Whether you like the valuation or not, Core Laboratories (NYSE:CLB) is certainly an impressive company; it delivers consistent free cash flow no matter how difficult the industry backdrop is. With its Q1 2016 earnings release, the headline numbers paint a pretty dire picture. Revenue was down 16% QoQ and EPS (ex-items & Fx) was down 43% QoQ. Additionally, the company expects even lower oilfield activity going through the second quarter, with the expectation that full year 2016 client spending will be down 27%. Despite the topline drop, the company was able to convert 28% of its Q1 2016 revenue into FCF, which equates to $43 million or roughly $1 per share (down only 3.5% QoQ).
For Q2 2016, the company guided for slightly lower results QoQ, with the midpoint of revenue and EPS at $147.5 million and $0.35, respectively. Guidance was not given for FCF, other than that it would exceed net income once again. The company maintained its belief that Q2 2016 will mark the low point in oilfield activity, with a "V" shaped recovery taking hold in Q3 2016. Any recovery is expected to be based on an increase in crude oil prices, which in turn would lead to increased worldwide industry activity.
The market must have liked Core's results, as the market sent to stock near its 52 week highs. Given that the company did not offer any type of guidance that would show a significant increase in revenue or earnings over the next 6-9 months, what is the reason for the bullishness? To be honest, I'm not quite sure.
The valuation is starting to look extremely stretched with the stock at $130 per share. Absent a major uptick in oilfield activity in 2H 2016, EPS for FY 2016 are trending towards $1.50, which would give the stock a PE over 85. From a FCF perspective, the stock would be trading near its normal multiple around 30x, assuming that FCF can be maintained so far above earnings similar to Q1.
But is it a safe assumption for FCF to remain almost 3x EPS? Once revenue starts to stabilize, the company will no longer benefit from the quarter lag in cash flow as receivables continue to drop commensurate with revenue. Therefore, FCF may drop in the next few quarters bringing it closer to net income. So while it is relieving that cash collection has not been an issue thus far (especially given the amount of E&P bankruptcies), a valuation multiple based on FCF will trend higher unless there is a commensurate drop in the share price.
So if oilfield activity does not significantly rebound through the end of the year, I estimate that Core Labs will report FY 2016 FCF around $2 per share. So the question is, will investors be willing to pay nearly 65x its FCF in order to ride a potential rebound in 2017?
Oil Markets Rebalancing
As something I consider to be a "must listen/read" for investors in the oil & gas sector, Core Labs updated its view on the rebalancing of the oil markets during its conference call. The company expects US land production to decline 1.1 million barrels by the end of the year, with the decline rate approaching 10.1% and set to fall further going into 2017.Additionally, Core upped its estimated global decline rate by 20 basis points to 3.3% net.
Performing the math, this means that 2.8 million new barrels of oil will be needed one year from now just to maintain current production. Couple this with the IEA's expectation that demand will increase by 1.2 million barrels per day in 2016, and you can see the seeds being sown for strong demand of Core's services and products going forward. Ostensibly, this is the reason why the company expects a "V" shaped recovery to begin 2H 2016, although management did not address anything about the current inventory overhang.
In my view, the inventory overhang is a clear risk to seeing a robust recovery in oil prices. Based on the price action of Core's stock, the market must be building in expectations of a significant increase in oil services activity. But on the conference call, Core management estimated that it would take a price between $65 to $75 per barrel for the US to start growing production by 500,000 barrels per day. And with the company's production enhancement segment largely tied to US onshore, this means that oil prices would need to double before the segment really starts turning to growth again.
Having said this, when you compare Core Labs to its much larger peers of Schlumberger (NYSE:SLB), Halliburton (NYSE:HAL) and Baker Hughes (BHI), you quickly realize that Core is the best house in a bad market. For instance, even Schlumberger recently complained that the downturn is getting steeper and that pricing pressure throughout the globe is increasing:
Sequentially, the first-quarter revenue decrease of 16% was one of the steepest quarterly declines we have posted since this downturn started. This was driven by a continuing drop in activity and persistent pricing pressure throughout our global operations as well as from project delays, job cancellations and activity disruptions.
So when Core notes that it expects its decremental margins to finally bottom out in the second quarter and still maintain 15% operating margins, this is a testament to the company's differentiated and technologically advanced solutions.
There's no doubt that Core Labs deserves a premium valuation based on its strong management team and ability to maintain strong margins and free cash flow; but at a forward FCF multiple of twice its historical average, the valuation is looking a little stretched. I'd prefer to wait until the oil inventory glut starts getting resolved or until the rig count appears to have finally bottomed before jumping back into the stock.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.