Computer Modelling Group ( Toronto - CMG ) -- Turns the Corner on Schlumberger

Computer Modelling Group (CMG.to $13.50) reported excellent on target Q2 (Sept.) results.  The company is the leading provider of simulation software used by energy companies to maximize output at existing oil and gas fields.  Computer Modelling provides the industry's best mathematics and user interfaces, helping customers figure out the most effective way to exploit a target.  The industry originated in the 1980s with the advent of high performance computers made by Silicon Graphics.  Then Schlumberger and Landmark Graphics developed software that helped companies process seismic data and other information, so they could find promising areas to drill.  Landmark ultimately was acquired by Halliburton.  Computer Modelling came onto the scene in the 1990s with an emphasis on reservoir development, particularly in challenging applications like heavy oil and enhanced recovery.  The giants dominated the market through the mid-2000s and still control most of the so-called "black oil" segment today.  Those are the simplest fields to drill, like in Saudi Arabia.  There still might be some giant pools of sweet crude in the Arctic Sea.  Other than that, though, the easy stuff has been found.  These days new fields still have tremendous potential.  But they're locked into tar sands, and shale formations, and other difficult to exploit locations.  Demand for Computer Modelling's technology is accelerating as the energy industry has shifted its attention to those high potential but complex sites.

Earnings were flat at $.12 a share (excluding stock option expense).  Reported sales declined 10% to $12 million.  That doesn't sound too impressive.  But unit volume was up by approximately  20%.  Backlog expanded.  And a new product line with enormous potential finished up in R&D and will enter beta testing in Q3 (December).  Computer Modelling sells is software either on a perpetual basis or as an annual subscription.  In the latest quarter the perpetual component virtually disappeared.  Recurring revenues advanced 18%.  That figure was understated by 6%, moreover, since Computer Modelling reports results in Canadian Dollars but earns most of its income in U.S. money.  The looney went up in the period.  Costs were affected by the end of the company's relationship with "The Foundation."  That's a non-profit financed by 13 oil companies that had been paying 50% of Computer Modelling's new product development expenses. It also used to own 40% of the company's stock.  Those shares were sold last year.  The R&D payments ended in Q1 (June).

Not to worry.  Pretax margins remain above 50%.  And Shell and Petrobas each are continuing to finance 33% of the R&D project (as they have for the last five years), while granting Computer Modelling 100% ownership of the software.  That next generation "Dynamic Reservoir Modeling System" will allow operators to simulate all their above ground operations in addition to their drilling activities, maximizing a project's total return on investment.  Shell and Petrobas will get first shot at the technology.  But once commercialization begins, probably late in calendar 2012, Computer Modelling will retain any earnings without recourse.

Demand is accelerating.  Computer Modelling recently broke into the Middle East market (click on "Labels" below).  Business also is vibrant in South America, the U.S., Asia, and Africa as more heavy oil and other enhanced recovery type projects come on line.  Demand in Canada has plateaued for the time being due to the U.S. State Department's decision to block a pipeline designed to transport tar sand crude to refineries along the Gulf of Mexico.  Well financed operators in Canada are continuing to develop their properties.  But a number of smaller companies have scaled back.  An alternative pipeline to the West Coast is being contemplated, to send the heavy oil to China.

Shale oil and shale gas represent large opportunities.  A lot of shale operators originally eschewed simulation, figuring they couldn't miss.  Simulation has become increasingly popular with experience.  The technology is helping producers target wells more productively.  Demand is starting to jump as a result both in shale gas and shale oil plays.  The international shale market remains in an early stage of development.  But tremendous potential is believed to exist, particularly in Eastern Europe and China.  Computer Modelling is likely to benefit from the trend, similar to the way Carbo Ceramics has in the proppant industry.

We estimate income will rise 28% this year (March) to $.65 a share.  The exact number will depend on the split between perpetual and annual licenses.  Next year $.80 a share represents a realistic target.  Long term growth of 20%-30% appears sustainable, bolstered by the new DRMS product line.  Technology trends remain favorable.  Advances in parallel processing have made simulation software increasingly powerful and easy to use.  The trend towards hard to recover energy sources promises to reinforce demand.  Market share gains already are being realized.  The company's two main competitors, Schlumberger and Halliburton, have long viewed simulation as a complementary product line serving a niche market.  Customers still rely on those giants for a wide range of oilfield services.  Increasingly, though, they are selecting Computer Modelling's best of breed simulation technology.

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Computer Modelling Group ( Toronto - CMG ) -- Breaks Through in the Middle East

Computer Modelling Group ( CMG $13.00) reported excellent on target Q1 (June) results.  The company is a leading provider of reservoir simulation software that helps energy companies extract reserves most efficiently.  Its expertise is in heavy oil, tar sands, and other challenging deposits.  Competition is provided by Halliburton and Schlumberger, which provide software better suited to "black oil" reserves that are easier to lift.  Those companies are major energy service providers that enjoy strong marketing connections to many large customers, particularly national oil companies.  In the June quarter Computer Modelling made the largest sale in its history to a Middle Eastern national oil company, displacing Schlumberger.  The deal drove earnings up directly by 50% to $.18 a share.  Creation of such a prominent reference account could pave the way for transactions with additional Middle East customers in future periods. 

Demand from tar sand producers in Canada remains intact despite recent declines in worldwide energy prices.  Technology improvements, some provided by Computer Modelling, are keeping costs on a downward sloping curve.  Environmental objections are being overcome.  And construction of a pipeline to get the oil to world markets is likely to begin fairly soon.  The Canadian government would prefer to direct the pipeline to the United States.  The U.S. Environmental Protection Agency has raised a wide range of objections to the project, though, which probably won't be resolved before the 2012 election.  Whether the Canadians will wait that long remains to be seen.  The Chinese government appears willing to fund an alternative project ending at the west coast, the plan being to ship the oil across the Pacific.  Either way, production is likely to keep expanding in the Alberta tar sands region.

The "DRMS" offshore software project is nearing completion.  Shell and Petrobas provided two thirds of the funding for that effort, even though Computer Modelling will keep 100% ownership of the technology.  The two majors will get to use the software first, and they get the right to market it on a commission basis, as well.  Shell and Petrobas plan to test the software in their own operations starting in Q3 (December).  Commercial sales are expected to begin late next year.

For fiscal 2012 (March), we are raising our earnings estimate by a nickel to $.65 a share (+27%).  Excluding any DRMS contribution gains of 15%-20% appear sustainable in subsequent years.  If the company makes further inroads in the Middle East substantially faster growth could emerge.  The odds of that happening appear favorable.  The DRMS line is a wild card, but it too appears to offer terrific potential.  Downside risk is muted by the 4% cash dividend. 

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Computer Modelling Group ( Toronto - CMG ) -- Order Rate Improving

Stock price reflects 2-for-1 split.

Computer Modelling Group (CMG $10.75) appears on track to report excellent on target Q1 (June) results.  Orders for the company's energy development simulators remain vibrant, despite the recent decline in oil prices.  Project activity hasn't diminished in Canada.  And the company is continuing to make competitive inroads in other geographies.  Computer Modelling is the leading provider of reservoir simulation software for heavy oil, oil sand, and other challenging targets.  New discoveries are becoming increasingly more difficult to recover, boosting interest in the company's technology.  Financial results might be less dynamic than Computer Modelling's unit volume gains due to currency factors.  Most of the company's personnel (costs) are in Canada, while more than 70% of sales are priced in U.S. Dollars.  The Canadian currency has been relatively stronger this year, creating a negative translation effect.    Even so, pretax margins are likely to remain in the 45%-50% vicinity.

The DRMS software will enter beta testing in Q4.  That technology simulates the above ground operations at energy projects, allowing customers to maximize all aspects of the work, not just extracting the oil.  Petrobas and Shell are footing the bill for the development work and will get first shot at the software.  But Computer Modelling will retain all rights to the software and will be able to market it to anyone once it is commercialized in 2012.  Final work is focusing on integrating the simulators with customer databases and other computer resources, simplifying the user interfaces so engineers can use the technology without extensive training, and speeding up the processing speed even more.  In laboratory testing the new programs already run faster than the company's existing products.

Results will be affected by mix between perpetual and annual licenses.  Perpetual buyers spend more up front.  Annual deals generate higher recurring revenue.  Either way, the total number of licenses in force is poised to keep advancing.  Demand for oil is likely to remain robust at least for several more decades.  Computer Modelling is a key player in developing new reserves to meet that projected demand.  The new product line could amplify results further.  The shares remain a solid investment. 

Computer Modelling Group ( Toronto - CMG ) -- Q4 Results

Computer Modelling Group (Toronto - CMG $28.00) reported Q4 (March) results that were below our expectation.  The company prices its energy simulation software either as a perpetual license or on a year to basis.  More customers elected the annuity format which provided less upfront revenue.  Unit volume was on target.  The recurring fees will enhance future reporting periods.  Earnings were down 10% at $.28 a share (excluding non cash stock option expense).  Sales were flat at $14.4 million (Canadian).  For the entire fiscal year earnings rose 16% to $.99 a share.  Revenues improved 14% to $51.8 million.   Consulting was the fastest growing segment, although it only represented 16% of total sales.  Computer Modelling has upgraded its technology substantially over the past two years, adding functionality that many users need help with to implement.  Those engagements usually lead to license sales.  License sales also are benefiting as different divisions within large companies adopt the technology. 

Long term growth promises to remain vibrant.  Almost all new energy discoveries are difficult to develop, and candidates for Computer Modelling's technology.  Halliburton and Schlumberger continue to offer simulators for conventional fields but have been unable to catch up in the high end segment.  Worldwide energy demand continues to rise, fueled by emerging economies.  And even at current price levels oil and natural gas provide far superior price performance compared to alternative sources.  A second line will be introduced later this year, focused on above ground facilities.  Those simulators will enable customers to maximize productivity for their entire projects.  The company is partnering with Petrobas and Shell.  Computer Modelling will retain all rights to the technology even though it only paid a third of the development cost.  Petrobas and Shell will get first crack at putting it to use.  Substantial leverage is possible by selling the new line to existing customers and bundling it with existing products when making new sales.

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Computer Modelling ( Toronto - CMG ) -- Follow-up Report

Computer Modelling (CMG $25.00) reported Q3 (December) results that were somewhat below our expectation.  The main reason for the shortfall was a higher concentration of annual software license sales compared to perpetual licenses.  The company gives customers a choice of payment plans.  More took the year to year approach in the December period, requiring a lower upfront outlay.  Non-GAAP income slipped 9% to $.21 a share.  (All figures are shown in Canadian Dollars.)  Revenues increased 3% to $12.1 million.  Deferred revenue increased 17%, presenting a more accurate picture of the company's underlying growth rate.  Product development and marketing costs expanded in the period, pressuring margins to a degree.  Pretax income remained at 47% of sales.  The R&D line went up as Computer Modelling began putting on the final touches to its next generation software line.  Sales from that product will pyramid on top of the company's existing packages.  Computer Modelling improved its current products, as well, separating itself even further from the competition.  Selling efforts in the Middle East haven't borne fruit to date.  Political uncertainty may slow down those initiatives.  But new petroleum finds are becoming increasingly complex to analyze, even in the Middle East.  Demand is likely to emerge because Computer Modelling's software has been proven superior to Schlumberger's by a wide margin in those kind of applications.

We are maintaining our full year (March) earnings estimate at $1.10 a share.  The trend towards annual licenses may continue, in which case a lower number probably will be reported.  Those deals would lay the groundwork for greater recurring income in the future, though.  Rising energy prices promise to bolster demand over the intermediate term.  Tar sands, shale oil, shale gas, deep offshore, heavy oil, and other complex formations are where the action is when it comes to new discoveries.  As those fields get the go ahead demand for Computer Modelling's software is sure to follow.  The pipeline fiasco now afflicting the U.S. oil market may exert a slight restraint on activity.  But the U.S. has become one of the company's smaller markets, so the net impact shouldn't amount to too much.  Reported results also will be effected negatively if the U.S. Dollar declines materially, since two thirds of revenue is denominated in that currency while most costs are paid in Canadian Dollars. 

Financial results could accelerate sharply after the new software line is introduced.  The technology was field tested last year.  The software currently is being enhanced to run faster with better user interfaces.  Commercial launch is expected later this calendar year.  With a major new product in the wings, demand still growing rapidly for the company's core product, and no direct competition in sight, these shares continue to hold exceptional appreciation potential.  Meantime, the shares are yielding a 3%-4% cash dividend.

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Computer Modelling Group ( Toronto - CMG ) -- Follow-up Report

Computer Modelling Group (CMG $25.00) appears on track to report excellent on target Q3 (December) results.  The company is the leading provider of simulation software used by energy producers to exploit heavy oil, tar sand, and other complicated reserves.  Computer Modelling is gaining market share from Schlumberger, which still leads in the conventional market, because most of the easy to produce oil already has been found.  New discoveries are increasingly complex and require the company's high performance software.  Demand is rising across the board in response to escalating petroleum prices, which recently climbed above $90 a barrel.  Anything higher than $75 per barrel generally causes the pace of exploration to gain momentum.  Business remains vibrant in Computer Modelling's established markets.  The company has started to penetrate new accounts, as well, which used to rely exclusively on Schlumberger or their own internal technologies.  Geographic expansion is materializing, too, in response to beefed up marketing efforts.  Schlumberger has not responded with competitive high end products yet, and it appears that a major development effort is not underway.  Start-up competition has not emerged, either, and the likelihood of anyone new catching up at this point has become a dim prospect.  Computer Modelling is applying the finishing touches on a more comprehensive next generation system, which promises to lengthen its competitive lead after it is commercially introduced, perhaps as early as 2012.  Meantime, orders are pouring in as the energy industry prepares for a sustained increase in petroleum demand as the Third World matures over the next few decades.  Income is poised to keep rising at a fast pace.  Much of that is likely to be paid out as cash dividends, moreover, providing shareholders with a superior return comprised of both income and appreciation.

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Computer Modelling Group ( CMG - Toronto Exchange ) - Follow-up Report

Computer Modelling (CMG $21.00 Canadian) reported excellent on target Q2 (September) results.  Sales advanced 47% to $13.3 million.  Earnings climbed 73% to $.26 a share, excluding non cash stock option expense.  The company sells its reservoir modelling software to the energy industry both as a perpetual license and on a recurring year to year basis.  Up front revenue is greater on perpetual sales.  That format does generate some recurring revenue in the form of annual maintenace contracts, however, ensuring customers they receive technology upgrades when they become available.  New unit sales typically are tied to new development projects.  Computer Modelling doesn't break out unit volume but it appears activity picked up sequentially in Q2, bolstered by stronger petroleum prices and improving access to capital.  Results also benefitted from a modest pick-up in perpetual license sales, especially compared to the first quarter when they were practically zero.  Year to year renewals still account for a majority of the business.

The next generation DRMS ("Dynamic Resource Management System") went into service in Q2.  The initial applications will be at sites being developed by Computer Modelling's software partners (Shell and Petrobas).  Those energy giants are each paying one third of the product development costs, although Computer Modelling will retain 100% rights to the technology.  The partners get first crack at the system, though, and that lock-up probably will extend for awhile.  Commercial sales to outside customers are likely to provide a major boost to results through the decade.  But that contribution is likely to modest over the next year or two as Shell and Petrobas fine tune the software and reap the initial benefits for themselves.

The core operation remains in a high growth mode.  New oil discoveries are being made, but they have become increasingly complicated to exploit.  Most of Computer Modelling's sales continue to come from North America.  Interest is building in the Middle East, Asia, and Africa, however.  Those markets promise to keep results marching higher well into the future.  We estimate fiscal 2011 (March) income will reach $1.10-$1.30 a share (Canadian) on sales of $55-$60 million.  Further improvement is likely next year, especially if inflationary pressure increases in the energy complex.  By then the DRMS line should start making a substantial contribution.  Note - Computer Modelling's stock also trades in the U.S. under the ticker symbol CMDXF.  Trading is more liquid in Toronto.

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Computer Modelling ( CMG - Toronto Stock Exchange )

Computer Modelling Group (CMG $18.00 Canadian) is the leading provider of simulation software used by energy companies to model underground reservoirs.  Customers rely on the technology to test a range of possible production strategies so that the most efficient method is identified.  The process continues for as long as the field remains productive.  Conditions change over time as reserves are brought to the surface, causing new approaches to become better solutions.  Schlumberger and Halliburton, the two leading oilfield services companies the world, dominated the industry since its inception in the mid-1980s.  The advent of supercomputers made by Silicon Graphics and Cray Computer made it feasible to perform the analysis on computers.  Schlumberger and Halliburton focused on so-called "black oil" reservoirs, which involved relatively straightforward drilling programs.  Computer Modelling entered the fray a decade later with an emphasis on hard to produce reserves, among them heavy oil and tar sand projects.  The company has continued to invest aggressively in the technology, leveraged by third party funding relationships that leave Computer Modelling with 100% ownership of the intellectual property. 

Growth is accelerating as new oil discoveries become increasingly complex.  Computer Modelling is gaining market share as exploration moves towards reserves that are more difficult to drill.  Software sales tend to be made on a project by project basis, and the programs tend to stick with each project until the field is completely exploited.  Since most of the easy to produce oil already has been discovered, new business is gravitating towards more complicated fields.  Computer Modelling's large competitors still control a number of major oil company accounts (especially the national ones), so despite its superior technology the company still holds a minority share of the market.  But that percentage has been rising over the past decade as more geophysicists familiarize themselves with the software, and a growing number of top tier energy companies sign on as customers.

A new product line offers additional leverage.  Computer Modelling has been developing a more comprehensive system in combination with Shell and Petrobas over the past four years.  The technology encompasses all of a project's above ground facilities in addition to reservoir modelling, and appears to be ideally suited for deep offshore drilling.  Petrobas plans to put the software to the test on an unnamed project starting this week.  The company recently raised $75 billion to develop the world's largest offshore oil discovery in Brazil.  That might be it.  Shell is starting a project of its own.  If the software performs as expected further expansion in those two companies is likely.  Commercial sales to other oil companies probably would follow in future years.

Earnings are rebounding following a temporary decline in fiscal 2009 (March '10).  Energy companies around the world delayed projects last year due to the recession and the uncertainty that created about the future of energy prices.  Now that crude has stabilized in the $70-$80 per barrel range, and interest rates remain low, many of those projects have gotten underway again.  Computer Modelling netted $.85 a share (Canadian) last year, down from $.99 a share the year before.  (Please refer to our "Accounting Notes" section.)  In the current fiscal year, ending next March, we estimate income will rebound to $1.10-$1.30 a share.  The company sells licenses on an annual basis, and as perpetuals that customers own forever.  Annuals sell at about 40% of the perpetual price.  Perpetual licenses generate annual maintenance fees equal to 20% of the selling price, entitling the owner to software updates as they come available.  Either way, the company creates a long term recurring revenue stream.  Perpetual sales generate more income right away, though.  So this year's exact income figure will hinge on how the license sales are split up.

We estimate total revenues will rise 21%-33% to $55-$60 million.  In the first quarter (June), earnings advanced 50% to $.24 a share on an 18% revenue increase ($12.1 million).  In 2-3 years earnings could reach $1.75 a share on sales of $70 million.  Applying a P/E multiple of 25x suggests a target price of $45 a share, potential appreciation of 150% from the current quote.  Note - The stock also trades in the United States on the Pink Sheet exchange under the ticker symbol CMDXF.