All about converts

CDIS analysis – May 16, 2005

Summary

I estimate a 300 over Libor spread for CDIS based on strong credit metrics but offset by their small size and exposure to a capital intensive and cyclical industry. The company is not rated by S&P or Moodys. I would rate CDIS a B+ credit. The recent price for the converts of 94 vs. 42.55 and 300 over Libor spread imply 21% vol.

The converts are protected for both dividends and takeover (less than 90% stock). I believe the credit is solid for the following reasons:

1)      In practical terms, the credit will be correlated with the oil and gas industry, which continues to do well. TheGulf of Mexico, where CDIS primarily operates, is seeing increasing drilling activity, thus benefiting CDIS operations.

2)      The company has a strong cash position and liquidity. CDIS has $362M in cash and $443M in debt ($300M converts and $143M in bank debt). The company expects to generate about $100M in free cash flow in 2005.

3)      One support for the credit is the company’s large oil and gas reserves of 12.5M barrels in oil reserves and 74.7 Bcf of natural gas, which are valued at about $500M after taxes and production costs (based on $40 oil and $5.50 gas prices). Every $1 move in oil prices leads to a 7c move in EPS, which is the reason for the company’s wide range of $2.30 to $2.90 EPS for 2005.

4)      CDIS management has enough on its plate for 2005-2006 and will only make small acquisitions with its free cash flow. They are happy with their capital structure and do not want to add any more debt.

5)      The major risk for CDIS is if oil prices plunges to below $25 per barrel (FCF breakeven), which is unlikely to happen in the near term. Other risks relate to oil reserve estimate revision or unforeseen shutdowns of its properties.

Business

CDIS operates in 3 segments of the oil and gas industry: Marine contracting, Oil and Gas Production, and Production Facilities. The company started off as a construction company that did late stage salvage work related to the closure of a mature deepwater oil and gas field. These services include underwater diving repair, robotics, and well service operations. In 1992, CDIS began to buy oil and gas properties that were at the tail end of their lives from major oil companies to ensure that once the property was abandoned, that CalDive would get decommissioning work. In 2002, CDIS entered the production facility business and currently owns two facilities. CDIS operates primarily in the Gulf of Mexico and recently expanded into theNorth Seain 2002.

CDIS future is directly linked to its oil and gas production business. Without its oil and gas production, CDIS would be just another offshore construction company struggling to keep its construction assets busy and generating mediocre results.

Marine Contracting

Despite the higher oil and gas prices in recent years, theGulf of Mexicohas been lagging in construction work because the GOM has more mature fields that lag the market. Now that oil companies are more comfortable with the sustainability of high oil and gas prices, construction activity in theGulf of Mexicohas begun to pick up. So far in 2005, CDIS Weatherford and Schlumberger are all reporting strength.

 About 30% of work for this unit is for internally owned oilfields and 70% for outside companies. The captive work has kept CalDive operations busy during the lean times, which has caused several competitors to exit the industry.

Shelf Operations

Shelf contracting encompasses surface/saturation diving and salvage work in support of marine construction activity. In 2005, CDIS acquired Stolt’s operations and Torch’s vessels and placed all of these assets into a separate subsidiary. After the acquisitions, the company will have 17 vessels. This segment has been very competitive with several players competing for contract jobs. With the acquisition of Stolt and Torch assets, the market in the Gulf has narrowed to CalDive and Global Industries, which should lead to a better operating environment.

Deepwater Contracting

Deepwater contracting encompasses a variety of construction related services in water depths up to 10,000 feet. CDIS has 5 vessels, each addressing a different need in the deepwater construction phase.Cal Driveis the dominant player in this segment for the Gulf. 

Robotics

Remote operate vehicles (ROVs) are needed to perform operations in depths below 1000 feet. Construction related work in water depths beyond 1000 feet can not be performed by humans – pressures and temperatures are too extreme. CDIS owns trenches that bury pipelines underneath the sea floor. CDIS got into this segment through its acquisition of Canyon Offshore.

Well Operations

Well operations consist of a wide array of services used to carry out well intervention work on existing wells. Wells that are already producing oil or natural gas occasionally need remedial work. These types of services are performed by hiring a drilling rig (even though no drilling is to be done, access into the well requires a rig) and then hiring the oil service company to perform the remedial work that is required. CDIS’s 2 vessels (Seawell forNorth Sea, Q4000 for Gulf) are a replacement for the drilling rig at a much lower cost.

Oil & Gas Production

CDIS strategy is to buy oil and gas properties that are at the tail end of their lives from major oil companies to ensure that once the property was to be abandoned, that CDIS would get the decommissioning work. Over the past two years, the company has expanded its property purchases to include newly discovered reservoirs that oil companies have decided not to develop (called Proved, Undeveloped reserves (PUD)). This model works well because it relieves the original owner of its decommissioning liabilities and CDIS exploits the remaining reserves more efficiently.

CDIS currently has 12.5M barrels in oil reserves and 74.7 Bcf of natural gas. Every $1 move in oil prices leads to a 7c swing in EPS, which is why the company has such a wide range of guidance at $2.30 to $2.90 for 2005.

Production Facilities

CDIS decided to build, own and operate deepwater production facilities without necessarily owning any of the producing oil and gas properties that utilize the facility. The company currently has one facility Marco Polo with another one being constructed called Independence Hub.  CDIS does not own controlling interest in either property and thus accounts for this under the equity method.

Capital Structure and Credit Analysis

CDIS has $362M in cash and $443M in debt ($300M converts and $143M in bank debt). The company expects to generate about $100M in free cash flow in 2005. Capex for 2005 is expected to be $220M consisting of $110M maintenance, $45M for Independence Hub, and $65M for PUD oil field acquisitions)

The 3.5% converts are takeover and dividend protected and senior ranked. The converts are contingent interest with 0.25% contingent if trading over 120% of the principal amount.

The converts are not rated by S&P or Moodys. I would rate CDIS a B+ credit and estimate the spread at 300 over L. CDIS has strong credit metrics but offset by their small size and exposure to a capital intensive and cyclical industry

The most comparable company to CDIS with publicly traded debt is Key Energy (KEGS) which is rated B/B1 and is trading at about 325 over treasuries. CDIS is similar in size to KEGS but KEGS is less profitable with an interest coverage ratio of only 1.5x.

One support for their credit is their large oil and gas reserves of 12.5M barrels in oil reserves and 74.7 Bcf of natural gas, which are valued at about $500M after taxes and production costs (based on $40 oil and $5.50 gas prices)

The company said they are comfortable with their capital structure and will not look to add any debt in the near future. They are still on the look out for acquisitions, particularly looking for more mature properties and to enter theNorth Sea.

Stock Valuation

At $43, CDIS trades at 15X 2003 EPS estimate of $2.86 and EV/Ebitda of 7X, These compare to 18X PE and 7X EV/Ebitda for the oil and gas industry. The stock will move with oil prices.

Risks

Oil and gas prices go down.

The biggest risk to the company is if oil and gas prices go down. Management said that they will be able to operated FCF positive as long as oil prices stay above $25 per barrel. If that is the case, they can cut back on their capital expenses and acquisition activity.

Oil and gas reserve estimates is less than expected.

CDIS currently has 12.5M barrels in oil reserves and 74.7 Bcf of natural gas. If this is less than expected, CDIS would have to write-down their assets. However, given that the company owns mature oilfields with proven reserves that are less likely tobe revised down. CDIS also does not have exploration risk since the oil fields that they own or buy are already proven

Unforeseen shutdowns of its properties

CDIS would be at risk if its properties are shut down due to hurricanes or other reasons.