|Shares Out. (in M):||0||P/E|
|Market Cap (in $M):||788||P/FCF|
|Net Debt (in $M):||0||EBIT||0||0|
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BRISTOW GROUP (BRS)
Bristow Group is the world’s largest provider of helicopter services to the offshore oil and gas industry. At $33, BRS presents an opportunity to own a:
We think fair value for BRS is 12 - 15x Mar09 earnings -- $48 - $60 -- implying 45 - 80% upside potential, with essentially no downside risk given the roughly $35 liquidation value.
We think fair value for BRS is 12 - 15x Mar09 earnings -- $48 - $60 -- implying 45 - 80% upside potential, with essentially no downside risk given the roughly $35 liquidation value.
This value opportunity exists because of some readily identifiable factors: legal “hair,” accounting restatement, technicals from recent convertible deal, and new management team that has only just begun to communicate with the street. As we describe below, the question “Why will perception change?” is also readily answerable: legal concerns are overblown and likely to be resolved for de minimus dollars in the near term, technicals will subside, significant industry tailwind over next several years, substantial earnings growth ahead, and more pro-active communication with the public as story has cleaned up.
Bristow Group is the world’s largest provider of helicopter services to the offshore oil and gas industry. With a consolidated fleet of 332 aircrafts and an additional 148 aircrafts operated by unconsolidated JVs, Bristow is a market leader in nearly every oil/gas producing region of the world. The offshore helicopter industry is more dependent on production than exploration, and therefore is significantly less cyclical than most other OSX segments. Moreover, the industry is benefiting from a tightening supply/demand situation.
In order to support expected production growth, industry participants currently estimate that we will need 200-400 additional helicopters for the offshore industry over the next 4 years. While the existing market leaders have secured orders for over 150 new helicopters over the next few years, the 2 main medium/heavy helicopter manufacturers (Sikorsky and Eurocopter) have sold out their capacity through 2009, and thus there is likely to be a supply shortage over the next few years. With increasing demand, and limited supply, the outlook for pricing and margins is quite favorable.
BRS has by far the best balance sheet in the group (no net debt as of Sep-06) and has recently completed a mandatory convertible offering to further capitalize itself to take advantage of upcoming growth opportunities. We expected BRS to earn $3.30 for Mar-2008 fiscal year and approximately $4.00 for Mar-2009. FCF is higher than earnings because maintenance capex is less than depreciation as all real maintenance capex on the helicopter fleet is expensed on the income statement. With no multiple expansion, this earnings growth would result in a $40 stock, some 20%+ above today’s $33 level. Applying a more likely 12 – 15x multiple to those earnings would result in a $48 - $60 stock, 45 – 80% upside. Our downside is well protected by the secondary market asset value of the current fleet of owned-helicopters, which we estimate to be around $35 per share.
Background and Legal Issues
Bristow Group was once known to the investment community as Offshore Logistics (“Air Logistics” is still the company’s operating brand in North America). Under a previous management team, Offshore Logistics unfortunately made a number of legal mistakes and became a target of several investigations. Without taking up too much time here, I’ll just quickly summarize them into 3 categories:
1. Improper payments made to customers and government officials in Nigeria
2. Underpayment of payroll taxes, import duties and violation of currency transfer restrictions in overseas subsidiaries (primarily Brazil)
3. DOJ investigation of antitrust activities in the Gulf of Mexico
Since the initial disclosure in late 2004/early 2005, these legal issues have overshadowed the improving fundamentals of the business, and have put significant pressure on the share price. We believe this is an opportunity in disguise, since we believe these legal issues are now mostly behind them and provide a catalyst for BRS to return, untainted, to the mainstream investment community. Here are our rationales:
1. BRS self-reported its Foreign Corrupt Practices Act violations to the SEC, and the Board has completed an Internal Review and fully cooperated with the government on a voluntary basis.
2. BRS has replaced its entire senior management team since late 2004, and terminated all employees, agency/business and JV relationships implicated.
3. BRS has a 30-40% market share in
4. BRS has corrected underreported taxes and is in full compliance today.
5. The largest FCPA-related fine in history was approximately $30mm (about $1/share for BRS). A recent case also in the oil/gas industry involved ABB Vetco, which had made illegal payments over 5 years in 22 countries (vs. 1 country for BRS), and it paid only $16mm. Interestingly, BRS CFO Perry Elders was brought on as the Chief Accounting Officer at Vetco, and he helped ABB negotiate a settlement with the DOJ. Legal counsel who specialize in FCPA investigations tell us they would be surprised to see more than $5 - $10mm of fines for BRS. We assume $10mm.
6. The DOJ antitrust investigation targeted all helicopter participants in the GoM, even though helicopter rates have increased only 5-10% per year, while rig and boat day-rates have typically more than doubled or tripled during the same time period. None of the participants have heard from the DOJ regarding this matter in over a year, and we do not expect the DOJ to pursue this matter any further, although it’s unclear if there will ever be a final resolution.
Cyclicality – unlike many other offshore service companies, only about 1/3 of BRS’s business is tied to exploration activities while 2/3 are tied to production platforms. Typically, exploration activities (e.g. drilling) tend to be highly correlated with commodity prices and go through steep boom/bust cycles, while production levels tend to be more stable. This is partly because by the time an E&P makes the decision to build out a production platform, it has already spent a good deal of money on seismic and drilling (i.e. sunk costs) and therefore requires a fairly low hurdle rate (in terms of commodity prices) to justify the build-out of the remaining production infrastructure and the continued servicing of the production platform.
Contracts – the majority of BRS’s revenues come from longer-term contracts instead of spot rates. While the contracts for small helicopters in the Gulf of Mexico can be as short as 1-2 quarters, the bulk of Bristow’s earnings come from medium and large helicopters in overseas markets that operate on contracts ranging from 3-5 years. Typically, those contracts are protected in the first year, and can be terminated thereafter with a 6-month notice. While some investors correctly point out that Bristow is susceptible to changing customer spending decision, the reality is that these are long-term relationships, and early terminations are very rare even during the downturns.
Pricing – while BRS hasn’t seen its day-rates go through the roof over the past few years (like other more cyclical OSX names), they have been improving steadily (5-10% per year) and are more defensive in case of an industry downturn. In fact, according to the company, rates in the Gulf of Mexico have not declined for over 10 years (through the last boom/bust cycle). In addition, unlike much of the OSX, we believe the helicopter industry is still under-earning from its asset base (see section on Valuation) and that rates will continue to improve, even if the commodity prices decline marginally.
From a macro point of view, the offshore helicopter industry is going through a long-awaited replacement cycle driven by a few factors:
1. Many of the newer offshore developments are further from land and in more difficult environments. There is a trend to replace smaller aircrafts (4-7 seats) with medium and large aircrafts that can carry more people, fly further and in rougher conditions.
2. The existing fleet of Western medium/heavy helicopters is old and need to be replaced. For example, the Sikorsky S-61 and Aerospatiale SA-332 are designs from the 1960’s and 1970’s. While updates have been made periodically, the latest designs (Sikorsky S-92 and Eurocopter 225) represent a significant leap in technology.
3. Many developing countries built their own helicopters in the past. Most of those aircrafts are becoming obsolete and will need to be permanently retired.
According to industry participants, we will need a minimum of 200-400 additional helicopters by 2010, with 200 for new production opportunities and at least 200 (probably more) for replacement opportunities. The leading operators have locked up 150+ newbuild slots through 2013, and new orders of medium/heavy helicopters are looking at 2009 delivery at the earliest.
Return on Investment
Given the asset-based nature of BRS’s business, return on invested capital is probably the best metric to follow for the company and specifically, we focus on EBITDA/Fair Market Value (aircraft + 10% for working capital). We will use this formula interchangeably with ROIC. We use EBITDA in the numerator for two reasons. First, we are looking for pre-tax un-levered rates of return. Second, helicopter maintenance capex is almost fully expensed above the EBITDA line. For regulatory and safety reasons, helicopter components are completely rebuilt every few years. Thus, while all the parts except for the airframe are replaced (via income statement expenses), the original equipment is still depreciated based on accounting driven assumptions (7 year depreciation to 50% residual for new equipment). BRS generates net gains on its asset dispositions suggesting accounting depreciation is too punitive vs. economic reality. Also, given the supply demand characteristics for helicopters right now, used helicopters are typically sold for more than they cost to purchase.
Historically, competition has been brutal and ROIC occasionally got pushed into high single-digits. We believe a number of things have changed
1. New management teams at BRS and CHC are now appropriately focused on returns on capital instead of operating margins. In the past, segment chiefs at BRS would hoard assets to generate highest absolute EBITDA for their division, with no consideration for how much assets they’re tying up. Under the new management team, each division is compensated based on their returns on capital, so that each segment chief is incentivized to bid carefully and to return underutilized assets to other segments that can utilize the assets more productively.
2. Consolidation of operators and a tight supply/demand situation has created an easier environment whereby a competitor doesn’t need to compete on price. Bristow has been able to find additional work whenever it walks away from a suboptimal bid.
3. As the projects become more demanding, safety has become a top differentiating factor and a considerable barrier to entry for start-ups. BRS has distinguished itself on its superior safety record.
4. While the competitors do not speak directly with each other (for obvious antitrust reasons), each has independently said that returns on existing contracts are too low, and that all new contracts are bid at a higher level. Over time we expect the existing contracts to roll over and for the entire fleet to operate at a higher margin.
5. While BRS owns most of its fleet (310 out of 332) and has positioned its balance sheet conservatively to absorb its entire newbuild program, Bristow’s main competitors (CHC overseas and PHI in GoM) are expanding their fleet via operating leases. By leveraging their capital structure to the hilt, CHC estimates that it has an ongoing variable cost of 10-12% (7% lease rate, 3% expected long-term economic annual depreciation of assets and 2% for overhead). Thus, even in a downturn, CHC would not be able to bid below 10-12% ROIC. In the past, when most of the competitors carried their fleets on the balance sheet, management teams would take a “mental write-down” of their assets during downturns, and bid irrationally in single digit ROIC because they assume the original investment was impaired anyway. In the future, we believe 10-12% ROIC is a bidding floor for BRS’s competitors. While BRS’s peers would be losing money below 10-12% ROIC, BRS would still be able to generate over $3.00 of earnings.
BRS is currently earning a run-rate EBITDA of $160mm on an asset base (including working capital) of $1.3bn, or an ROIC of 12.5%. As existing contracts come up for renewal over the next few years, BRS is in the process of raising this ratio up to 15% for existing generation aircrafts. For new aircrafts where the supply/demand situation is much tighter, Bristow is bidding to generate 20-25% ROIC.
But are those returns reasonable? Take EBITDA/FMV of 15%. Assuming a 7-year straight-line depreciation schedule with 50% residual value and 35% tax rate, the actual 7-year unlevered IRR is only 6.4%. At EBITDA/FMV of 20%, the unlevered IRR is 10.3%. While these returns don’t look all that fantastic (hence our argument that the industry is vastly under-earning), in reality the actual returns are slightly better because the true economic depreciation is nowhere near the book depreciation of 7%/year. Most industry participants assume long-term economic depreciation of 3%/year, while more recently evidence actually points to long-term economic *appreciation* of these assets. Many, if not most, of BRS’s assets can be monetized for more than their original newbuild costs 20 years ago. Below we show the true 7-year unlevered, after-tax IRR for 15% and 20% EBITDA/FMV scenarios, assuming 0%, 3% and 7%/year of true economic depreciation of the assets.
0%/year Economic Depreciation
3%/year Economic Depreciation
7%/year Economic Depreciation
Thus, it’s hard to argue how 15% pretax ROIC is too high. We certainly don’t believe BRS’s E&P customers will tie up their own capital to chase these meager returns in the current environment.
In late Sep and early Oct, BRS issued $230mm of mandatory convertible preferred. We view this issue as primarily a deferred equity offering with a conversion cap and floor, combined with a small current dividend to supplement the slight conversion premium and 3-year cost of carry. The net result is that the preferred will convert into somewhere between 5 to 6.5mm shares.
But how many shares do we expect the arbs to short out? We were told that most arbs were using hedge ratios of around 1 share/pfd, implying a total of 4.6mm shares to be shorted for the whole issue. We estimate the arbs to have picked up 50-65% of the whole issue, so we’d expect a total of 2.3-3.0mm shares to be shorted as a result of this deal. Yet from 9/10/06 to 10/10/06, shorted shares only increased by 400K. It’s unclear what the short interest is on 11/10/06 (to be reported shortly), but this factor could potentially explain the recent volatility and weakness of the stock price.
1. Assuming potential legal fines of $10mm and capitalized leases of $75mm, we estimate a TEV of $1.055bn and a Mar-2007 EBITDA of $165mm. We must also remember, however, that given Bristow’s rapid expansion plan, the TEV and EBITDA are both constantly moving, and current EBITDA is understated because not all new aircrafts have been fully ramped.
2. In 18 months (Mar-2008), we expect Bristow to take on an additional $200mm of debt for a TEV of $1.255bn (assuming stock price of $33.00), while run-rate LTM EBITDA (after ramping) has grown to $233mm, resulting in a multiple of 5.4x.
3. Our model is conservative in that we assume no margin improvements for the existing fleet, even though we know that below-market contracts are being re-priced worldwide, and that West Africa is currently in turn-around mode.
4. While 5-6x EBITDA may not seem extraordinary for certain OSX sectors, we don’t think it’s appropriate to compare Bristow to rig and boat companies. First, maintenance spending on the helicopter fleet is expensed above the EBITDA line. Thus, capex needs are much smaller for BRS. Second, our belief is that whenever a sector is trading at a significant premium to replacement value, those assets are currently “over-earning” and that the market is anticipating rates to come back down. Without getting into an off-topic argument on whether or not rig/boat stock prices are appropriately discounted, we’d only like to point out that Bristow is currently trading at replacement value, with no value for its corporate structure, customer relationships, safety track record, and locked up newbuild slots.
1. We are expecting earnings of $3.30 and $4.00 for Mar-2008/2009 fiscal years. It should be noted that both of those years assume only half-year contributions from the newbuilds of those respective years. Full-year contributions (or run-rate) would add another $0.20 or so to each year.
2. It should also be noted that we’re assuming the most punitive conversion factor for the recently issued mandatory convertible preferred, which has a sliding conversion ratio (at conversion prices of between $35 and $43). For example, if BRS stock trades below $35 when the preferred is converted in 2009, 6.5mm shares would be issued. But if BRS stock is trading above $43, only 5mm shares would be issued. Our estimates are based on 6.5mm shares issued. Using 5mm shares (which we think is more likely, as we believe BRS stock will trade above $43 long before the conversion date), our EPS for 2007 and 2008 would increase by $0.18-$0.21 per share.
Free Cash Flow:
1. This metric has not been a focus for most investors, given Bristow’s significant expansion plans. Yet those expansion plans are hiding the fact that Bristow is actually an excellent generator of free cash flow.
2. Bristow expenses nearly all of its maintenance costs in the income statement, as most parts of the aircraft are replaced according to regular schedules based on age or hours flown. True maintenance capital expenditures are closer to $15mm.
3. Assuming a more normal use of working capital ($10-15mm/year), we estimate Bristow to generate “FCF” (operating cash flow less maintenance capital expenditures) of $110mm for Mar-2008 ($4.00/fully converted share) and $135mm for Mar-2009 ($4.80/fully converted share) or FCF yields of 14 -17%.
4. What about ultimate replacement of the fleet? Most industry participants conservatively estimate “true economic depreciation” of at most 3% a year (implying average life of 30-35 years). Since the current stock price is fairly close to the asset value, we can simply reduce the above FCF yields by 3% to get to an “economically sustainable FCF yield” of 11-14%.
5. More recent anecdotal evidence suggests that the “true economic depreciation” may be closer to zero in today’s strong environment. Many (if not most) of BRS’s current for-sale fleet are being monetized for more than what BRS originally paid for, allowing BRS to consistently book gains-on-sales as they renew their fleet.
1. BRS gives excellent breakout of the specific models of its consolidated fleet.
2. We have spoken to numerous helicopter deals to assess the value of BRS’s fleet.
3. There is also an “Official Helicopter Blue Book” (offered by HeliValue$) which appraises helicopters based on model and age.
4. Our best estimate is that BRS has a current liquidation value of $35+ per share. It should be noted that our liquidation value assigns no value to the Production Management business, Bristow’s customer relationships, safety track record and corporate structure.
The new CEO of BRS, Bill Chiles, left a COO position at Grey Wolf to fix-up Offshore Logistics. Previously Bill had built-up his own rig company, Chiles Drilling, and sold it to ENSCO. While there is no public indication that he plans to do the same thing here, facts and circumstances suggest it wouldn’t be out of the question for the following reasons:
1. Bite Size – at about $1bn enterprise value, BRS is in the “sweet spot” for private equity buyers, and would also be manageably digestible for strategic acquirers.
2. Financial Buyers – two private equity firms had discussions this past year about taking competitor CHC private at just over 9x LTM EBITDA (forward EBITDA depends on your assumptions, but may be around 7-8x). This would imply ~ $47/share for BRS. The deal ultimately fell away because CHC already has significant off-balance sheet lease financing, and putting more financial leverage would’ve been difficult given the upcoming purchase commitments.
3. Attractive LBO Returns – we estimate IRR of 25%+ using conservative leverage and financing assumptions.
1. As an OSX type name, Bristow may trade in sympathy with the OSX index. If oil goes back to $40, the stock will likely trade down on market sentiment, even though the lower commodity prices have little fundamental impact on Bristow’s business.
2. Bristow has not yet fully resolved its legal issues. While we don’t expect any material negative surprises until the issues are fully closed the risk remains.
3. Price competition. The two primary market competitors are currently pricing rationally. If any of the players were to abandon their current discipline and price for market share that could upset the industry dynamics.
4. Overbuilding of supply. Some investors see the current order book (150 aircrafts) and worry about too much supply coming online. We believe a combination of upcoming demand and the fact that the manufacturers are fully booked until 2009 mitigate this issue. In fact, most of BRS’s 2008 orders are already committed to contracts, while the rest are earmarked for specific customers/projects.
5. Because many countries have restrictions on foreign ownership of aircraft operators, BRS structured many of its foreign operations in complicated JVs. As a result, 30% of BRS’s total fleet of 480 aircrafts are held by unconsolidated JVs. While we believe BRS is applying the appropriate accounting treatment for its JVs, it is critical for BRS to maintain solid internal controls and remedy any material weaknesses. Even if BRS changes the accounting treatment of some of its JVs, the economics and cash flow of these deals do not change.
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