Core Laboratories: Another Leg Lower

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About: Core Laboratories N.V. (CLB), Includes: SLB
by: Rob Barnett
Summary

In light of lower oil prices for longer - Core Labs has hit difficult times.

Core Labs is a play on off-shore oil and higher oil prices.

The company's stock price has more than halved in the last year and could halve again.

Cyclical stocks can offer exceptional capital appreciation if purchased at the right price. Core Labs is not there yet.

I last wrote about Core Labs in May 2018. At the time, the stock was trading at around $120 and I thought that the stock was significantly over-valued and I recommended that it should be SOLD: Core Labs: Stock Price Continues to Confound its Intrinsic Value.

Since then the stock price has more than halved (recently trading at around $50). It is now time to update my valuation in order to work out whether a trading opportunity exists.

Company Description

Core Labs (NYSE: CLB) is service supplier to the Oil & Gas exploration sector. The company was established in the US in 1936 and is now domiciled in the Netherlands but operates 70 offices in over 50 countries throughout the world.

It is a relatively capital “light” business with its services being mainly intellectual property based. The company supports the explorers for oil and gas by helping them to lower the costs of finding, developing and producing these commodities.

From early on the company’s focus has been on technology and gaining a deep understanding of the geology of oil and gas fields combined with the interplay of fluids (oil, natural gas and water) in the production environment. Core Labs, with Schlumberger (NYSE: SLB), are considered to be the global leaders in this field.

Core Labs’ is organized into two divisions

A brief summary of the activities of each division follows:

Reservoir Description

Essentially this is a low capital, laboratory-based segment where analysis is conducted on core samples of rock and reservoir fluids.

Most oil and gas explorers have the capability to do this type of analysis in-house but the more complex work is out-sourced to companies such as Core Labs.

This type of analysis is required both for on-shore and off-shore exploration but the off-shore work is more complex and more profitable (for Core Labs).

Some key metrics for the Reservoir Description division:

  • Contributed 59% of total revenues in 2018 (almost exclusively service based).
  • 80% of revenues are generated outside of the US.
  • 40% of the revenues are related to off-shore fields.
  • 15% of revenues are related to exploration work.

Production Enhancement

This division sells a combination of products and services for well completions and to well production.

Core Labs provides advice on how to identify, remediate and minimize the damage to production formations that may occur during drilling and well completion. The products include perforating guns and charges primarily sold to on-shore tight oil operations.

Some key metrics for the Production Enhancement division:

  • Contributed 41% of total revenues in 2018.
  • Around 66% of revenues are thought to come from products.

Market Overview

The Oil Field Services and Equipment sector is cyclical. Its success is almost entirely dependent upon the price of oil. Companies in this sector typically have higher sales and growing earnings when oil prices are rising.

The price of oil is driven by the normal commodity interplay between demand and supply. The historical price of oil since 1984 is shown in the following chart:

Source: Tradingview.com

The price of oil fell from a peak of $113 in 2011 and bottomed at $28 at the end of 2016. The price has been rising slowly ever since.

The demand for oil for the last 10 years has been relatively stable as shown by the following chart from Statista :

Source: Statista

The data indicates that the market is mature and long term demand is growing at around 1.3% and remains very steady.

This probably indicates that the movements in the price curve are being driven by supply-side responses.

So what has been happening on the supply-side?

Here is a chart using data from Baker-Hughes showing the historical relationship between the numbers of production oil rigs and the average price of WTI crude oil:

Source: Author’s chart using Baker Hughes General Electric data.

From the chart we can draw the following conclusions:

  • Activity in the Sector is linked to the price of oil.
  • There has been a dramatic improvement in rig productivity over the last 20 years given that production volumes today are higher than 20 year ago (less rigs are producing the same or more total volume).
  • The rig count has recently started to increase as the price of oil rises.

Rystad Energy, a major consulting company in the Sector, released a report in May 2019 showing their rankings of the cheapest sources of oil supply in the world:

According to Rystad:

  • There has been a dramatic reduction in the average break-even cost of North American (NA) tight oil.
  • Over the course of the last 3 years the average break-even cost has reduced by almost one-third.
  • North American tight oil suppliers have a break-even cost that is within 10% of the Middle East onshore suppliers.

This is not good news for companies such as Core Labs who are particularly reliant on more exploration activity in the off-shore market.

Future Exploration Activity / Oil Price

Both Core Labs and their largest competitor, Schlumberger ( NYSE : SLB), have reported a significant increase in final investment decision (FID’s) announcements by their ultimate customers - oil exploration and production companies.

During its recent 1 st Quarter Earnings conference call, David Demshur, Core Labs’ Chief Executive Officer, stated:

“The last and most important trend for Core is that client discussions have continued to increase for international and deep-water longer cycle projects that will be needed to meet future production demands.”

“The foreshadow (sic) of the increase in activity has been evident in the 20 FIDs approved in 2017, another 30 announced in 2018, while 30 or more are queued up in 2019. Revenue from these longer cycle projects is(sic) mainly been absent from Core’s Reservoir Description revenue streams dating back to 2015 and should start to bolster revenue in 2019.”

These statements are also supported by Rystad Energy which produced the following chart in December 2018:

Source: Rystad Energy, Press Release, Dec 2018

The surge in project approvals might be considered to be surprising since the price of oil remains around the long term, inflation adjusted, average. Rystad Energy claims that since 2014, oil-field development costs have fallen by as much as 30%. This means that the historical relationship between the price of oil and the level of exploration may have changed which might account for this potential exploration activity.

Using data from Index Mundi and the St Louis Federal Reserve , I have estimated that the average inflation adjusted oil price between 1976 and 2018 was $60 per barrel with a standard error of $27.

Unfortunately the Oil Futures market does not provide us with any reliable future price information. Being a storable commodity, the Futures price is today’s spot price adjusted for storage costs and the cost of money.

Because I have no better information, my long term forecast for the price of oil is based on a reversion back to the 40 year mean price of $60 per barrel. I have used this price to estimate the Terminal Value in my valuation.

Ok – let’s start some valuation work by looking at the historical financial performance of Core Labs.

Core Labs’ Historical Financial Performance

The following chart shows Core Labs’ revenues and operating margins since 2006:

Source: Author’s compilation from company annual reports.

The drop in revenues and margins over the last few years coincides with a steep decline in off-shore exploration - particularly deep water exploration. This highlights how significant this segment is to Core Labs’ future profitability.

Core Labs’ Return on Invested Capital

A key metric for assessing the strength of a company’s value proposition or economic moat is their historical return on invested capital. Core Labs is particularly pleased with its performance in this regard and claims that it is the Sector leader:

Source: Author’s compilation using company annual reports.

Note that in my calculation I have adjusted the Operating Earnings for the impact of operating leases and I have also eliminated cash and investments from the capital base.

Core Labs’ Moat

The ROIC chart shows that although there has been a substantial reduction in ROIC over time, it is still very healthy. This would suggest that Core Labs does indeed have a strong moat. I think that Core Labs’ moat comes from:

  • Proprietary intellectual property in the Reservoir Description and premium perforating system (sub-set of Production Enhancement) segments.
  • Network effects generated from the vast number of deep-water projects it has completed in the Reservoir Description segment (the company has developed an extensive data base of global deep-water geology from the projects that it has completed).
Recent Events

  • Over the last 12 months the price of oil bottomed in December 2018 at around $42.
  • The price rallied until late April where it peaked at around $66.
  • However the price has been declining since then and is now $53.
Recent Share Price Action

Source: Morningstar

The price chart shows that Core Labs’ share price has come under tremendous pressure over the last 12 months and there is no indication that a floor has been reached.

Historical Returns

Source: Morningstar

The data from Morningstar shows that Core Labs and the Oil & Gas Equipment Services sector have not been good investments for more than 5 years.

Over a 10 year horizon Core Labs has out-performed its Sector but it is has massively under-performed relative to the US market over this period.

Key Risks Facing Core Labs

There are 3 key risks facing Core Labs:

  • Future price of oil.
  • Future break-even cost differences between onshore and offshore oil production.
  • Sustainability of their proprietary intellectual property.

Core Labs’ future profitability is intimately tied to the price of oil and to the level of off-shore exploration. The level of off-shore exploration is both tied to the price of oil and also to the relative break-even cost differences between off-shore and on-shore oil (particularly North American tight oil).

I think that the price of oil in the medium term (baring a geopolitical event) will be heavily influenced by the availability of relatively low cost North American (NA) tight oil. The major risks to the availability of NA tight oil are:

  • Higher interest rates (many of the producers are financially challenged).
  • Changes in regulation (particularly from any future change in Federal government).

At this stage I think that it is unlikely that interest rates will increase in the short term but it is inevitable that over the medium term they will increase.

I suspect that when that happens it will trigger a wave of Sector consolidation in North America but, provided that regulatory conditions are sympathetic, tight oil will remain a viable source of supply for many years to come.

On the intellectual property front. I think that it is inevitable that Core Labs’ competitive position will weaken over time (history shows that all technical advantages are competed away over time). There is already some minor evidence that this is happening as shown by the reduction in their margins. This may take many years to play out but it will happen.

My Investment Thesis for Core Labs

I expect that Core Labs’ revenues and margins will continue to follow their long held relationship with the price of oil. At this stage I see no reason why the price of oil will dramatically increase.

Thus I am predicting that Core Labs will continue to be a play on the price of oil. Whatever strategic actions that the company is claiming to be making will have no significant impact on the company’s long term financial position.

I note that the current consensus forecast is for an 11% increase in revenues in 2019. At this stage I think that this estimate is too high.

At the end of the 1 st quarter, revenues were flat and the company’s guidance for the 2 nd quarter is also flat. I suspect that this will continue to drive the share price lower over the coming months.

At the current oil price I think that the recent level of buy-backs and dividends paid by the company will also come under pressure. I suspect that the situation is finely balanced:

  • Annual Operating Cash Flow is around $110 – 120 M.
  • Net capex is around $20 – 25 M (assuming no acquisitions).
  • This leaves between $90 – 100 M of cash to pay down debt and to payout to shareholders in a combination of share buy-backs and dividends.

For the last 2 years the company has spent about $97 M per year in dividends and on average $12 M per year on stock buy-backs.

Thus my conclusion that this situation is finely balanced.

The company has $295 M in debt outstanding. The debt is evenly split between two senior debt note issuance and a credit facility. One of the debt notes (Series A) is due in September 2021. There are covenants around the senior notes and the credit facility.

If the company is forced, for cash flow reasons, to cut its dividend payment this will no doubt place more pressure on the share price in the short term.

I suspect that this event may happen in late 2019 or 2020 if there is no increase in the general level of exploration activity across the industry.

Discounted Cash Flow Valuation Methodology

The DCF is relatively straight-forward. A Free Cash Flow to the Firm approach is used with a relatively short 2 stage model. The model is based on the historical relationship between Core Labs’ revenues and the price of oil.

Over 5 years the model moves from today’s oil price to the expected long term price of oil. It uses the oil price to estimate revenues and margins.

The model only seeks to value the cash flows of the operating assets. The valuation has been performed in $USD.

Key Assumptions in Core Labs’ Valuation

Revenues will grow in line with the price of oil. I have developed a regression equation based on the historical relationship between the price of oil and Core Labs’ reported revenues:

Source: Author’s compilation using company annual reports.

You will note that the regression model accounts for almost 85% of the variation in the company's revenues.

Operating Margins will also grow in line with Revenues. I have also developed an Operating Margin model based on the historical relationship between revenues and reported EBIT margins:

Source: Author’s compilation using company annual reports.

Note that the reported Operating Margin has been adjusted for the impact of operating leases.

  • Capital productivity levels will be maintained into the future with reinvestment remaining at the current level of Δ Sales / Net Capital of 1.4 ± 0.2.
  • The current Return on Invested Operating Capital (around 27%) will decline over time before settling at a mature phase return of 12 ± 1% (although much lower than the current return this is still an exceptional long term return compared to the market). This will result in a mature phase excess return of 3% reflecting the strength of CLB’s relative competitive position.
  • The long term tax rate is expected to be 24%.

The assumptions relating to the Cost of Capital using the Capital Asset Pricing Model are:

  • The unlevered beta was determined by running a screen for Oil Services companies on GuruFocus and adjusting for individual company leverage in order to determine a Sector average. The result, after correcting for cash was 1.11.
  • The current Cost of Equity is estimated to be 10.26% based on an risk-free rate of 2.38% and an Equity Risk Premium of 6.44% (I have used Damodaran’s May mature market ERP of 5.62% and adjusted for the country risks where the company operated ).
  • The company’s pre-tax Cost of Debt is estimated to be 3.65%. This is based on an estimated credit rating of BBB with a corresponding default spread of 1.27%.
  • Based on these inputs, the current Cost of Capital is estimated to be 9.36% (I estimate this to be in the highest 3rd quartile of all US companies).
  • I expect that Core Labs’ mature Cost of Capital will decrease towards the median of all US companies: 9.0 ± 0.5%.

I have used a Black-Scholes pricing model to value the management options at $0.7 M.

I have valued the equity investments using the Sector’s average Price to Book ratio of 1.14

I have assumed that the future price of oil will continue to follow the historical distribution for oil pricing that took place from 1976 to 2018 (but with adjustments for the impact of inflation).

Discounted Cash Flow Valuation Output

The valuation is almost exclusively driven by the expected price of oil. The impacts of the other inputs into the calculation are completely drowned out by any movements in the oil price.

Source: Author’s model.

I also developed a Monte Carlo simulation for the valuation based on the range of inputs for the valuation. The output of the simulation was developed after 50,000 iterations.

Source: Author’s model.

Now you will note that the valuation distribution is not perfectly symmetrical – this is a feature not a bug. This is caused by my assumption that the price of WTI is normally distributed with a median price of $61 and I have not allowed any values below zero.

My model suggests that the intrinsic value for Core Labs is between $6 and $100 with a typical value around $23 per share.

What Valuation Inputs Need to Change to Justify Today’s Stock Price?

Given that the estimated intrinsic value is so much lower than the current share price it is worth thinking about what combination of oil price and operating margin would give a value which is closer. I substituted a range of values into model to produce the following table:

Source: Author’s model.

The table shows that in order to generate an intrinsic value equal to the current share price we require a WTI price over $90 and an operating margin over 31%. These conditions also need to persist into perpetuity. It is my view that this is highly improbable.

Conclusion

I have now valued Core Labs several times. My last valuation was in May 2018. My valuation back then was $27 per share. At the time the stock was trading at $121. My recommendation then was that the stock was a SELL particularly if the price of oil went lower.

One year later the company’s share price has more than halved and my valuation really hasn’t changed that much. I still recommend that the stock is a SELL.

This time around my valuation shouldn’t cause the same angst as my last effort – although in hindsight it was correct.

The Oil Services sector is quite interesting in terms of relative valuations.

Core Labs has traded at a median Price to Trailing Earnings (P/E) multiple of 30 for the last 13 years. It currently trades at a P/E of 24. The stock has historically traded at a large premium to the rest of the Sector but this appears to be slowly declining.

I am advocating that the stock doesn't deserve any premium and should trade at a multiple of around 12 times earnings which is more in line with the stock's growth and earnings profile.

A quick snap short of the Oil Services sector reveals the following information:

Source: Morningstar

I think that the Haliburton ( NYSE: HAL) multiple is more appropriate for this Sector given the competitive challenges that exist for these companies. If this multiple was applied to Core Labs, the stock price would be around $28 – quite close to my valuation.

My advice to Core Labs’ shareholders is to SELL until there is a clear signal that the price of oil is going much higher. The time to own this stock is when the oil is heading for an extended period of higher prices. Unfortunately I don’t see any immediate catalysts for this to happen.

I have been an owner of Core Labs in the past. I really like cyclical plays – they are not for the faint-hearted and they require patience – but they can provide wonderful opportunities to make exceptional returns over modest time horizons. Valuation is the key to these plays. A good intrinsic valuation will provide guidance for patient investors.

The time will come when Core Labs will present us with a wonderful opportunity – it is just not now.

Once again thanks for reading my article. All comments seeking a response will be replied to. Good investing. Until next time.

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.