Core's Strength Is in Its Services

 Core Laboratories (CLB) operates under a simple premise: The better that oil companies understand their reservoirs, the more oil they will ultimately produce. Core facilitates better understanding by providing the descriptive analysis of the geological and fluid characteristics of reservoirs to increase production both in the immediate term and over the life of the asset. Core's services are unique and highly valuable--the firm generates the highest returns on invested capital in the oil services industry and shows no signs of slowing down.

Understanding a reservoir involves three components: the qualities of the rock, how the fluids (oil, natural gas, and water) will flow through the rock over time, and how to prevent or mitigate damage to the reservoir, which could impair recovery. Core provides services for all three, on a piecemeal as well as an integrated solution basis. It is the only independent service company in the world to offer many of these services globally (although some of the international oil companies do comparable work internally), and its accumulated knowledge and capabilities have served as a substantial barrier to competition.

We believe the firm's prospects are very bright. Greenfield oil reserves have become more difficult to find and costly to extract, leading both independent and state-owned oil companies to spend an increasing amount of capital to maximize production at mature fields. Core's services almost perfectly align with this trend, since small differences in the reservoir recovery (several percentage points) can make large differences in the economics and lower the risk of these massive investments. As such, we believe the firm will increase revenue at a greater rate than overall growth in global exploration and production spending as oil companies increasingly rely on Core's expertise.

Data and Expertise Dig a Very Wide Moat
We believe Core's moat is as wide as they come. The company's three-year historical average return on invested capital (including goodwill) of 50% is currently the fifth highest of the more than 200 wide-moat companies we follow.

The primary source of Core's wide moat is its intangible assets. Working with clients to improve reservoir recoveries in oil fields around the globe, the firm has accumulated decades of geologic data, built considerable knowledge within its workforce, and developed numerous proprietary processes and products. We believe these intangible assets translate into a level of expertise that customers increasingly recognize as valuable and that will continue to create new opportunities for additional work.

Additionally, we think the firm benefits from a network effect by performing multiclient reservoir characterization studies. Producers agree to share information in a specific basin or resource play, such as the Permian, where Core has now signed up more than 60 firms to study the geology and reservoir characteristics. After the study has been completed, Core becomes the disseminator of best practices to improve production and reserves as the play is developed. The more producers that sign up, the more robust the data set and valuable the study is to all participants. Strong participation also means there is nearly zero likelihood that a competitor would be able to duplicate Core's work in a commercially successful manner. As a result, Core is positioned as the thought leader and premier provider of production improvement services in the region over the life of such a play, which in the majority of cases can last for decades.

Relatively More Insulated From Oil Price Shocks
The greatest risk facing the oil services industry is lower oil prices for a prolonged period. Lower oil prices would immediately constrain oil producers' capital spending budgets, which could lead to lower (or negative) revenue growth for Core Labs. It pays to think about how to position a firm in order to minimize the risk of lower oil prices, and Core has done just that. The firm concentrates its services on capital spending activity (by producers) related to improving flowing production and reservoir recovery, instead of exploration. In a commodity price downturn, producers are far more likely to maintain spending on producing assets, which insulates Core from downward shocks of oil prices far better than many of its oil services peers.

Management's Shareholder-Friendly and Forward-Thinking
CEO David Demshur and CFO Richard Bergmark established Core Labs through a leveraged buyout in 1994 and have led the firm with exemplary stewardship, in our opinion.

Management's philosophy for operating the firm is very shareholder-friendly. The company's three financial tenets are based on what its shareholders value most (and what we look for when analyzing companies): maximizing return on invested capital, increasing free cash flow, and returning capital to shareholders. To this end, management has been extraordinarily successful, achieving an industry-leading ROIC of 50% in 2013, increasing operating cash flow to nearly 10 times capital spending, and returning more than $1.6 billion to shareholders since its inception, in the form of dividends and share repurchases.

Aside from financial achievements, we like management's forward-thinking approach to strategy and rigid adherence to theoretically correct capital budgeting practices. Managers have publicly stated that they are peak-oil enthusiasts, which has directed the firm to focus on delivering services for production improvement over exploration in the context of a world where new reserves are increasingly difficult to find and exploit--a strategy that has paid off handsomely. Management's capital budgeting standards require new investment projects to deliver returns of at least 30%-40%. The high hurdle rate safeguards the firm's high ROICs from erosion from poor investments.