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Zedi Part 8 – The Conclusion: Contemplating the Recovery Scenarios

October 10th, 2013 | Posted by Torin in ZED

This about does it for Zedi. I want to show one last chart:

zed26

For me, it is impossible to look at this chart and not think “gosh, what would happen if the natural gas market actually improved?”

I am going to streamline the analysis as much as possible. Forget estimating revenue and profit by segment or product line; I am simply going to take a guess at the net present value of each new Zedi-equipped well. That NPV estimate will provide an easy way to sketch the various recovery scenarios.

In my NPV model, I assume that:

-new wells have a 25 year useful life

-upfront monitoring equipment sells for $6,500 per unit

-upfront monitoring equipment sales earn a 35% gross margin

-data management fee per well is $1,100

-data management revenue generates an approximate 80% gross margin

-data management fees increase 2% annually per well

-data management revenue brings an incremental 15% incremental corporate overhead expense

-profits are taxed at the standard Canadian corporate rate

-the discount rate is 10%

These assumptions in aggregate yield an average NPV per Zedi-equipped well of about $7,500. You can adjust them as you wish to derive your own NPV estimate.

The next step is to estimate how many new wells will be outfitted with Zedi products each year. Zedi says that has a 30% to 40% share of new Canadian natural gas wells; I’ll use 30% to be safe. But the more important assumption is the number of new wells being drilled. Here is the historical chart again:

ZED7

From 2003 to 2008 the average number of wells drilled was about 14,000. I assume these were boom conditions that will not repeat, and 10,000 drilled wells is a safer annual figure. At 10,000 wells and 30% penetration, Zedi would be looking at 3,000 new unit sales per year. At a $7,500 NPV for each well, that’s $22.5 million, or ~$0.23 per share, of value…almost one third of the company’s current market cap. That’s in just one year.

Let’s say that the recovery does come, and that it is sustained. Let’s say that the number of new wells drilled hovers around 10,000 annually for five years. In this case, the NPV to Zedi would be roughly $113 million, or $1.13 per share. Add that to the current intrinsic value, and then add five years of retained cash earnings from the existing business, and we would be looking at a ~$2.75 stock in five years.

zed25

It bears emphasizing with bold print that there is a lot of false precision in this analysis. I am making point estimates for wildly fluctuating figures, years into the future. I really don’t know whether 10,000 new wells per year is a realistic recovery estimate. Maybe a lower number is more appropriate. But even at five thousand wells instead of ten thousand, the $2.75 value is only reduced to $2.20…still a very, very attractive IRR from the current share price.

On the other hand, the analysis above focuses solely on the value be created by the Canadian natural gas business. It ignores any possible future value creation from:

  1. Further growth in Silverjack sales
  2. Further growth in Silverjack data fees
  3. Increased penetration of electronic/remote monitoring in the U.S.
  4. Growth in international markets, where penetration of electronic/remote monitoring is very low
  5. Smart acquisitions
  6. New product innovations
  7. Share repurchases or other financial methods of value creation 

Industry conditions can’t get much worse. Canadian natural gas well drilling is down more 90% from the peak. Drilling has basically declined for six straight years. The number of wells drilled doesn’t have far to go until it hits zero, at which point there will be no further to fall.

It is hard to make predictions, especially about the future. No one knows what the recovery will look like, how long it will take to come, or how long it will stick around. But from here, the probability that things will get better is far higher than the probability that things will get worse. Zedi is performing fine—even well—in the current environment. Today’s valuation provides a big margin of safety. In a recovery, the upside to an investment in ZED shares is undefined…but awfully fun to contemplate.

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That’s it for Zedi. As disclosed above, Monte Sol and its affiliates own ZED shares. So do the insiders: they report owning 8% of the company, with the CEO alone owning 4%. This 8% figure understates the total insider ownership of the company, however, because it excludes all non-director executives, save for the CEO. There are a number of non-director Zedi employees who regularly buy small amounts of stock in the open market, including the founder/former Chief Scientific Officer, the CFO, the COO, the Chief Marketing Officer, the General Counsel, two SVPs, and a VP. Adding in the reported equity (but not option or RSU) holdings of these employees brings insider ownership to 12.5%.

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