Only 40% of the oil in a field is typically extracted. Core Labs' (CLB) powerful technology helps drillers get an extra 1%, 2%, or more. This may sound trivial, but the last barrel pulled out is the most profitable. That extra few percent of production can translate into millions for driller's bottom lines.
There's so much to love about this company -- but I still can't invest in it. Before we get to why, let's talk about what makes Core Labs great.
1. Core Labs should bounce back from this down cycle with vigor.
Core Labs serves established, operating oil fields. The business has few ties to exploration, which -- erratic even in boom times -- is often the hardest hit slice of the oil industry in downturns. With minimal exposure to exploration, Core Labs should be shielded from the worst of this cycle trough.
More importantly, Core Labs has navigated its way through many oil cycles. It's instructive to look back at how the business performed in the past. Let's look at the 2008 to 2009 cycle -- the most recent -- as an example. Here's Core Labs' quarterly revenue through that cycle:
Source: CLB Revenue (Quarterly) data by YCharts.
Two things become apparent from this chart. First, there's a lag between oil prices and the effect on revenue. Oil drillers -- Core Labs' customers -- are reacting to oil prices, and it takes a few months for those reactions to filter through to Core Labs' results. Second, the collapse and recovery of oil prices had an effect on revenue, sure -- but that effect was muted.
Unlike its actual financials, Core Labs' stock took a beating in 2008 to 2009:
The share price was much more correlated to the movement in oil prices than it was to the performance of the business. This deviation from business fundamentals is understandable. Investors were running scared -- not only were oil prices plummeting, the entire financial world seemed on the verge of disintegration.
But those times when stock prices depart from the underlying business can create opportunities. Investors who bought in the depths of that down cycle watched their shares rise 635% during the next five years. During the same time, the S&P 500 rose 105%
2. Core's high margins are only getting higher.
Core Labs turned every $1 in revenue into $0.32 of operating profits in 2014. Those juicy margins are the result of a fantastic business -- one that owns little hard equipment and offers a highly valuable service to its customers. Even better, there are two reasons investors should expect margins to continue to expand.
The first reflects the changing mix of services Core Labs offers. Their three segments come with different margins.
Source: Company filings. Chart by author.
It's no surprise that management has focused on growing the higher-margin segments, and their efforts have paid off. During the past five years, low-margin Reservoir Description work has grown 4.5% per year. Compare that to high-margin segments Product Enhancement and Reservoir Management, which have expanded 15% and 13.7% annually.
More fundamentally, Core Labs' work scales well. After a good deal of upfront work developing a new service, it doesn't cost much more to deliver that service to a new client. A prime example is Core Labs' multi-client reservoir studies. In several North American oil fields, Core Labs has undertaken extensive studies, the resulting data sets of which it is able to harness for services to many drillers involved in the region.
3. Management is exceptionally shareholder friendly.
Core Labs' business throws off gobs of cash. In recent years, only about 12% of that cash has been required for reinvestment in the business. That leaves management with a lot of money with which to play.
Lesser management teams might go hog-wild with wishful acquisitions or overzealous executive compensation packages. But not Core Labs.
The company pays a steadily growing dividend. The more potent use of capital, though, is stock buybacks.
Unlike far too may companies, Core Labs' management team understands that buybacks only make sense at the right price. When the stock is high, it doesn't repurchase shares. When the stock is low, it backs up the truck. In 2008 to 2009, it also repurchased bonds that had collapsed in price.
This beautiful behavior is the exact opposite of most companies, and it's happening again right now. In last week's conference call, CEO David Demshur told analysts:
Core has increased its dividend 10% year-over-year and will aggressively repurchase shares... we see little difference from the 2008 to 2009 downturn to today's current downturn... History does repeat itself and long-term Core Lab investors will once again be rewarded.
Why I still can't do it...
One insurmountable obstacle stands between me and Core's stock: its price. Despite falling by more than half, I'm having difficulty getting comfortable with today's stock price.
Let's assume this current downturn looks roughly like that of 2008 to 2009. By my valuation, Core Labs would need to grow revenue around 18% per year -- margins expanding all the while -- on the back of a recovery simply to justify today's stock price.
That's a lot riding on an abnormally high growth rate. Any failure to meet those embedded growth projects could prove disastrous for the stock.
Don't get me wrong... on the surface, the stock is cheap. It's fallen dramatically both in absolute value and in multiple. At 13 times EV/EBITDA, this is the cheapest we've seen the stock since September 2009.
The valuation that matters most to me, though, is the stock's absolute valuation. When I model out potential scenarios for Core Labs in the coming years, they all reflect a wonderful business -- but no scenario I'm comfortable banking on makes the stock look attractive today.
