Drilling Into Core Labs
Board: Value Hounds
[See Post for Tables]
Sometimes you think you understand a company and appreciate its business model only to go back a few years later and find the analysis got buried in details and was completely useless.
I did that with Core Labs and failed to buy because I missed the point. Hope to get it better this time through. Still not a buyer, but at least I know why.
Core Labs is in the oil services sector. Core has a moat of sorts at least for now. The moat is the highly technical high margin reservoir analysis they go after and their workforce of 1300 scientists that tend to stay with the company –turnover of 2%.
They have some competition in certain areas of the business. In products, Schlumberger sells instruments that directly compete. But in providing comprehensive high quality core sampling, well diagnostics and project planning, there is little direct competition.
CLB enhances and manages oil and gas reservoirs. The company can tell a client about the three fluids in a reservoir (oil, gas, water) and about the characteristics of the rock and whether it will let the fluids flow. This business falls under reservoir description and part of the service is analysis of core samples; where they get their name. Some of the business is done out of the field and at refineries providing analysis of octane in gasoline and blended gas.
Production enhancement includes perforating products that explode downhole and fracture rock to let fluids flow. Core also designs completions of wells to ensure maximum recovery of fluids. They are good at fracture design and procedure, production flow and allocation and cementing and casing depth control.
Reservoir management integrates the information from the other two segments and designs game plans to maximize production.
Case study from the Q3 CC
A client was trying a certain type of completion technology and needed details on how the fracturing was most efficiently and economically produced over the length of the well:
Rob MacKenzie - FBR Capital Markets
So effectively, as the clients – as operators try these more, they spend the money and time on analyzing it so it’s a net positive for you guys?
That is correct. We’ve got a good example in the Granite Wash, where it was a 21-stage completion. They used the sliding sleeve technology. And after they completed their stimulation, the well flowed exactly what they thought it would flow, so they thought they had a very successful completion and stimulation of all 21 stages. What our tracers did show that the first nine stages did not take any stimulant and all the production was essentially from the last 12 stages. So that client, in the next drilling operation, used plug and perf, and made their best well that they ever have.
So it’s on a case-by-case basis, Rob, but it is providing additional fracture diagnostics services to the company.
The company is always looking for new technology. CLB is now in the process of developing reservoir saturation technology that identifies reservoirs that absorb water allowing production of more hydrocarbons This came out of observations while working with Petrohawk. The higher flow rates for wells were creating less permeable rock. Ultimately they found by slowing and even choking the wells led to higher total recovery. Those observations will be turned into advanced capabilities to look at the porosity of a well and its relationship to flow.
Key tenets of Core’s business philosophy
High returns on capital
First and foremost they will not take on business that is low margin and doesn’t meet their threshold return on investment. When they design their business segments and take jobs, it’s always the high return work they are looking for. For that reason they have refused to do on well-site analysis of samples like mud logging. Mud logging is a relatively low margin analysis of sediment and rock that is recovered as the well is drilled. Their business in core sampling, especially in deepwater reservoirs, is much higher margin with less competition. The reservoirs are difficult and complex and require certain expertise.
Are other individuals and companies doing lower-tech, lower-margin projects? For sure, no question about that. But the market that we address, we have not seen any serious competition enter, nor do we think we will see any serious competition enter in the near future.
Returns to shareholders
In addition to maximizing returns on invested capital, the company is dedicated to returning value to shareholders. CLB has been buying back shares and paying a small dividend. There were 53.8 million shares (adjusted for split in 2010) in 2006 and that was whittled down to 47.5 million shares in Q3 2012. Options abuse is non-existent. However, the company issues a large number of restricted shares. In 2011, 177,255 restricted shares vested compared to just 42,000 options. The options are performance-based compensation for management and restricted shares are given to employees to help retain them. The overall employee turnover rate is 6% and turnover for the scientists is only 2%.
Repurchases have been less effective over 2010-2011. Dilution in 2010 was due to settling 2006 warrants adding 706,395 shares in addition to restricted shares. Stock buyback slowed in 2011 to only 10,000 shares and $1 million spent at $110 per share.
For the past three years, share repurchases totaled 1.2 million shares vs. 116,000 in options exercised. Total paid was $125 million. In 2012, share counts are down to 47.5 million and the repurchase strategy has been more effective.
Core Labs also pays a dividend that has been increasing for three years. The yield is 1.1% and the payout ratio is only 25%. I would expect per management comments a series of dividend increases going forward.
Free cash flow
Free cash flow is the third key business principle guiding Core Labs. They are careful with capital spending and demand high returns. They will not spend unless the returns meet their threshold at around 30% to 40%. That goes for both capital expenditures and acquisitions. In the first nine months of 2012, $1 out of every $6 in revenue was converted to free cash flow. Around 2/3 of capital spending goes for growth and the rest is maintenance.
While ROIC is high, free cash flow yield is low at 3.3% compared to leaders in other sectors, but holds its own against two big companies in oil services -- Halliburton is in negative numbers for free cash flow and SLB has a free cash flow yield of 4.4%.
From the Q3 CC:
Based on the most recent calculations available from Bloomberg, Core’s return on invested capital was the highest of any company in the oil field services comp group listed by Bloomberg Financial. And also, Core’s weighted average cost of capital was the lowest.
The weight average cost of capital is 8.8% and the spread between WACC and ROIC is widely positive.
Capital spending is two-thirds growth and their careful approach to spending has not sacrificed growth or margins. The company’s policy to stay away from low margin work and stick to their high margin circle of competence has kept margins remarkably stable and growth high.
Business has been slowing in 2012 and September 2012 growth is considerably less than September 2011.
Q3 2012 proforma operating growth 6.1%
Q3 2012 proforma net growth 11.6%
The natural gas business continues to disappear and CLB has been pursuing oil related business. They expect gas rig activity will continue to wane into the fourth quarter. Core’s revenue mix is closer to 80% oil and 20% natural gas, a shift from the previous 70%-30% earlier this year and in past years.
In 2012 worldwide activity in oil and gas was essentially flat. Despite decreasing rig counts and the transition to oil from gas, Core managed revenue growth. In 2009, even they could not pull off positive earnings growth and if we head down that path again and see global recessions, 2013 will look a lot worse than just the slower Q3 2012. Core expects growth to continue into 2013.
Q3 combined revenue increased 6.1% year over year. Business is seasonal and year-over-year is the only way comps make sense. The reservoir description segment with exposure to Canadian oil sands revenue comes in primarily in Q2. Reservoir description revenue increased 4% in Q3 2012 and 13% in Q3 2011. It’s clear that 2012 growth is beginning to lag 2011 and 2013 could be even slower.
Production enhancement with only 4% growth is still mainly dependent on North American well completion and stimulation. The decrease in rig counts has slowed growth.
The slowing revenue growth is seen across the two largest business (description and production) segments and in consolidated revenue growth.
The other way to divide the company is into services provided and products sold. Services revenue was $174.5 million -- up 9% and product sales for the quarter were at $71 million and essentially flat year-over-year.
The hot spots for business
Core is predicting future growth will be deep sea and that includes Brazil, Mexico and the Gulf of Mexico. The coast of Africa is developing rapidly. Shale and fracking in both oil and gas is important and they do offer reservoir description and management techniques that improve production significantly from these sometimes difficult wells.
A few recent projects
The company is analyzing core from a deepwater well in Namibia for Petrobras. Petrobras continues to be Core’s largest national oil company client worldwide.
The first shale Core cut in Australia is being analyzed in the field for gas absorption with full laboratory analysis of the rock to follow in Q4. Core was recently requested by a major client to increase technical capability and processing capacity in Australia for several large potential shale developments.
Core Lab Malaysia is working on core and geological samples from a high pressure, high temperature deepwater well in the Malay basin. Asia Pacific continues to be a revenue growth region for the company.
Business in deepwater has been so brisk the company is expanding facilities in Houston. To meet the increasing workload from primarily deepwater Gulf of Mexico and international deepwater environments, they added 105,000 square feet, increasing core viewing and layout rooms by 13 new rooms.
Around 30% of all oil is produced offshore and 40% of Core’s revenue is from offshore. As new-build deepwater rigs start to come into the field over the next few years, they will see increases in revenue and that the 40% of revenue from deepwater will trend higher.
The converse also hold true. As rig and drill ship activity drop, so does their revenue. That was partially the reason for the revised guidance. Idling 100 rigs in horizontal drilling will decrease EPS by as much as 10¢. They are vulnerable to recession-based decreases in demand and activity.
Guidance from Q2 for Q3 2012
(Q3 results in parentheses)
Part of the recent share price decline is due to the miss in Q3. Q2 2012 guidance was for revenue of $250-$260 million ($245 million); EPS between $1.17-$1.25 ($1.13); revenue growth 10% (6.1%). The stock dropped nearly 20% the first week of October when it revised guidance and warned of decreasing rig utilization.
Guidance for Q4 2012 and comments on 2013
They anticipate that North America activity levels will remain similar to third quarter levels while international activity will continue with moderate increases. Roughly half of their revenue is international. Fourth quarter 2012 revenue is expected to range between $245 million and $250 million, with EPS in the $1.10 to $1.17 range.
The outlook for 2013 remains positive. With the continued support from Brent crude pricing and the expected delivery of additional deepwater drilling rigs, Core expects to continue to work to increase in established fields and new field development projects will be additive.
Core almost always trades at a premium to other companies in oil services. Measuring by PE, it has traded as high as 36 down to a low of 22 today over 5 years. In comparison SLB traded between 22-16 and HAL was between 13-8. Looking at cash flow yield, Core seems less pricey. HAL is free cash flow negative and can’t be calculated and SLB is 4.4%.
What the market is pricing in
For Core this is particularly useful since it always trades at a premium to other oil services companies. At $100 per share the market is looking for 10-year growth at a shade over 14% per year and 1% terminal growth. The 14% growth is close to the average over the past 8 year. The range is –10% (2009 an outlier) up to 19%. The average has been 12%. Core looks fully valued at current prices but normally trades well above at a premium. If it meets or beats 2012-2013 guidance, there is no doubt the market will pay a higher premium than the current PE of 22. If we use the 5-year high of 36 the price would be $160 using the TTM EPS of $4.49. Considering its 52-week high was $143, on raised guidance and higher earnings, it’s not an unlikely scenario. Core is never cheap and it may be this is the low if they meet guidance in the 4th quarter and 2013 works out. We will know about Q4 fairly quickly; predicting recessions, fiscal cliffs and their impact on drilling activity and oil demand is far more difficult and 2013 is an unknown. There is no doubt Core will return to its premium pricing if everything works out per their guidance. There is a danger in overpaying if guidance has to be lowered again. The long-term outlook for Core is strong with deepwater and shale as focuses of production. As always it’s a question of when to get in and if we feel lucky. To improve the chances of being lucky, an investor would do well to keep track of rig counts in November and December. Idle rigs in excess of Core’s expectations will affect guidance and another missed quarter would be a buying opportunity.