For anyone investing in the energy space - or considering an investment - I consider Core Laboratories (NYSE:CLB) quarterly conference call an essential piece of due diligence. As a technology based oil service company, it is often a leading indicator as to where production is headed, and the most recent quarter was no exception.
Based on a new paradigm of oil production and price landscape that is starting to become clear, I believe that a divergence between the oil service companies and the price of oil will lead to outperformance in specific sub-sectors. This article will detail my rationale as to why Core Labs is a terrific way to play a rebound in the oil market, regardless of how much oil prices rise.
Source: Core Labs
Oil Production Heading For a Drop
Core Lab management provided some very important insight into the current oil glut and when it sees supply and demand balancing. On one hand, the company moved back the goal posts by delaying its expectation of a V shaped recovery until the 2H 2016, as opposed to the late 2015/early 2016 timeframe originally expected. But the company did state their miscalculation of the supply dynamics was due to an unexpected increase of 250k bpd from the deepwater Gulf of Mexico, which was the result of investments that began many years ago.
To counter that supply, however, Core Labs now expects a higher US decline curve of 7.8%, which could possibly reach 10% as the year progresses and new investments are lacking. Additionally, the company now expects the global decline curve to rise 60 basis points to 3.1%, which coupled with growing worldwide oil demand, will put the worldwide oil markets in a production shortfall by the end of the year.
Therefore, after a soft start to 2016 activity, the second half of the year should see significant recovery in both oil price and rig activity. Interestingly, the company sees this happening even if there is not a significant recover in oil prices, likely signaling that the majors have their eye on the long term prize. In response to a question about whether the 2H 2016 recovery will be based on oil prices rising or deferred projects being re-instated, management noted:
Yeah, a little bit of both… So I would say we would weight more towards the natural balancing of the markets in pricing. And we do have some large clients that are looking to commence some development projects during the second half of 2016. So it's a blending of both. I would weight it 60% to price stability and increasing, and 40% from client input that those projects will take place.
Oil Price Set To Rise?
I'll be the first to admit that I have no idea what the "fair" price for a barrel of oil is, particularly in a scenario where the supply and demand is balanced. I'm fairly certain that it is no longer the $80-100 price that a barrel fetched prior to the downturn, mainly because of improved technology and lower rig/service costs. But I also believe it's well north of current prices around $30 per barrel.
To demonstrate this, look no further than some of the commentary Core Lab management made during the conference call. The company stated that its completion diagnostics helped an operator prove the value of a multi-zone completion that cut rig time to 18-20 hours per zone. This allows each zone to be completed much quicker (although the exact time savings is hard to determine without more detail), which allows better rig productivity, lower costs per well, and quicker cash flow.
Additionally, Core Lab noted that its proprietary PERFRAC-HERO charges allowed significantly lower pumping pressures, which can reduce the required horsepower up to 30%. In this case, reduced horsepower means lower pumping costs, and once again, lower completion costs. With its HERO-HR charges and guns growing 33% yoy, Core Labs is poised to grow market share as customers continue to adopt advanced technology to counter low oil prices.
This means that the operator is happy as its production goes up (or remains stable depending on the individual well dynamics) and costs go down. Ultimately, the operator can decrease its LOE per barrel, which could make the difference as to whether a leveraged operator can survive the current downturn. This is why Core Labs describes its primary services as "mission critical" to its clients and why it can weather a downturn much better than its more commoditized service peers (and deserves a premium valuation - more on this later).
As far as Core Labs is concerned, this increased productivity actually means that it will be able to sell more products and services in a shorter time frame, which allows it to meaningfully outperform the rig count. And as completion technologies, ultimate recoveries, and rig productivity all continue to improve, lower E&P costs will ultimately re-define a "new normal" oil price in a balanced market.
Given that new technology is at the heart of this "new normal", operators will be forced to continue the adoption of more advanced technology in order to survive, which will only place more demand for Core Labs services and products.
While Core Labs is certainly not the only oil service company providing advanced completion and reservoir description technologies, I believe that the market will start re-pricing the more commoditized companies. This means investors must perform the necessary due diligence before investing in the oil services sector, whether it's Schlumberger (NYSE:SLB), Baker Hughes (NYSE:BHI), Halliburton (NYSE:HAL), or the Market Vectors Oil Services ETF (NYSEARCA:OIH).
Well Positioned For Recovery
I continue to believe that Core Labs is one of the best positioned companies in the sector. Management is able to quickly right-size its operation based on industry activity, and has maintained impressive margins and free cash flow (NYSE:FCF) despite the difficult backdrop. For FY 2015, the company was able to convert 24% of its revenue into FCF, which is a tribute to the advanced - and unmatched in some cases - technology. Management really honed in on this aspect during the conference call, when it stated that it had no need to make an acquisition to capitalize on a recovery:
…One thing about down cycles is better valuations do not make bad companies into good companies. So, our perspective is we haven't seen good companies to acquire that fit our three segments… So we don't see acquisitions really adding to this at this moment.
This type of confidence certainly makes one feel better about an investment in Core Labs, as management places great emphasis on efficiently allocating capital, rather than just a pure top-line focus. And given that the company has been able to remain solidly profitable while others within the industry are struggling to break even, Core Labs appears to be a great way to play a rebound in the oil markets, without taking on the pricing and production risks of the individual E&P names.
When considering how to value Core Labs, it's important to consider that its superior technology and skilled workforce will generate significant cash flow despite the dramatic industry downturn. Therefore, I believe that Core Labs should trade at a premium to its peers, with maybe the exception of Schlumberger - although Schlumberger's mega cap status probably deserves a lower multiple due to the law of large numbers.
Given that Core Labs primarily provides services and products for oil production, as opposed to exploration, the company is able to outperform the rig count by a pretty substantial margin. For instance, in FY 2015 Core's revenue was down 23%, whereas the rig count dropped by almost 35%. And as the rig count starts to improve (it will eventually happen), this impact will work the opposite direction by providing nice incremental margins as well.
So if we assume that there is a sustained 10% rise in the rig count as the year progresses, I think it's a distinct possibility that Core's FCF could expand by 20% or more. I could even argue that as the oil markets start to balance and eventually turn to a deficit by the end of the year - as projected by the company - that operators would increasingly focus on maximizing production and ultimate recoveries on existing fields to ease their cash flow pressures. This could re-inflate service costs and really boost margins. And since production enhancement and maximizing ultimate recoveries (enhanced oil recovery, re-fracs, flow profiling, etc) is Core Labs specialty, a rising oil price could give the stock a moonshot.
To determine a valuation that I find attractive, I'm going to consider three scenarios. The first scenario is that oil production stays stubbornly high, which keeps a lid on oil price and rig activity at its current level. For this scenario I'm going to assume that Core's results for the rest of the year will mimic the guidance given for the first quarter.
This means that FY 2016 revenue would come in at $650 million and that 24% of that revenue will continue to convert into FCF. This equates to $156 million of FCF, and using a multiple of 25xFCF that it averaged over the past few years, equates to an Enterprise Value (NYSE:EV) of $3.9 Billion. With a current EV of ~$4.7 Billion, this implies that the stock is currently 17% overvalued.
The second valuation scenario assumes that the market is anticipating an average 10% gain in rig count over the course of the year, with Core's FCF growing by 20% over Q1 guidance. This implies $187 million in FCF, and once again using the 25x multiple, brings the implied EV to $4.7 Billion. Under this scenario the stock would be trading right at fair value.
The third scenario is if investor sentiment starts to turn more favorably for the industry with specific sub-sectors out performing, with the technology based service providers particularly in favor. Additionally, higher decline rates and lack of recent investment will eventually cause oil supply to tighten more than expected, which leads to a rush of new investment. In this scenario I would expect valuation multiples to rise, possibly as high as 30-35x forward FCF, as seen in previous cycle troughs. Using the 10% rig count gain and 30x FCF multiple, fair value for CLB would be at an EV of $5.61 Billion, or almost 20% higher.
Other than the obvious risk of oil prices and rig activity declining further, there are 2 major risks that investors should be watching. The first risk is that Core Labs is unable to maintain its technological lead and its services could become more commoditized. The market would likely assign a lower valuation multiple, and when combined with lower revenue and margins, would send the stock plummeting. Given the company's patented technology and history of innovation, I don't see this risk materializing anytime soon, but should certainly be on the radar.
The second risk is cash collection from customers. The longer oil prices stay in the doldrums, the greater the risk of E&P bankruptcies and difficulty collecting payment. Much to my surprise, this has yet to be an issue.
As of the end of 2015, receivables stood at $145.7 million, which was actually down $7 million QoQ and down 26% YoY - which aligns well with revenue being down 23% YoY. Maybe Core's services are considered too mission critical to its customers and it won't have a problem with cash collection in the future, but DSO has trended up from 65 days in 2014, to 66 days in 2015, and 68 days in Q4 2015. Or maybe this problem will start to appear in Q1 2016 as operator hedges start rolling off, cash balances dry up, and bankruptcies start accelerating. Either way, it bears watching and consideration.
I believe that Core Labs is extremely well positioned to weather the storm in oil prices and rig activity, but even better positioned to capture meaningful gains in any type of recovery. While the stock is certainly not cheap or trading at a depressed valuation, investors should expect to pay for quality. I'm going to continue watching for signs of a bottom in the oil markets, with Core Labs being my favorite risk adjusted play for a recovery.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CLB over the next 72 hours.
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.