Description

Core Laboratories (“CLB”) is a leading and one of the best managed oil field services company whose shares are likely to be worth 2-3x in 2-3 years’ time as oil prices recover and activity on the oil patch returns to at least sustenance levels. Whilst CLB may not appear optically cheap at 11x EBITDA LTM, I think the market is grossly undervaluing the quality of its main Reservoir Description division and its potential to return to historical levels of profitability as the wider industry recovers. CLB is the proverbial baby that has been thrown out investors’ portfolios alongside all other oil and gas investments. On top of owning quality assets, CLB management are excellent operators and have proven to be very shareholder-friendly, and are therefore likely to increase dividends or resume share buybacks as operating conditions improve.

Attractive Valuation

At $15.00, CLB is attractively valued at ~16x UFCF LTM (excluding NWC changes) and ~6x UFCF average from 2004-2019, for a business that is lowly leveraged even based on depressed, if not trough, EBITDA. CLB’s main Reservoir Description division has a very strong business model, and if it wasn’t operating in the brutally volatile oil and gas industry, would be comparable to much more highly valued consulting or certification peers. In fact, during better times, CLB has traded at nosebleed EBITDA multiples that prompted one analyst to compare it to ADBE, but one doesn’t have to believe in a return to peak profitability and peak multiples in order to make a multiple of one’s investment from current price levels.

Asset Quality: an entrenched industry leader

CLB’s main business is their Reservoir Description division, which is the global leader in their field, and I will focus on this part. Its Production Enhancement division is also one of the leading global players, however, Production Enhancement’s financial performance has been more volatile than Reservoir Description’s as it faces stiffer competition than Reservoir Description, which is basically has no peers. 

Reservoir Description provides analytical services to the oil and gas industry, performing testing services for rocks and liquids for the oil and gas industry. Particularly for large and expensive projects, i.e. mostly offshore fields, the oil majors are willing to spend good amounts of money to better understand the field characteristics by analyzing the rock and the mud / liquids obtained from the drill core. The goals are to better assess (i) potential reservoir size, (ii) potential production profile, and (iii) potential ways to optimize recoveries. Particularly for big and remote projects that cost $100mn+ in upfront capex, spending a few extra million on testing is a drop in the bucket if it means that operators can increase production by 20-30% or can extend field life by 2-3 years.

Reservoir Description dominates the market due to (i) long history of working on all major oil and gas projects around the world, and (ii) proprietary analytical tools. The paid for testing results are not actually the interesting bits; the real “value add” part is frankly the consulting-type services CLB provides to their customers on top of the testing results, “for free”. Because of CLB’s work on most major oil fields in the past and present, CLB is best positioned to help operators understand how their reservoirs compare to other reservoirs found elsewhere, and how to best exploit them. In a way, CLB has internally built a “data library” similar to the multi-client libraries of the seismic exploration companies. Furthermore, because CLB has been internally developing or otherwise externally acquiring niche and highly specialized toolmakers, Reservoir Description has entrenched themselves in the supply chain and made itself indispensable.

Management Quality: steadfast and focused

CLB’s management team is outstanding, commanding great technical expertise, salesmanship, but also possessing an almost scientific approach to business in a highly volatile industry. Through internal R&D, acquisition of toolmakers, and aggressive hiring of entire lab teams made redundant by oil majors at the bottoms of the cycles, CLB over the years has become the de-facto brain trust of the oil and gas industry, doing business with all the major players from IOCs to NOCs. 

CLB’s success and financial attraction stem from their “3 financial tenets” of (i) generating free cash flow, (ii) pursuing only high ROIC activities, and (iii) return cash to shareholders. Of course, operating in such a volatile industry has meant that there have been occasional hiccups, e.g. buying back shares at the peak of the cycle followed by a rights issue in 2016, however, overall management has aptly avoided major capital allocation blunders. Of course, sometimes parts of CLB have fallen behind peers in terms of product innovation, but CLB management generally stays very close to the market and have not shied away from taking aggressive action in order to catch-up and surpass peers.

Industry Outlook: is this the bottom for the oil and gas industry?

This is obviously the billion-dollar question, and unsurprisingly, I do not think that we should write off the entire oil and gas industry. I have offered some views in the Methanex write-up earlier this year, so I will refrain from repeating the same points here. I am a believer that most things turn out to be cyclical, however, the risk here is that the last cycle turns out to coincide with the onset of a structural decline, e.g. with newsprint in 08/09. 

Key Risks

Peak Oil

A lot has been written about it, but for now, I believe there is just no alternative to liquid hydrocarbons. As far as I am aware, there is no other low cost, high density energy storage medium available that can readily replace oil and its derivatives as a fuel, let alone as a chemical feedstock. Whilst this can change, but is unlikely to happen overnight. 

Shale vs. Conventional

This is an interesting debate that is relevant to CLB because of its relatively large exposure to large capex conventional projects compared to the smaller and more nimble shale oil industry. I do like the lower capital intensity and shorter duration of shale oil plays per se just as I do like this for any other industry. However, very few management teams have the discipline to intentionally reduce production during times of low prices in order to be ready to produce at full throttle when the next oil price spike comes. If, however, shale proliferates globally at the expense of the big projects, CLB’s Reservoir Description business will face serious structural headwinds.

New Competition

Given the relatively high ROCEs in the niches that CLB operates in, there has been new entrants in some niches, however, these have mostly been confined to Production Enhancement’s activities as far as I am aware. Due to the dynamics described, it will be much harder for any new player to compete with CLB’s Reservoir Description division.

Disclaimers

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Catalyst

No hard catalyst per se, but recovery of oil prices and industry activity levels or the resumption of share repurchases may cause the stock to rerate higher.