Core Laboratories (CLB) has carved out a dominant and exceptionally profitable niche in the oil service industry. The Company has a singular focus on obtaining, analyzing and rendering proprietary datasets related to the quality, efficiency and efficacy of a client’s oilfield production and development activities. In addition, the Company utilizes these data sets (and experience) to develop highly differentiated tools and equipment that are particularly useful during the development and production stages of an oilfield.
In essence, Core Labs is “Big Data,” but considering that Core Labs was founded in the 1930’s, they were into “Big Data” well before the term started showing meaningful interest on Google Trends.
However, unlike some publicly traded “Big Data” companies - particularly those companies classified as “Information Technology”- Core Labs is extraordinarily profitable. Using return on invested capital (ROIC) as a proxy for profitability, the Company is at the top of the oil service industry - by a factor of 2X and 3X.
We believe that Core Labs’ peer-leading profitability stems from a laser-like focus on their petrophysical data analysis niche as well as strict capital discipline. Broadly speaking, the Company’s goal is to reduce the risk and increase the reward of developing an oilfield - not too different from most oil service companies. However, Core’s value chain is highly differentiated relative to most oil service competitors. In fact, much of Core’s service work is developed in a laboratory setting (thus, the “Labs” in “Core Labs”), where they conduct controlled analyses of fluids and rocks obtained from a client’s oilfield. These geological “core” and fluid samples represent direct measurements from an oilfield, so the resultant data sets that Core remits to the client represent the actual petrophysical properties of that client’s hydrocarbon reservoir. The industry often refers to this data as “the ground truth.” Compared to data sets from more indirect measurement services (e.g. wireline logs) favored by larger rivals, Core’s unbiased and highly accurate applied data services serve as critical inputs for clients when designing the most optimal production processes.
We believe Core’s long-term focus of developing and reinforcing their core and fluid dataset niche, and subsequent innovation in development and completion tools, is what has driven the Company to consistently superior rankings in customer satisfaction in the energy services industry, especially in core and fluid analysis. As for pricing these services, we estimate that the direct cost of most of Core’s services represent a mid-to-low single digit percent of the total cost of developing a well, yet the value of the data greatly exceeds the cost of this service, as it is used in almost every phase of oil and gas development. Given the low cost/high-value nature of Core’s services, combined with best-in-class capabilities and reputation, we suspect that the Company will have a strong grip on pricing power for many years to come. Furthermore, given the Company’s competitive advantages and culture we view Core’s profitability to be highly defensible, especially - particularly its culture of compensation - which revolves around ROIC. Simply put, anything that boosts relative ROIC, boosts executive and managerial compensation. Consider, there are only a few ways to boost ROIC: add value for clients and then increase prices/cut costs (increasing the numerator of ROIC) and/or become more capital efficient (reducing the denominator of ROIC) - both are very straightforward concepts that we think are notoriously absent from many corporate strategies. Yet the Company has mastered these concepts and motivated their employees accordingly. We think the scarcity of this highly disciplined approach is prima facie evidence that it is a difficult strategy to copy.
Core, too, has a long history of double-digit bottom line growth. The Company’s total addressable market are exploration and productions (E&P) budgets - especially the production portion of the budgets, which the company believes has the lowest risk of being cut during downturns, due to the mission-critical nature of Core’s value proposition. Core’s services are critical because of the inherent, constantly changing profile of a hydrocarbon reservoir. For example, any time oil or gas comes out of a reservoir (it is in production), or fluids or gasses are added (production enhancement), the reservoir profile changes. These changes conspire to form the “decline curve” of a reservoir, which management suspects reduces global hydrocarbon production by 2.5% per annum - or over 2 million barrels of oil equivalent per day. So tracking those profile changes are key to maximizing returns on investment for E&P’s, as the production decline curve of a reservoir “never sleeps.” Effectively, Core’s addressable market is any oilfield on the planet (the Company believes there are about 4,000 oilfields world wide), with the Company having done work on about 1,250 of those fields, increasing that count by a targeted 40 to50 fields per year. Ultimately, we believe the Company can grow the top line by several percentage points faster than E&P budget growth, with high levels of productivity and stable pricing power driving even faster bottom-line growth.
Core Labs’ superior profitability and capital discipline has led to exceptional financial strength, marked by over 50 consecutive quarters of free cash flow generation. The Company carries about $370 million in long-term debt, which we think is perfectly manageable, when compared to the roughly $250 million in trailing 12-month free cash flow. We do not expect Core to leverage the balance sheet for any sizeable M&A, given their obsessive focus on maximizing ROIC. However, we would welcome aggressive buybacks, given current historically attractive valuations.
After peaking at over 35 times forward earnings (a 10-year record) earlier in 2013, the stock has since pulled back to a range that is well below the stock’s 5 and 10-year averages. It is in this range that we have felt comfortable adding the Company to portfolios. While we are certainly aware of the impending downturn in earnings over the next 12 months (driven by the precipitous decline in oil, inevitably flowing through to lower E&P budgets) we believe the market is overly discounting Core’s longer-term potential for growth. The E&P industry is notoriously cyclical, but we believe the mission-critical nature of Core’s businesses should insulate them in this cycle and for many more to come. We hope to continue purchasing shares at what appears to be historically attractive valuation.
From David Rolfe (Trades, Portfolio)’s Wedgewood Partners 4th Quarter 2014 Client Letter.
