Last week, I sold Transocean (NYSE:RIG) from the Messed-Up Expectations real-money portfolio I run for The Motley Fool. There were several reasons, but it boiled down to investment thesis drift, something that can lead investors down the garden path to places they don't want to go.
Today, I'm going to invest in a new company to the MUE portfolio and lay out the thesis very clearly. I'll also be keeping my eye on the company and the thesis to make sure this one doesn't drift away from me.
The company I'll be investing in is Core Laboratories (NYSE:CLB), an oil-related company. It works alongside oil drillers, but it doesn't drill for oil itself, unlike Transocean. (Just so everyone's clear on where I stand, it is also an active recommendation of Stock Advisor, and I cover it within that service. I also own shares personally and am short a put.)
The core of Core Labs
The company operates in three related segments, all dealing with looking at what is down there in the reservoirs being tapped, describing what it looks like through sampling, and providing suggestions on how best to manage and recover the oil and natural gas from the well in a cost-efficient manner. It's involved in drilling around the world, both onshore and offshore, and it sells its services to the rig operators.
The rig operators are likely to buy these services because it helps them get more material out of the ground. The incremental barrels of crude oil are the most economical in the reservoir, according to management, and if Core Labs' services can help recover those cheaply, it makes the drilling operation more profitable for everyone.
It's been doing this for nearly 80 years. Current management has been there a long time, too, including CEO David Demshur (CEO since 1995, at the company since 1979), CFO Richard Bergmark (CFO since 1994, at the company since 1991), and COO Monty Davis (COO since 1999, at the company since 1987).
What's been happening
A quick look at the one-year price chart for Core Labs shows a massive price drop of nearly 60% from top (last April) to bottom (end of January). From about August onward, the drop has been fairly well linked to the drop in oil prices. The earlier drops (e.g., the one in May) came from a downward revision in earnings, while the one a month earlier came from missing analyst estimates when it reported first-quarter earnings.
While each segment's quarterly revenue has not grown year over year during 2014, the company's total revenue has. In fact, the company's grown quarterly revenue year over year since at least 2010. Admittedly, those growth rates in 2014 were quite small, however. The year-over-year growth could even turn negative, as it did in 2009, the year after the last big drop in oil prices (and the last time the company actually saw year-over-year declines in revenue).
However, if you look at the share price movement for Core Labs from back then, the share price dropped hard as oil prices fell in 2009, and then started climbing again as oil prices recovered in 2009, despite the declines in quarterly year-over-year revenue growth.
During the last conference call, management made comments that today's situation strongly reminds them of what happened the last time oil prices dropped this way a few years ago. Oil supply and demand got out of balance, Demshur said, oil price dropped sharply (as did the share price), then oil prices started coming back up almost immediately (a V-shaped recovery). Demshur expects to see something similar this time, too. In fact, it might have already started, as oil prices are up about 15% from the lows.
Why I'm buying
The above is part one of the thesis, namely that I expect the share price of Core Labs to recover as oil prices recover, and I don't expect oil prices to stay as low as they are for an extended period of time. When an experienced executive like Demshur talks about history rhyming as he did, I tend to listen. Doing so has worked out well for me in the past.
The second part is what the current price is expecting from company performance. Using the recent closing price of $112.99 and the last year's $267 million in free cash flow, current expectations are for about 13% growth in FCF over the next five years, 7% for the five years after that, and 2.5% from then forward (matching inflation), using a 12% discount rate. Over the past three years, the company has grown FCF at 15% annually, while it's managed 10% annually over the past five years, so the 13% expectation is right in that ballpark.
However, I expect the company's link to the price of crude oil to dominate, and this investment is more about trying to exploit any rise in oil prices while holding a company that's of higher quality than Transocean. In contrast to Transocean, Core Labs is an asset-light company (it only spent $37 million in capital expenditures in 2014) and consistently generates cash flow from operations in excess of net income, even during 2009, the disappointing year mentioned above.
I do not expect to hold this company for many years in the portfolio. However, if it continues to perform well and generate strong free cash flow (allowing for the chance that, similar to 2009, this year could see year-over-year declines in revenue), I'd be willing to look at the situation again to see if it is worth holding using a different thesis.
Come discuss this investment on the MUE discussion board.