FINANCIAL STATEMENT ANALYSIS

2012 13, Term VI CA K.P.Rajendran kprajen@gmail.com

Seitel Inc.

Case Analysis

Seitel Inc.
Seitel, Inc., is a leading diversified energy company providing seismic data and related geophysical technology used in oil and gas exploration and production.

Seitel Inc.
The Company sells its proprietary information technology to oil and gas companies and has developed an evolving crude oil and natural gas exploration and production company.

Seitel Inc.
Since its inception, the Company has been engaged in the development of a proprietary library of seismic data, created by both the Company and others.

Seitel Inc.
Seismic surveys and the analysis of seismic data for the identification and definition of underground geological structures are principle techniques used in oil and gas exploration and development to determine the existence and location of subsurface hydrocarbons.

Seitel Inc.
The Companys U.S. seismic surveys extend to virtually every major domestic exploration and development region, with the majority of seismic surveys covering onshore and offshore the U.S. Gulf Coast.

Seitel Inc.
In addition, the Companys international seismic surveys are concentrated in Western Canada and the Continental Shelf offshore the United Kingdom and Ireland.

Seitel Inc.
The seismic data library, which consists of both two-dimensional (2D) and the more modern threedimensional (3D) data, is marketed to major and independent oil and gas companies under license agreements.

Seitel Inc.
The case deals with accounting for a nontraditional inventory (i.e. not hard goods)

Seitel Inc.
The case also provides an insight into the accounting for inventory-like investment by explaining the the concept of inventory in the information age.

Seitel Inc.
The case also focuses on the following specific issues:
The Financing strategy of the company The classification of and accounting for its seismic data bank The companys seismic revenue recognition practices

Seitel Inc.
Measurement of the cash flow from operations. Accounting for drilling activities and Quality of earnings of the company.

Seitel Inc.
Question 1

What were Seitel, Inc.s seismic data businesss operating and financing strategy?

Seitel Inc.- Operating Strategy

Seitels seismic data business strategy is to acquire and provide proprietary seismic data to the oil and gas industry through the sale of primarily client financed non exclusive multi-client seismic surveys, and the resale over and over again of those compiled surveys from its data library.

Seitel Inc.- Operating Strategy

The company also purchases seismic data for its data library from other companies.

Seitel Inc.- Operating Strategy

For the success of this strategy, It is important that the data library is the type of data people want in the location that they required it, and in the locations that are active.

Seitel Inc.- Operating Strategy

This turnover of leases creates growth in Seitels revenue, earnings, and earnings per share.

Seitel Inc.- Financing Strategy

The Company finances its expanding data library through borrowings, resale of data and presold multi-client surveys. The Company does not have major investments in land or marine seismic acquisition crews.

Seitel Inc.- Risk Factors

The companys strategy involves a high level of risk because: The industry is highly competitive Revenues depend on energy industry demand and prices Regional events may affect the companys concentrated operations (coast and offshore in the U.S. Gulf of Mexico).

Seitel Inc. Risk Factors

Technological changes can render old data less useful Existing data is of less interest to oil and gas companies over time.

Seitel Inc. Operating and Financing Strategy

It is in large measure managements faith in this strategy that supports its capitalization of data acquisition costs, data library amortization policy and investment plan.

Seitel Inc. Operating and Financing Strategy

That is, the ability to resell data over and over again justifies a long amortization period and high up front investments in building an expanding data library.

Seitel Inc. Operating and Financing Strategy

The nature of the industry and, in particular, its business risks should raise questions about the reasonableness of the companys longer and slower than industry practice amortization.

Seitel Inc.
Question 2
Would you recommend to Seitel, Inc. that it change its seismic data library amortization policy? What policy would you recommend? What would be the approximate impact on the companys net income?

Seitel Inc.- Accounting Policy

The companys seismic library accounting policy states that: Costs incurred in the creation of the Company's proprietary seismic data, including the direct and incremental costs of Company personnel engaged in project management and design, are capitalized.

Seitel Inc.- Accounting Policy

Substantially all the costs incurred to develop the Company's seismic library have been for programs created by the Company.

Seitel Inc.- Accounting Policy

The Company uses the incomeforecast method to amortize the costs of seismic data programs it creates. Under the income-forecast method, seismic data costs are amortized in the proportion that revenue for a period relates to management's estimate of ultimate revenues.

Seitel Inc.- Accounting Policy

Since inception, management has established guidelines regarding its annual charge for amortization. Under these guidelines, seismic data created by the Company is amortized in a set period of time based on historical experience with both the timing and amount of revenue.

Seitel Inc.- Accounting Policy

Management estimates that 90% of the costs incurred in the creation of seismic data is amortized within five years of such data becoming available for resale for two-dimensional seismic data and within seven years of such data becoming available for resale for three-dimensional seismic data.

Seitel Inc.- Accounting Policy

If anticipated sales fall below the benchmark guidelines, amortization is accelerated. Depending on actual sales performance, the costs of the Company's seismic data are fully amortized within 20 years or less.

Seitel Inc.- Accounting Policy

The Company also purchases existing seismic data programs from other companies. The costs of purchased seismic data programs are generally amortized on a straight-line basis over ten years.

Seitel Inc.- Accounting Policy

However, the costs of a significant purchase (greater than 5% of the net book value of the seismic library), are amortized using the greater of the income forecast method or ten-year straight-line method.

Seitel Inc.- Accounting Policy

Under these amortization policies, the Company would expect the percentage of net seismic library as of December 31, 1998 to be amortized to be 13%, 15%, 16%, 14%, 12%, and 30% for the years ending December 31, 1999, 2000, 2001, 2002, 2003 and all periods thereafter, respectively.

Seitel Inc.- Accounting Policy

On a periodic basis, the carrying value of seismic data is compared to its estimated future revenue and, if appropriate; is reduced to its estimated net realizable value.

Seitel Inc.
There should be no issue with the Company capitalizing its data library costs and choice of the incomeforecast method to amortize the bulk of these costs.

Seitel Inc.- Data Amortization Policy

The issue to focus on is the data library amortization schedule, particularly since it appears the amortization rate appears to have been reduced during the early amortization period in 1998 (Refer Table 1 of case).

Seitel Inc.- Data Amortization Policy

The following points regarding data library amortization should be noted:

Seitel Inc.- Data Amortization Policy

1. Industry practice is to use much shorter amortization periods with higher accelerated early year writeoffs. (Petroleum Gas Svs uses a maximum three years write-off of its 3-D data while Grant Geophysical, Solid State Geophysical and Veritas use a maximum four-year write-off period for their 3-D data)

Seitel Inc.- Data Amortization Policy

2. The 1998 amortization schedule in Table 1 is essentially a straight-line amortization rate which does not reflect the industry experience that seismic datas useful life and greater revenue generation potential is highest in its early years.

Seitel Inc.- Data Amortization Policy

3. The amortization schedule reflects managements estimate of total revenue, which leaves too much room for judgment that the Companys incentive program may bias toward overvaluation of the data library.

Seitel Inc.- Data Amortization Policy

4. The uncertain nature of the drilling industry and rapid seismic technology advances suggest that conservative amortization schedules should be employed.

Seitel Inc.- Data Amortization Policy

5. The size of the net data bank carrying amount ($303 million) relative to the Companys net worth ($232 million) suggests prudent accounting might be advisable, since a major correction to the assets carrying amount would have a significant negative impact on the Companys book value.

Seitel Inc.- Data Amortization Policy

6. In the case of many purchased data libraries, the straight-line amortization schedule can lead to a mismatch of actual revenues (the bulk of which come in the early years of the amortization schedule) and the related investment costs (which are spread out over periods that could be as long as 10 years).

Seitel Inc.- Data Amortization Policy

7. The Company invests more and more each year to acquire data for its library relative to current revenues (in 1999 Q1 it spent more on data acquisition than revenues), which suggests it may not have sufficient revenue experience from its new investments to generate reliable amortization schedules.

Seitel Inc.- Data Amortization Policy

While competitors use much shorter amortization periods with higher accelerated early year write-offs, companys answer to its critics is:
Relative to its competitors the Companys data is better (partly because it does not have to conduct speculative surveys to keep survey staffs busy).

Seitel Inc.- Data Amortization Policy

The Companys sales force is better than its competitors at generating revenues from databases.

Seitel Inc.- Data Amortization Policy

Do you find these reasons convincing?

Seitel Inc.- Data Amortization Policy

If one concludes the companys amortization schedule may unreasonably back-end load the schedule, then it follows that the carrying amount of the companys data bank is overstated and should be written down to its fair value.

Seitel Inc.- Data Amortization Policy

A shorter and more accelerated amortization schedule will also improve the quality of earnings as follows:
Even though the earnings may be lower, the price-earnings ratio might be higher if the potentially adverse accounting issue was no longer a negative valuation factor.

Seitel Inc.- Data Amortization Policy

The probability of future significant data library impairment write-downs would decrease. Managements credibility on other potentially contentious issues, such as revenue recognition, might be enhanced.

Seitel Inc.
Question 3
If Ms. Lee treats Seitel, Inc.s seismic data library as inventory, what were the potential financial statement, financial ratio, and stock price ramifications of this treatment?

Seitel Inc.
The principal financial statements impact of classifying data library investments as inventory would be to include these expenditures as operating activities in the Companys statement of cash flows.

Seitel Inc.
This reclassification would highlight the fact that on a cash basis the Company has failed to earn a spread between its selling price and cost of sales since 1996. For example, the companys net cash provided from investing activities was:

Seitel Inc.
Year Cash flow from Operations ($ millions)
67.3 76.2 97.5 29.0

Data Library Investment ($ millions)

49.7 76.6 119.3 62.6

Net ($ millions)

1996 1997 1998 1991 (Q1)

17.6 (0.4) (21.8) (33.6)

Seitel Inc.
The accelerating data library investments in excess of revenues might be troublesome for investors, particularly when it is coupled with a slowdown in the first five years amortization charges.

Seitel Inc.
Question 4
Should Seitel, Inc.s seismic data library be accounted for as an inventory-like asset?

Seitel Inc.

In other words, Should Seitel, Inc.s seismic data library be accounted for as an inventory-like asset and treated as operating activity for statement of cash flow purposes?

Seitel Inc.
The term Inventory means any asset:
held for sale in the ordinary course of business (Finished Stock); in the process of production for such sale (Work-in-progress); or in the form of materials or supplies to be consumed in the production process or in the rendering of services (Raw material stock).

Seitel Inc.
The term Property, plant and equipment means assets that:
are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes; and are expected to be used during more than one period.

Seitel Inc.
It can be argued that data library expenditures are inventory-like, but not inventory in the usual sense. It can go stale and is a product that is sold in the normal course of business. On the other hand, unlike most inventory items it can be resold again and again.

Seitel Inc.
It can also be argued that the data library is more like a production equipment because it has a limited life, can be used over and over again to produce revenue, and its utility declines with use and age.

Seitel Inc.
It can also be concluded that the data library is a knowledge asset and as such is similar to an intangible asset with a limited life.

Seitel Inc.
If data library is considered to be an Inventory like asset it should be classified as an operating activity, whereas if it is like production equipment or intangible asset it should be classified as an investing activity.

Seitel Inc.
Clearly, the classification decision has consequences for the measurement of cash generated by operating activities.

Seitel Inc.
The Companys balance sheet does not report current assets or liabilities (an unclassified balance sheet) because management considers the Companys operating cycle to extend well beyond 12 months.

Seitel Inc.
This is consistent with the view that the data librarys useful life is very long. Consequently, the data library is reported on the Companys unclassified balance sheet in the same place as it would on a classified balance sheet (after accounts receivable), but there is no current asset subtotal.

Seitel Inc.
Question 5 As a potential investor in Seital, Inc. common stock, what primary operating performance figures (i,.e., net income or EBITDA) would you use to judge managements performance and for Seitel, Inc., stock valuation purpose?

Seitel Inc.
Reported net income is probably a poor indicator of management performance. It would be preferred to use an adjusted earnings figure based on a faster amortization schedule.

Seitel Inc.
Cash flow-type performance measurement, such as EBITDA, are not preferred because they ignore the responsibility of management to recover its data library investment before it can claim to have earaned a return on that investment.

Seitel Inc.
For investment valuation purpose, again, an earnings figure adjusted for a shorter amortization schedule would be preferred. Such a figure would be more useful for investors using a comparable valuation methodology, which uses the valuation of comparable companies to determine the value of the subject company.

Seitel Inc.
Question 6
What are the factors that should be considered in order to determine the quality of earnings of the company?

Seitel Inc.
Apart from the inventory and amortization issues considered in question number 2, the following issues should also be considered to assess the quality of earnings of the company:

Seitel Inc.
The company may be recoding revenues prematurely. It records all of the revenue upfront when the customer signs a contract to review data, not when the customer later signs the supplemental contract giving the customer from its point of view the right to exploit the data.

Seitel Inc.
Valuation of the barter transactions may introduce upward bias into the measurement of revenues. The company is a net user of cash (negative cash flow from operations and investing activities).