Will Core Labs Get Much Cheaper?

By Stephen D. Simpson, CFA | November 08, 2012 AAA

Energy sector investors have learned to expect that a handful of stocks never get that cheap, and specialized service provider Core Laboratories (NYSE:CLB) is definitely one of them. Unlike many energy service companies, Core Labs has a surprisingly consistent record of not only positive free cash flow, but free cash flow growth coupled with double-digit returns on invested capital. While rivals such as Schlumberger (NYSE:SLB) are trying to capture some of Core Labs' business, its strong competitive position seems very much intact. The real question for investors is whether they can get comfortable paying nearly twice the normal premium for a services company.

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OK Third Quarter Results in a Tough Climate
When Core Labs reported earnings back in mid-October, they were something of a mixed bag. The company did pretty well relative to expectation and it was definitely solid in comparison to other service providers such as Schlumberger, Halliburton (NYSE:HAL) and Baker Hughes (NYSE:BHI), but it was still soft in absolute terms.

Revenue rose 6% from the year-ago quarter and fell about 1% sequentially on normal seasonality. Reservoir description revenue fell 2% sequentially (but rose 4% annually) on seasonal weakness tied to Canadian oil sands. Production enhancement saw 4% annual growth and flat sequential performance despite a 6% sequential decline in rig counts. Lastly, the small reservoir management business saw 45% growth from last year, but a 3% pullback from the second quarter.

Not surprisingly for this company, profitability was quite respectable. Gross margin improved more than a point from last year and was steady on a sequential basis. Operating income jumped almost 19% from last year and rose about 5% sequentially on a reported basis. If you strip out some items, however (insurance settlement, retention awards and so on), the year on year improvement shrinks to 6%, while the sequential comparison reverses to a 3% decline.

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A When, Not if, Business?
It's not hard to see why investors bid up these shares and how/why the company is able to produce such solid financial returns in what is normally an extremely cyclical business. Companies that use Core Labs' offerings can improve their recovery levels from a range of 30-40% to 45% or more, and while a 5% improvement may not sound like much, it amounts to quite a lot when you're talking about millions of recoverable barrels of oil and huge incremental margins on that "extra" oil.

Consequently, I have a hard time imagining that clients such as Total (NYSE:TOT) or BP (NYSE:BP) are not going to continue to use Core Labs for reservoir description and/or production enhancement. Likewise, I think investors should be aware of the substantial overseas potential. While about half of the company's revenue comes from the United States today, I believe that will shrink in the next decade - not because U.S. oil production is going to decline, but rather because the drilling and service intensity in non-U.S. fields is so much lower than in the U.S.

Competition Coming ... As Always
I don't want to give the idea that Core Labs has an open runway to easy money. Companies such as Schlumberger, Halliburton and Baker Hughes already compete extensively in production enhancement. While competition is a little different in reservoir description (many oil/gas companies try to handle this internally if possible), Schlumberger and Weatherford (NYSE:WFT) are both trying to step up their game here, and Schlumberger's considerable technology and R&D capabilities make it dangerous to underestimate them. On the other hand, Core Labs has a large base of experienced scientists and has generally seen very low turnover.

The Bottom Line
It's hard not to like the persistence of growth in Core Labs' business; it's one of the few energy service companies where a discounted cash flow model doesn't seem fatuous. On the other hand, it's not like this stock is ever all that cheap; so much so, in fact, that I don't follow it closely on a quarter-to-quarter basis, as it often seems pointless to hope it'll get cheap enough to buy.

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All of that said, the shares are down about 11% over the past year, and this is perhaps as close to "cheap" as the stock is likely to get - provided you don't believe that energy demand is going to fall significantly and/or rivals like Schlumberger are going to step up and start grabbing share. At 15 times next year's EBITDA (nearly double the normal energy services multiple, but about average for Core Labs), these shares would seem to be worth close to $110. That certainly doesn't make it the cheapest energy services name, but given its historical performance, it may just be enough of a discount for some investors.

At the time of writing, Stephen D. Simpson owned shares of Weatherford since September 2012.

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