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For ION the valuation is tricky and not nearly as straightforward as running a DCF for a typical company. Due to its cyclical nature and the fact that the company really plays on the periphery of the oil and gas services industry I think about this a bit different. Let's walk through how I'm thinking about the company.

1) While this company may have a great future long-term what I was really looking for was a company a bit under the radar that is levered to exploration spending coming back online. My latest pick Schlumberger makes a solid play on the cycle and also a good long-term play as the top dog in the industry. ION, on the other hand, is a very small seismic player which will need support from its new friends in China to maximize its cash flow potential. I don't necessarily feel the same way about Schlumberger and ION although I will keep an open mind as time goes by. ION is rather a good play for the upcoming cycle and most likely a sell in my eyes at some point in the cycle.

2) Instead of using a typical DCF where assuming cash flows over long periods of time will be inherently difficult for a cyclical company that plays on the periphery of a massive industry I look more to probabilities. What is the likelihood of a spending cycle, when will it likely occur, to what extent will ION benefit, etc.

3) In terms of valuation I need to know what I'm currently paying for the company relative to its earnings power if a) I am right about the spending cycle and b) If I am wrong.

If I'm right and the cycle begins in 2011 we can expect between $0.25 and $0.45 a share in EPS in fiscal 2011. Since ION is currently at a net loss in the trailing twelve months next year's earnings will begin earnings growth. In 2012, I expect earnings in excess of $0.70 a share if all goes right. A 12 times multiple of this more "normalized" earnings level is appropriate which would put the stock at $8.40 or right around where we are at currently. If earnings in 2012 are more like $0.85 then we are looking at a $10 stock. All of this assumes that we are in the early stages of a spending cycle.

International spending typically lags when it comes to an exploration spending cycle and since China now plays a pretty big role in ION's business I am not holding my breath with these estimates, rather they serve as a framework for my expectations. The big piece is whether spending on exploration and seismic services begins this year which should give a big boost to seismic companies and start to help us form our future expectations in terms of earnings.

If I'm wrong about the spending cycle or we encounter a double dip recession then the stock could fall substantially from its $8+ level. Substantially meaning below $5 a share. From here investors will need to determine whether to buy some more, hold, or sell. The good thing about spending on services in the oil & gas space is that spending will come back so investors should have confidence holding the stock if nothing company specific has changed for the worse.

Now back to the scenario in which we are right and the stock earns say $0.70 in 2012. This is where it gets interesting and we will need to make assumptions about the duration of the spending cycle (if it's say a 5 year cycle we can expect some serious earnings growth from the $0.70 level). We will also need to access the risk of a recession that could could cut the spending cycle short and depress the stock price. The market will be making its own assumptions that could have the stock as high as $12 a share depending on the outlook come 2012. There will be some assumptions that will need to be made, but first things first we need spending to pick up!

Hopefully this sheds some light on what i think ION is capable of in terms of earnings power and how I think about its valuation.

Fool On!

Bryan (TMFCaccamise)
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