Core Labs: My Favorite Oil Sector Dividend Play

| About: Core Laboratories (CLB)

Summary

Core Labs is unique amongst the oil sector, delivering strong returns on invested capital and high free cash flow conversion.

Core offers the potential as a very good future dividend payer for dividend investors.

Current valuation looks reasonable given a cyclical earnings trough, and I'm happy to buy the business at these levels.

Core Labs (NYSE:CLB) isn't a business that will be familiar to most people when considering dividend payers in the oil sector. However this is a business that is well worth putting on one's watch list. The business offers a rather nice 2% dividend that has been strongly growing since it was introduced in 2008. Core Labs hasn't been immune to the general turmoil in the oil sector and the company's share price has shown annual declines since 2014. Current pricing may represent attractive entry points for long term dividend holders.

High quality business that benefits from a network effect

Core Labs is a service provider to the oil and gas sector. The company offers software solutions and analytics that allow oil and gas producers and explorers to better understand their available reservoirs and optimize extraction techniques to maximize yield.

Core Labs has been benefiting from trends that have been taking place in the oil sector in recent years. With declines in low cost, easily accessible oil fields, producers have been laser focused on increasing yields from existing reservoirs. Additionally, deep sea drilling and shale exploration have served to propel increases in the business in recent years.

Core Labs has a strong network effect that solidifies with each additional customer. Each new reservoir that Core services provides additional data that helps improve Core's reservoir and geology mapping. This in turn strengthens the quality of the data set that it is able to offer to new customers and the analytical insights that it can offer to improve reservoir utilization.

A very unique business in the oil sector

Core is unlike almost any business in the oil sector. It has much higher returns on invested capital and higher revenue to cash flow conversion. Core has had returns on invested capital at close to 50% over the last few years, and has even managed almost 30% in the midst of a terrible industry downturn in 2015. This is substantially better than other oil services companies such as Schlumberger (NYSE:SCL), which has a return on invested capital of just 4%, and more than double high quality integrated businesses such as Exxon, which have returns on invested around 15%. Such high rates of return on invested capital auger well for future earnings generation to investors. Provided Core Labs has good future growth opportunities, Core will be able to derive substantial future earnings growth.

Core has amongst the best revenue to cash flow conversion rates in the oil sector as well. The oil sector is full or explorers and refiners that are capital intensive with very modest free cash flow conversion. Exxon (NYSE:XOM) and Chevron (NYSE:CVX) are only able to convert 2-3% of revenue to free cash flow. Even Schlumberger is only able to convert 15% of revenues to free cash flow. Core consistently converts close to 25% of revenues to free cash flow.

Good dividend potential and strong prospects for capital growth

Core's high returns on invested capital and strong level of free cash generation auger well for long term dividend growth. While Core's current dividend yield is modest, Core has ample opportunity to aggressively increase the dividend yield going forward. Core's payout ratio has also been a rather modest 30% (although this has spiked in 2016 given abnormal earnings compression). With low cost easily accessible global reserves dwindling, drilling activity has been focused on more unconventional drilling such as shale exploration and deep sea drilling.

With the higher cost of such drilling activity, the need for more accurate reservoir analysis is going to become paramount, increasing the need for the types of services provided by Core Labs services. Analysts estimate that Core Labs will enjoy earnings growth at close to 20% annually over the next 5 years. This is well in excess of most businesses in the oil sector. This strong earnings growth and relatively low payout ratio offers good potential for strong dividend growth.

In addition to being a good dividend prospect, Core should also provide investors with good total return. Investors who put $10,000 into Core Labs in 1996 would have well over $390,000 today, That's annualized returns of 20% for the last 20 years. Core is set for a similar level of earnings growth for at least the next 5 years, which augers well for capital growth.

Modest risks to the business

There are risks with the Core Labs investment case. A sustained downturn in the oil price is chief among them. Lower oil prices will reduce the feasibility of new drilling activity and production. Core Labs is somewhat insulated from a dependence on new exploration activity given it has a business focused on optimizing existing reservoirs. However an extended lack of new drilling activity will depress revenue streams from new production. This is a part of the business that has grown substantially in recent years. My view is that oil prices will resume a slow and steady uptick once higher cost production makes its way off the market. The large unknown is exactly how long this process will take, however I feel confident that this will eventually occur.

Many oil producers are also developing their own in house core competencies in data analysis and machine learning to assist them with production optimization. The risk is low that these capabilities will ever match Core's value proposition and cause oil explorers to move projects in house, however this remains a risk nonetheless.

Valuation

Core's share price has been caught in a downdraft for the last few years. However given revenues have also fallen, Core trades at a PE ratio of close to 40x earnings, which seems expensive. With earnings currently at a cyclical low, Core should show strong near term earnings increases which will improve rapidly improve the perceived valuation of the business. Morningstar rates the business 4 stars, and I'm happy to buy here with the expectation of solid longer term earnings and dividends.

Disclosure: I am/we are long XOM, 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.