Core Laboratories (CLB), a mid-cap oil servicer focused on production enhancement and research optimization, has had a tough run over the last few months. Since May, Core Labs has fallen by about 23% due to revised guidance.
Chart by Sharp Charts
Earlier this year, Core Labs revised its 2014 earnings guidance from $6.00-$6.25 per share to $5.80-$6.00 per share. Last year, Core Labs earned $5.32 per share. Effectively, Core Labs revised its midpoint growth expectation from 15% to just 11%. As you can see above, equity prices went from $190 per share down to about $165 on the revised growth announcement back in May.
But at $165 per share, Core still traded at over 30 times earnings. So, although investors were disappointed by the more modest guidance, many also seemed willing to give Core Labs a second chance.
Last week Core Labs gave its second quarter earnings results, and essentially reaffirmed that revised guidance. Shares responded by dropping another 8%. The reality seems to be finally sinking in: Growth might be slowing, thanks largely to reduced capital spending on the part of E&Ps.
Over the last few years, shares of Core Labs have been on a sustained upward trend. This recent drop represents a major sea change for the stock: Shareholders of Core Labs haven't seen this kind of downward momentum in at least a couple years. This article will examine why growth has slowed, it will look at future growth prospects, and finally, it will examine valuations.
Why earnings decelerated
Core Labs Form 10-K
As you can see above, revenue comes from three different divisions, but most comes from either Reservoir Description orProduction Enhancement. But what do those terms mean?
Core's Production Enhancement segment, these days, is primarily concerned with deepwater oil and gas operations. Recently, many newly-drilled Gulf of Mexico wells have reported ultimate recovery rates lower than the usual, expected 40%. This phenomena is not restricted to just the Gulf Of Mexico, either. Similar issues have arisen off the coast of Brazil. Core Labs' services are ideally positioned to help deepwater operators raise production curves .
Reservoir description helps E&P companies profile recently explored fields. Core's services do not involve the exploration itself, which is a higher-risk activity. These days, Reservoir Description is centered around core samplings in shale plays. As you might imagine, revenues in this segment have been propelled forward by parabolic increases in activity over the last five years in the Bakken, Eagle Ford and Niobrara shale plays.
Reservoir Description is the source of Core's earnings deceleration. As the Eagle Ford and Bakken develop and begin to mature, demand to understand geology and flow rate decreases in these shale plays.
Hoping For Resurgence
I believe that investors were hoping for a resurgence in core sampling activity this quarter. Those hopes were placed in emerging North American shale plays such as the Tuscaloosa Marine Shale and the Wolfcamp. While there has indeed been a marked increase in activity from the TMS in Louisiana, the Wolfcamp in the Permian Basin and the Codell in Colorado, this increase was not enough to offset decline in core sampling in the Eagle Ford, Bakken and Niobrara.
However, investors could later get a second wind as operators in those three maturing shale plays switch their focus from acquisition and drilling to well optimization. For example, average reservoir recovery rates in the Bakken and Eagle Ford are 8%-9%. Management believes that, with the help of some interesting new production enhancement technologies being applied to horizontal plays, ultimate recovery rates can be bumped up to 11% or so.
Many of these promising enhanced oil recovery techniques have their inspiration in enhanced oil recovery in vertical drilling plays. For example, a number of operators have expressed interest in CO2-injection into horizontal wells. While that project is currently very small, if the economics work, we could be seeing much more CO2 flooding in both the Bakken and the Eagle Ford.
In addition to this, Core is also looking at light hydrocarbon gas flooding. For example, using methane or butane to help push out the oil is something that could work well in areas that are already flaring off significant amounts of gas. The Bakken is the first shale play that comes to mind here.
Above, FAST Graphs shows us the strong relationship between growth, momentum and valuation within shares of Core Labs. Here, the 15-year average P/E ratio is represented by the dark blue line. The stock price is the solid black line.
Since 2008, Core Labs has almost always been trading at well above its average P/E ratio, which signifies that the stock is really caught in a bullish trend. As long as expectations continued to rise, so too did valuations. At one point this year, the P/E ratio surpassed 37 times.
However, once management bowed to the new reality of flattening E&P spending, and readjusted growth estimates accordingly, the stock came crashing back down to earth. And at nearly 27 times earnings, Core Labs could still have a ways to go.
With an expected growth rate of just eleven percent; Core would sit at $130 per share and still have a reasonable PEG (Price to earnings/growth) ratio of two times. At $130, the corresponding P/E would be 22 times. That means a potential downside of another 13%. Caution is warranted here, not because Core is a poorly-run company (it isn't), but because the valuations just got too high on exuberant expectations.
If you are interested in jumping into this excellent company right now, beware of the additional downside if things do not improve next quarter: There could be a ways to go before the stock fully reflects reduced growth expectations.
Core Labs is an excellent company. It consistently has the highest return on investment capital metrics within the oil services industry. The company's dividend, while not yielding too much here, is growing by strong double-digits each year, and has lots of room to run. This quarter Core Labs converted a remarkable 20% of its revenue dollars into free cash flow.
However, those invested in Core Labs have done so for the consistent growth which the company provides. Muted growth expectations could continue to mean downside for the stock. If you want to buy right now, do so with caution and leave some dry powder in case shares drop to $130. It could happen.
Disclosure: I am long CLB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.