Friday, February 3, 2012

Odyssey Marine Best Seen on TV, Not In Your Portfolio

The Jaded Consumer recently submitted an article at Seeking Alpha with the above title, which the editors decided to rename "The Best Way To Play Odyssey Marine And Shipwreck Exploration". When I started writing the article, I wasn't yet thinking about the long/short prospects of Odyssey Marine being shorted in favor of a major offshore oil and gas support services provider such as Oceaneering International or Subsea 7, which use some of the same (or better) equipment and skill sets but do so in a business model that has actually been proven to make a profit. I was thinking that while it's cool to watch underwater exploration televised by the Discovery Channel, it really sucks to "stand under a cold shower tearing up £50 notes".

Comments quickly arrived from those who watched OMEX – a crowd that surely has interest in Odyssey's yarn about the almost-in-hand treasure, or it wouldn't be watching OMEX news. The thrust of the comments was that (a) Odyssey is about to pull up one (or more) of the wrecks, and (b) it's a ton of money on that wreck (or those wrecks) and it'll push shares to $____ (number varies with enthusiasm of advocate). The comments thus assume that Odyssey is capable of salvaging a wreck at a net profit. Built into this assumption are a several important axioms, the doubt of which would considerably impair the the bull case: (1) Odyssey is capable of recovering from the sea floor valuable cargoes, substantially intact, despite their being lost for many years, (2) Odyssey will be able to prove some ownership interest in one or more of these valuable recoveries, (3) Odyssey's timeline to proving its claim will be within a commercially reasonable time frame, and won't require multiple new share issuances to keep the enterprise's lights on (and attorneys paid) while litigation drags on for years as it did with Mel Fischer, and (4) Odyssey's cost to recover property and defend a claim to title will not only cost so much less than the value of the recovered property, and be so quick that dilution can be ignored as a risk, but will provide so much upside that the risk of the shares going nowhere forever while OMEX burns investors' cash having fun hunting treasure around the world is really outweighed by the huge upside. Of these axioms, (1) is probably the safest so long as OMEX is able to raise funds in the public markets to keep trying. The others vary considerably by project.

Reaching for the Stars

With patience and unlimited resources, incredible things are possible. We've sent Man to the Moon and filmed him teeing off a Golf ball, for goodness' sake. This doesn't prove that there's a business to be built on the fact any time soon. Thanks to advances in ROVs that make possible three-mile-deep work trips without mortal danger, three miles' depth into the blackest sea is no longer as hard to reach as the surface of the Moon. However, since it's harder to see than the near side of the Moon, we know a lot less about much of our deepest oceans than we do about the Moon. What's more, the deepest oceans have been swallowing humans whose skills were defeated by Nature, and with them their vehicles and other property (including property extorted by European sovereigns from locals who preferred not to mine precious metals and gems at gunpoint without pay), some of which was sufficient to replenish a kingdom's treasury. No wonder shipwreck exploration captures the imagination!

And for only a few bucks, you can buy a share of OMEX.

How Big A Share Will Shareholders Buy?

A look at OMEX' Sept. 2010 Form 10-Q says something interesting about management's outlook for the future appeared in the third paragraph of Note J:
During our annual meeting of stockholders on June 1, 2011, an amendment to our Articles of Incorporation to increase the number of authorized shares of common stock from 100,000,000 to 150,000,000 was approved by the stockholders.
Given the other information in Note J – the public offering of more than 5 million shares during the quarter, the conversion into common stock of certain numbers of shares of various classes of convertible preferred, and the issuance of shares to accredited investors exercising warrants – one wonders just how much further dilution is in store. After all, the company had 72,973,773 shares outstanding at the end of September, 2011, and management sought and obtained an authorization increase to more than double that number. This is rather a puzzle for a company on the supposed cusp of success. It's not like the share price is so high it scares off potential investors . . . .

Let's have a look at Note E. Between year-end 2010 and the time OMEX' quarter ended September 30, 2011, OMEX' inventories declined a few hundred thousand dollars from about $6.4m to about $6.3m. Relatively little of this decline was in "merchandise" (a few grand); most of it was in the category of "Artifacts" (from about $6.2m to about $5.9m). Several tens of thousands of dollars in "packaging" also fell off the inventory sheet over the nine-month period. Just how liquid are these artifacts, and how hard is OMEX trying to sell them? If management consistently finds it easier to raise funds by issuing shares instead of selling its "inventory", how much confidence can investors have in the business case they should be counting on for share price increases in the event of a salvage success? Won't the investors get diluted to the point the success is irrelevant?

A few years ago, excitement about the $500,000,000 value attributed to the Black Swan project in the press led people to conclude OMEX was headed to the moon. A few more years of dilutive issuance into the project, we find that (a) if OMEX were to liquidate a $500,000,000 asset without transaction costs the one-time per-share impact of this would be $6.85 before taxes, but (b) the United States Court of Appeals for the Eleventh Circuit accepted Spain's position that OMEX is not entitled to the wreck, or even a salvage share, because it was a warship over which United States law bars the exercise of federal jurisdiction. A careful read of the opinion reveals that Odyssey Marine's legal argument in favor of federal jurisdiction (and its claim to a salvage award) turned on its ability to raise doubt that the vessel was in fact the warship Odyssey Marine had been seeking. In short, Odyssey Marine hoped to win in court by deceiving the Court about the identity of its find. How is this a recipe for success?

Unsurprisingly, the distinctive 19th century warship and its peculiar cargo were recognized by the Court for what they were, and the whole find was ordered surrendered to the King of Spain. OMEX' request that the Court of Appeals reconsider was rejected. The $2.6 million discussed in Note E as a recovery cost to be carried on its inventory sheet if title to the Black Swan passed to OMEX won't enter OMEX' inventory sheet; it'll just join OMEX' ongoing losses. Shareholders' share of the Black Swan is the same share as the rest of the public: the right to follow an exciting story in the news.

OMEX has clearer rights to a wreck known to investors as the "Gairsoppa" project. In this deal, OMEX entered a competitive bidding process to obtain a license to salvage a British vessel torpedoed in the Second World War with a cargo of "up to 7 million total ounces of silver". OMEX holds the risk of failure and the burden of any expenses, in exchange for which it is permitted to retain 80% of the value of the silver recovered under the contract. OMEX chartered a Russian vessel to find the vessel, then announced it was found. Assuming a 100% recovery and a silver content that is the same as the maximum estimate, OMEX could keep 80% of about $200 million. $160,000,000 before taxes would provide a gross recovery of nearly $2.20 per share before expenses and taxes. This could really help keep the lights on for a while, and stave off the next round of dilution. To ensure this, OMEX isn't doing anything like an archaeological recovery. The plan, as I understand it, is to use a huge underwater excavator to make a (hopefully small) number of big grabs to bite into and through the wreck where the valuables are believed to be. It will destroy the wreck, and not endear OMEX to idealists keen on history or war graves. OMEX is permitted to do this under its recovery contract, and won't face government interference, but it serves to highlight OMEX' nakedly commercial objective – this isn't bad for honesty, but it's murder on prospects to be allowed to work on projects that involve cultural significance. But, OMEX is desperate to show it can really find something it can sell.

The two bucks isn't anything to sneeze at, given OMEX' pricing south of $4, but to think of ongoing revenues one would have to see a track record of turning opportunity into profit. And that record is not good: OMEX is burning millions a quarter keeping its vessel in operation, and hasn't produced much for the benefit of investors in that time (though it's gotten some exciting press for its headlining principals). The real question isn't whether there's a valuable wreck that might be salvaged if the rights could be made clear, but whether there's a business case to be made that OMEX will generate a reasonable risk-adjusted return for investors.

The Quality of the Business
Some folks, especially value folks, like metrics. Hard numbers that show management's performance can aid the unemotional evaluation of a business' management and aid in the assessment of the likelihood that management will produce outstanding shareholder returns. One not-too-unexpected place to look for a performance metric of that kind is a business' accounts receivable. Are they collecting? Are they giving free credit? Are they taking on bad risks to make short-term sales?

So let's look at Note D. Accounts receivable fell over the nine months (12/31/10 to 9/30/11) from about $2.1m to about $0.7m. Now, this might be an exciting trend if paired with cash flow that showed conversion of receivables into cash. Unfortunately, as described in The Jaded Consumer's original piece on this enterprise, cash flow is enormously negative and – far from showing $1.4 million in receipts from collected accounts – shows that the company is only able to show positive cash when it prints enough shares to outweigh its multimillion dollar quarterly expenses. The income on the balance sheet is mainly non-cash income that flows from changes in values of derivatives, a value that is dwarfed by sources of loss that cost current cash. Despite that the purported purpose of the enterprise is to sell finds obtained from the sea, there is no income line for "sales of finds" (or even "of inventory"). The closest thing on the balance sheet is "Other", which is less than sixty grand – not enough to run the boat for even a single week.

So what explains the drop in accounts receivable? Note D offers a hint. Over the period, OMEX exercised a contractual right to offset nearly $2m owed to a 41.25%-owned sea-bed-mining subsidiary against the $2m the partially-owned subsidiary owed OMEX. Dorado Ocean Resources Ltd. wasn't the only deal between siblings that seemed to have a big impact on receivables. Neptune Minerals Inc., of which OMEX was a one-third owner at some point (the note describing it strongly suggests a risk of post-transaction dilution), entered a share exchange with Dorado under which Neptune assumed debt owed to OMEX by Dorado, while OMEX entered into a debt conversion agreement with Neptune to become an equity holder instead of a holder of debt. This makes good sense if the debt payee can't make its payments, which is likely given the business Neptune is in. Neptune has paid OMEX $9.6 million and an equity stake for geological exploration services designed to find exploitable mineral deposits on the sea floor on what amounts to an underwater mineral lease previously owned by Dorado. Between its dealings with Neptune and its dealings with Dorado, OMEX owes its partially-owned customers several years of underwater exploration services. Got that? OMEX owes services – funded by dilutive share issuance – as compensation for investment in its customers' unproven underwater mining businesses.

How did OMEX get neck-deep in someone else's treasure hunt? It all began innocently enough. In February of 2011, Neptune paid Odyssey $3m and an equity stake for a 50-day survey contract. Nice piece of business for a company that otherwise would be selling shares to make payroll, right? But, no. In June, Neptune and Dorado entered into a share exchange in which Neptune acquired Dorado and OMEX became a Neptune investor (and signed away debt owed OMEX for shares of a non-voting common). Within a week, OMEX had entered into a 100-day charter agreement with a couple of entities with the word Neptune in their names to operate Dorado's vessel (OMEX' having been slated for auction in the near future) to supply services for Neptune Minerals Inc. When the charter concluded in October 2011, OMEX had been paid $6.9m and owned "approximately a 33% equity ownership in Neptune[.]" To protect its investment, OMEX will be hard-pressed to say "no" to Neptune, especially if (as I read it) Neptune's subsidiary Dorado owns the vessel OMEX is currently operating. OMEX claims that it doesn't engage in off-balance-sheet financing arrangements, but I don't see financial statements for Neptune or Dorado or any of the archaeological entities which have revenue-sharing agreements with OMEX. I find the financial arrangements of OMEX peculiarly opaque for a business that is supposed to be so straightforward as finding valuable things and preparing them to generate revenue.

Perhaps Neptune's business will pan out, and OMEX will own a valuable stake in an underwater mining company. Was investment in underwater mining operations the reason investors entrusted their money to OMEX? Did investors expect OMEX to have weighed and soberly considered underwater mining regulatory risk and associated regulatory compliance? Did OMEX' management demonstrate a special aptitude for assessing the value of illiquid portfolio companies? Did investors think the purpose of their venture was to sell survey services for $69,000 per day plus a stake in the customer? How many days can Neptune afford at $69,000 per day, and at what point will Odyssey end up selling those days at a loss in the hopes of making the equity valuable?

Odyssey's track record of executing its announced plan of monetizing wrecks is poor. Its track record for developing uncollectable receivables is concerning. Its track record for teasing valuable wrecks as just-around-the-corner has been a key to raising excitement needed to fuel interest in further equity issuance, but they haven't produced value yet. Based on the comments in the SEC filings about the expectation that its ship will be sold for scrap following the reporting period, Odyssey has literally run one ship into scrap trying to find treasure at the bottom of the sea, and so far the only treasure it's appeared to have acquired has been the property of the Kingdom of Spain, and to have been recovered without any payment at all.

The Comparison
Other firms use similar (or better) technology and get real results. Subsea 7 and Oceaneering both use deep-water sensing equipment and work-class ROVs to provide sophisticated deepwater services, but instead of being paid $69,000 per day they charge well into the six figures a day for vessel equipped to provide underwater construction services to energy companies who need to install and operate equipment on the floor of the sea. By charging a six-figure sum, these companies produce double-digit ROI for investors rather than force investors to speculate on the possibility that a customer's underwater venture will turn profitable.

Consider the risk-adjusted returns: offshore energy services companies sell services to the likes of Shell, ExxonMobil, BP, and other energy firms whose natural resource assets are gaining in demand, and whose cash flow is outstanding. To access their offshore mineral assets, they engage third-party engineering and underwater construction firms whose tools and expertise are indispensable to efficient offshore operations. They sell services of skilled employees at a steep markup, and they sell the use of complex high-tech tools platforms (ships equipped for deepwater construction work) at a steep markup. They are regularly required to report to federal regulators when they encounter wrecks discovered accidentally in the course of their operations, bu instead of building a little plan to make money on the "treasure" they intentionally pursue the sure money: the services revenues and their associated early-completion bonuses.

Volatility certainly makes OMEX a potentially interesting trading target, but The Jaded Consumer doesn't pretend to have a secret to timing buys or sells to outsmart everyone else who buys and sells. The only question I pose is whether over the long run OMEX is a suitable investment. One can certainly argue that all it takes is one home run to profit, but think about how often the math changes on what constitutes a suitable profit – every time OMEX issues new shares, the size of the "win" required to make good increases. By comparison, the same types of tools and expertise boasted by OMEX is being sharpened to a razor's edge every working day at Subsea 7 and Oceaneering (and probably Fugro and many others not included due to lack of familiarity). These are the guys who rescue ROVs that other operators lose or entangle in obstacles. These are the guys with the skills to draw the huge fees Shell and ExxonMobil pay to make their deepwater aspirations come to life.

Unlike OMEX, Subsea 7 and Oceaneering are finding treasure their customers and investors can keep. OMEX is likely over the long run to experience a hit-and-miss string of projects with potentially difficult legal environments. Imagine the multibillion-dollar San Jose, sitting in the waters of Columbia, with every treasure hunter in the world salivating over it, and the navies of Spain and Columbia both poised to sieze anything found, and personal liability overhanging any treasure hunter who enters a jurisdiction with a treaty with Spain. Then consider Subsea 7, and every deepwater installation Shell needs in Brazil, and every post-storm repair required by ExxonMobil on the underwater portion of its drilling platforms across the Gulf. How many successes must OMEX win in order to put investors where they expected to be? How many months do you think can pass without Oceaneering or Subsea 7 billing millions of dollars for deepwater services?

In the near term, I view the long/short picture painted in the Seeking Alpha article as being subject primarily to media risk. The good news is that OMEX has been in the news so many times to such little effect that at the first hint of something that might pan out, risk-averse investors have an opportunity to bail before confirmation of a real find drives OMEX anywhere it hasn't been.


Jaded Consumer said...

For those of us who are keen on the excitement of the conflict over the disputed cargo lost from the Mercedes, the losing appellate brief filed by two of the individual cargo claimants is a good read, short, and persuasive of the arguments in favor of OMEX' claims. It is here. Unfortunately, it was the losing brief.

Anonymous said...

You might consider writing a book on the history of this company, if you haven't.
The story of the Black Swan recovery alone, especially the spiriting away of 1/2 $B in silver coins and artifacts into 747's in the dead of night, makes for fascinating reading.
Today I read Odyssey has agreed to comply with a court order to return the treasure to Spain...would make a great ending for a movie.
Maybe there are other books out, or in the making, haven't checked.

Jaded Consumer said...

The people in the best position to write an accurate version of the story are still working for OMEX. Given the difficulties apparently attendant in cracking the book market, I think I will probably leave that project to others.

Their effort to sneak the stuff away from Spain's grasp definitely helps explain some of the depth of the hostility between the parties. Is OMEX really going to be able to deal with governments skeptical of contracting with private salvors after its behavior toward Spain?