Why I Disagree With Jim Cramer and Bought (More) Shares of Core Labs

Image Source: Core Laboratories.

During one of Jim Cramer's lightning rounds last week, he mentioned that he would stay away from Core Laboratories because its past earnings looked "bad." It looks as though many people agreed with him. In the day after the petroleum industry service provider's second-quarter earnings were released, shares dropped by more than 10%. While I'm sure Cramer has good reasons for his sentiment, I just can't see it. That is why I added to my position in Core Labs following the latest earnings report. Let's go through why I'm not quite sold on this being a bad quarter for Core and why this stock drop may be an immense opportunity for investors to add Core Labs to their holdings. 

If this is bad, I wonder what great looks like
If you are looking at Core Labs for the first time, then you are probably looking at the latest earnings results and wondering why analysts think this was a bad quarter. After all, the company beat Wall Street estimates and posted increases in revenue and earnings, both sequentially and on a year-over-year basis. To really understand this situation, you need to look back a couple months to when Core's management lowered its second-quarter guidance. It cited lowered demand for fluid analysis in established shale formations such as the Bakken and Eagle Ford; delays in several of its clients' offshore drilling projects; and that some of Core's older products such as perforating charges were losing pricing advantage and were being phased out in favor of newer offerings.

So if we compare the second quarter's results with the original guidance, the reasoning for calling it a bad quarter are a little more apparent:

Core's expectations and results  Revenue (in millions) EPS Free Cash Flow (in millions)
Previous guidance range $280-$286 $1.48-$1.53 $70
Updated guidance range $265-$270 $1.32-$1.35 $65
Actual quarterly results $267.1 $1.35 (excluding foreign exchange and tax benefits) $53

Source: Core Labs press releases.

The item that stands out here is the big miss on free cash flow. This is important because one of the company's three tenets for investors is free cash flow generation. To be fair, though, management did say that capital expenditures were heavily weighted to the first half of the year as it ramps up for activity in the second half. 

So it wasn't a great quarter, and the reasoning behind the 20% drop in share price since the revised guidance makes a little more sense. At the same time, this wasn't a really bad quarter, either. Despite the slightly weaker numbers, there were several signs of promise that indicate this is only a temporary bump in the road rather than a course-altering ordeal.

  • This quarter, the company signed its largest contract ever in its reservoir description segment. This five-year contract with Kuwait Oil will be focused on studying how steam flooding-enhanced oil recovery techniques will work in its aging fields. 
  • Declining shale activity at established formations is being offset by increasing activity in emerging plays such as the Tuscaloosa Marine shale, the Woodford SCOOP play, and new formations in the Niobrara shale and Powder River Basin. 
  • Enhanced recovery techniques for older wells could be used in established shale formations. Core Labs estimates it can boost overall recovery at shale wells in the Bakken and Eagle Ford from single digits to the low teens. 

These elements suggest that the longer-term prospects for Core are still very solid, so jumping ship today seems a bit shortsighted. 

Buying a great company at a reasonable price
By just about every metric, shares of Core aren't what you would call cheap. When compared to the other top-performing oil-services companies -- Schlumberger and Halliburton (NYSE: HAL  ) -- as well as the S&P 500, Core trades at a premium even after this big stock pullback over the past couple months. 

Company Price to Earnings Enterprise Value to EBITDA Price to Free Cash Flow
Core Laboratories 26.96 19.25 23.35
Schlumberger 22.54 11.84 23.56
Halliburton 21.81 6.84 22.71
S&P 500 Index 19.6 13.01 N/A 

Source: S&P Capital IQ.

That being said, Core Labs sells for a premium because it is a top-flight company in the oil-services space. Core's offerings -- core sampling and analysis to characterize a new discovery, production enhancement technology for unconventional reservoirs, and managing the decline of older reservoirs -- strike a direct chord with two of the major needs in the oil and gas industry today. Massive but aging reservoirs like those in the Middle East still have lots of oil left, but need more advanced techniques and technology to extract it. Meanwhile, newer formations are in more geologically complex formations such as shale and high-pressure, high-temperature basins in deep offshore regions. Companies are preparing to spend billions to extract these resources, but they want to be more certain of the outcome before making a final investment decision. Core's products and services are custom-tailored for this market.

Because of its position, Core can demand very high margins for its offerings, which far outpace anyone else in the space. Combine this with management's disciplined approach to investments and you have a company that generates gobs of free cash and huge returns on capital.

Company

EBIT Margin Return on Capital Free Cash Flow Conversion Rate* 
Core Laboratories 31.5% 46.9% 25.4%
Schlumberger 19.1% 10.9% 3.5%
Halliburton 14.5% 13%

7%

*Free cash flow conversion is the total amount of free cash generated per $1 of revenue, so a conversion rate of 20% means $0.20 in free cash is generated per $1 of revenue. Source: S&P Capital IQ.

While shares may not be cheap by market standards, now is an opportune time to buy in as the stock costs just 80% of what it did just a few months ago. Heck, even Core's management has accelerated its already robust share repurchase program because of the steep discount on shares. If forced to choose between Cramer's advice to wait on the sidelines to see some more promising results and Core management's move to acquire a lot of company stock on discount, I would have to side with Core's management. 

What would cause me to agree with Jim Cramer on Core Labs
As long as Core keeps churning out high margins, increasing revenue, and a high cash conversion rate, then I'm a very happy owner of this stock. Still, based on where it is today and what lies ahead for Core, there are three metrics that would make me think twice about picking up more shares. 

  • Operating margins on an annualized basis slip below 25%.
  • Free cash flow conversion slips below 15% for consecutive quarters.
  • Revenue starts to decline while the rest of the industry remains steady.

This last point is critical. The oil and gas business is cyclical and will likely see rough times sometime in the future. If the industry is still running strong and Core starts to slip, though, then it might be time to reconsider.

What a Fool believes
I don't know Cramer's investment time horizon when it comes to Core Labs. Perhaps it's a bit shorter than mine, and over that time frame the prospects for Core aren't as great. In that case I can totally understand the logic behind avoiding Core Labs right now. For someone who plans on holding onto Core for a very long time, though, today is an opportune time to take advantage of the bearish sentiment from the likes of Jim Cramer and other Wall Street analysts and add Core to your portfolio. I did.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 03, 2014, at 3:27 PM, SkepikI wrote:

    uh, maybe I cant read but I dont see the Core ticker on this...am I missing something here Tyler? just a nit....

  • Report this Comment On August 04, 2014, at 9:46 AM, ahw5006 wrote:

    CLB is the ticker.

    While I have no position, I enjoyed your thesis on this one and agree with it. I like how you mentioned your stipulations for buying more in the article. Good analysts recognize how and when the story changes.

    From a technical standpoint, this stock is oversold which reduces risk in the short term. As long as it holds Friday's low I think this is a great risk/reward play.

    Interesting and informative article, thank you.

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