Core Labs Has an Edge in the Oilfield

 | Aug 29, 2013 | 7:00 AM EDT  | Comments
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Core Laboratories (CLB) is a mid-cap oil servicer that has carved out its own niche and is breaking away from its peers. And its free cash flow and returns on capital have been driving its stock higher.

Core is involved in reservoir description, production enhancement and reservoir management services. These services help companies improve reservoir performance and increase recovery rates from their producing fields. Core provides service production and production enhancement, which are often given budgetary priority over exploration and appraisal, so Core operates in less risky areas than do many other servicers. Core has carved out a niche by developing patented oilfield technologies.

By building up a pool of patents and talent instead of heavy machinery, Core has become a free cash flow machine. Last quarter, the company raised an astonishing $0.23 of free cash flow for every revenue dollar. This puts Core at the top of its class among oil servicers in the category of free cash flow, according to Bloomberg's Oilfield Service Report. More impressively, Core Labs increased net income by 12%, despite capital expenditures being only one-sixth of free cash flow.

Core Labs' ROIC
Data from Morningstar

Management lives by three tenets. The first two are to maximize free cash flow and return on capital, and the two are very much connected. Management's strategy of maximizing free cash flow acts as a competitor for capital within the company, ensuring that only the highest-return projects are allowed. It is no coincidence, then, that Core's return on invested capital (ROIC) is also at the top of that same Bloomberg report. Management expressly believes that stock performance over time is directly related to ROIC, and that belief has been validated by their stock, which has gained more than 2,500% over the last 10 years.

Looking at more recent earnings results, one thing about Core really stands out: constant process improvement in what it does. For example,

  • Margins have improved from 30.3%, from 29.7% in last year's first quarter.
  • Cost of product has declined to 68% of revenue, from 71%.
  • Core Labs continues to increase its revenue by 200 to 400 basis points above worldwide oil and gas activity.
  • Finally, this year we saw technological improvements bringing a 10% to 15% increase in lateral coverage for each horizontal well. This will especially help improve unconventional oil recovery rates.

Dividends are Core's third tenet, and they represent final outcome of the company's equation. Since the company is so disciplined in capital expenditure, all that free cash flow must go somewhere. That's where dividends come in. In the past two years, the company has increased dividends by double digits. I believe this will continue for the long term, because revenue and net income are growing steadily.

Core Labs' Dividends
Fast Charts

Core's stock is a victim of its own success, since the stock is trading well above its 15-year average P/E (the blue line) and its "fair value" (the orange line). Thankfully, this chart is also littered with 10%-plus pullback opportunities. Why? Often times, Wall Street's expectations get too exuberant, and the company's results "disappoint." As we can see, the steep drops have created opportunities when the stock trades well below its "normal" P/E. It is best to wait for these moments. Core Labs is a top-notch company, but it is well overvalued here, and we should wait for a pullback to add.

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