In what may be one of the most overstated market reactions of the year, Core Laboratories (CLB +0.00%) has seen share prices drop over 22% in the past couple of months thanks to some struggles in its quarterly earnings release and an announcement that its revenue for the quarter will be less than what was originally forecasted. There is a reason that Wall Street overreacted so much, and part of it is that the way to evaluate Core Labs is slightly different from its competitors. Let's take a look at why Core needs to be viewed differently than other oil services companies like Halliburton (HAL +4.20%) and Schlumberger (SLB +2.27%) and what investors should look for in the future when evaluating Core.
Staying ahead of the Curve
What sets Core Labs apart from the the Halliburtons and Schlumbergers of the world is that Core Labs is much more reliant on high margin services that come from technology development. The company can't really compete with these big players on more basic services because it doesn't have the infrastructure in place to do so. That's OK, though, because the company doesn't even try to.
Rather, Core Labs continually improves on its technology services, which gives it a competitive advantage. The challenge with this advantage is that Core perpetually needs to improve its existing services and develop new ones. So far, the company has been able to stay out ahead of its competition in this regard, but it is no guarantee that it will continue.
In fact, part of the company's most recent announcement that earnings would be less than expected this quarter will come from pricing pressure on some of these older technology services, most notably some of its charges and gun systems used for perforation of a shale deposit. As shale technology continues to develop, these types of technologies will become more like commodities, and Core will not be able to charge the pricing premium it once had.
So how will investors know when that technology development cycle isn't panning out like it used to? One metric that you can measure technology development at Core with is how much of its revenue is generated from services that are less than three years old. According to the company's most recent conference call, more than 70% of the company's revenue is generated from these newer systems. Also, some of the products that Core has developed to replace those more basic perforation systems are some of the fastest growing services in the company.
Not an earnings engine, but a cash cow
Not only is Core unique in the way that you need to evaluate the business, but you also need to look beyond some of the traditional financial metrics to get a better understanding of the company. That is because instead of focusing on earnings, Core Labs management's goal is to maximize free cash flow and return much of it to shareholders. Despite the fact that the company is perpetually developing new technology, its capital expenditures haven't exceeded 15% of its operational cash flow in the past five years. All of this excess cash has allowed the company to keep a squeaky clean balance sheet.
| Company | EBITDA to Interest Expense | Funds From Operations to Net Debt | Debt to Capital |
| Core Laboratories | 38.9x | 1.06x | 61.91% |
| Schlumberger | 31.2x | 0.82x | 22.17% |
| Halliburton | 17.0x | 0.65x | 36.2% |
Source: S&P Capital IQ
One thing that may stand out there is that Core's debt to capital ratio looks scary high in comparison to the standard bearers of the industry. The reason for this is that since Core uses that cash for dividends and share buybacks, the company doesn't retain much in earnings and it makes this number appear unusually high. Considering that the company could pay off all of its debt with funds from operations from a single year, debt to capital shouldn't really be given too much credence when it comes to Core.
With so few financial obligations, Core's management has been able to give much of that money back to shareholders. Since the company started its share buyback program in 2002, it has reduced its share count my more than 32% and doubled its dividend over the past three years. These sorts of initiatives don't show up in many financial metrics, but they are more indicative of Core's success.
What a Fool Believes
Even though it always seems that we are perpetually looking for new sources of oil and gas, the industry is a very cyclical one and companies like Core, Halliburton, and Schlumberger will always see prospects wax and wane with these industry cycles. However, as a long term investor you don't want to mistake these downturns for weakness in the business model. For Core Labs, its ability to create new revenue streams through technology development and generate free cash flow are the foundation of what makes it a compelling investment. As long as it can continue to do these two things, Core will remain a top investment in the oil services industry.
