcing growth.  The company has a close affiliation with Petrobas, Brazil's national oil company.  It also has close ties with leading producers in Colombia and Venezuela.  The latter has fallen behind in its payments to Computer Modelling.  Further delay is possible until the political situation there is resolved.  But the long term outlook in Venezuela remains positive.  Activity is rising in other South American nations, as well, with Argentina in particular preparing to start a major shale drilling initiative.  Middle East demand has been improving in recent years because even there new discoveries have become more difficult to exploit.  The company also is making inroads in Asia.  Shale drilling could become a substantial market in that region over the coming decade.

Competition remains scant.  Schlumberger provides simulation software for conventional oil fields but has been unable to keep pace with Computer Modelling in the high end.  Halliburton used to offer its own heavy oil simulators but now typically re-sells the company's.  A Russian start-up announced a competitive offering in 2013 but that product still hasn't been launched commercially.  Computer Modelling spends 20% of revenue on product development.  It also receives funding from Shell and Petrobas to develop a next generation system that simulates above ground facilities along with the underground drilling operations.  An active consulting team helps customers apply the technology.  It also collects feedback to help upgrade the systems cost effectively.

We estimate sales will advance 12% in the current fiscal year (March) to $77 million.  Earnings appear on track to improve 10% to $.76 a share.  Implementation of the Keystone XL pipeline could reignite Canadian activity over the next few years.  More important, demand by U.S. shale producers is likely to gain momentum as greater experience with the technology is obtained.  The customer count could increase to 60 or more in the U.S. alone.  And those customers probably will buy an expanding number of licenses.  International business is poised to rise in response both to greater conventional (heavy oil) drilling, and the adoption of horizontal fracking methods.  The next generation package recently began field testing by Shell and Petrobas.  That line is likely to generate incremental revenue within 1-2 years if all goes well.  In 2-3 years sales could reach $125-$150 million to produce income of $1.25-$1.50 a share.

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