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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Points International ( Nasdaq - PCOM ) -- Margin Leverage on Tap

Points International (PCOM $9.00) reported excellent on target Q3 results.  The company is the leading provider of loyalty program services.  Consumer oriented companies that issue miles and reward points hire Points to provide ancillary services like "topping off" and moving credits from one account to another.  Most partners embed a link to the company's servers on their own websites, making it look like their own operation.  Points actually performs the work and updates all the related databases.  The company also operates its own portal, "Points.com."  Consumers can trade directly with other users on a computer based exchange system to get rid of unwanted miles for a carrier they can use. 

Margins tend to increase as volume expands.  Part of that relates to typical economies of scale.  Performance also benefits from rising commission rates after quotas are achieved.  Fully taxed earnings advanced 17% in Q3 to $.07 a share.  Revenues improved 23% to $28.8 million.  Two new products were introduced in the period, impacting profitability.  Those costs are slated to fall in Q4.  Better commission rates are poised to kick in, as well.  And while the summer is usually a slow period for promotional activity, most of Points's partners ramp up those efforts in Q4.  So revenues should expand sequentially.  Earnings are likely to accelerate on the rising volume and expanding margins.

We estimate income will finish at $.25-$.30 a share (+79% to +114%) on sales of $130 million (+36%).  Next year $.50 a share represents a realistic target.  Sales could advance 23% to $160 million.  The long term outlook is bright.  Above average gains could be realized well into the decade.  Points faces little direct competition.  And the loyalty program industry is continuing to expand as new companies enter the fray and existing participants figure additional ways of printing their own money.

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Points International ( Nasdaq - PCOM ) - Just Rewards

Points International (PCOM $9.35) is the leading provider of loyalty program services for the travel and retail industries.  The company offers a family of specialized products that airlines and other types of customers embed into their own websites.  Those features give users more options with respect to their miles and reward points.  Points invented the "top up" more than a decade ago in conjunction with American Airlines, allowing travelers to purchase extra points so they'd qualify for free flights, hotel rooms, rental cars, or other services and merchandise.  Users are diverted from the main website when making those requests to Points's specialized system, where the transactions occur.  Results automatically are fed back to the airline's computer system to keep its records up to date.  Points earns a share of the extra revenue generated.  Margins usually improve as volume thresholds are achieved throughout the year, although every contract is different.  Other products include the ability to combine multiple accounts into a single stack of reward points; and a vehicle to move points from one person's account to another's, usually a relative or business partner.  Points has deals with approximately 50 companies.  A majority of revenue still is provided by the airline industry.  But large new accounts are being added on a regular basis.  Recent additions include Best Buy and Pay Pal.

Points.com is a stand alone website that allows users to manage multiple reward programs.  People can swap Delta miles for American miles, for instance.  Those transactions can be performed directly, usually at a steep discount; or on the company's trading platform, straight up with another user.  The Points.com website now represents just 5% of total revenue.  Awareness is starting to build, though, and some other Internet services the company is introducing could stimulate volume further in future periods.

The company launched a versatile rewards program for Internet retailers at the end of September.  The Incentify program sells generic points backed by the company to any online retailer that wants to establish a loyalty program.  Customers earn those points according to whatever formula the retailer wants.  Instead of be required to use the points with the same retailer customers can select from a list of partners that work with Points.com.  (For example, a customer might purchase $200 worth of running shoes from an online store, and turn the generic points earned into 200 miles on Lufthansa.)  More retailer networks and partners are being recruited, laying the foundation for a possible Christmas surge in activity.

Meantime, the core business continues to grow rapidly.  Rewards programs have expanded under all kinds of economic conditions over the past two decades.  That trend is continuing in the current malaise.  Airlines earn billions each year from the programs.  Other industries now are catching onto the benefits of printing their own money, too.  Points earns a share of the transactions it participates in.  The company is enjoying enjoys organic growth in the 20%-30% range.  New customers continue to be added.  A computer system upgrade in 2010 expanded capacity and facilitated the development of new services.  The company faces no direct competition, moreover.  While margins will be constrained somewhat by the sheer economic pressure of dealing with huge corporate customers, earnings are likely to expand faster than sales well into the future as volume builds, the company's own Internet activities gain momentum, and additional services are created.

We estimate 2011 sales will advance 31% to $125 million.  Earnings promise to accelerate in the second half of the year as volume thresholds are exceeded on most contracts, providing a boost in margins.  We estimate fully taxed earnings will climb 114% to $.30 a share for the entire year.  Next year income could rise another 67% to $.50 a share on sales of $160 million (+28%).  A stronger showing is possible if the general economy doesn't experience a recession.  In 2-3 years income could attain $1.25 a share on sales of $250 million.  Applying a P/E multiple of 20x suggests a target price of $25 a share, potential appreciation of 165% from the current quote.

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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.