Core Meltdown? We Don't Think So

 Core Laboratories (CLB) hit a rough patch after two successive cuts to management's revenue outlook within three weeks. The effect on the share price has been severe: The stock is now down more than 25% from its all-time high in April. In total, $2.7 billion in value has been wiped out, even though earnings will still grow at least 9% and free cash flow will increase 10% this year, under the lower revenue estimate. We think the market's reaction misjudges the impact of management's guidance goof and dismisses Core's extremely wide economic moat, which drives industry-leading margins and returns on invested capital. Management could do a better job of monitoring business activity and timing communications to avoid a similar incident in the future, but the market's reaction was overdone and the stock is undervalued based on reasonable forecast assumptions.

What Happened?
Expectations for Core were high before the first-quarter report in April. The firm's full-year performance for 2013 included all-time highs for revenue and net income. Free cash flow for the year grew 28%, and the company hiked its dividend payments 56%. Instead of confirmation that 2014 would be another year of strong performance, the first-quarter results came with a warning that winter weather and Gulf of Mexico project delays (with emphasis on the weather) would result in about $5 million-$6 million less revenue than originally thought. However, management said strong activity levels in March provided confidence in its full-year guidance for earnings and cash flow.

A second guidance revision less than a month later shook investors' confidence. Management lowered its estimates for revenue, earnings, and free cash flow, after April came in far weaker than anticipated. The first-quarter results that included the initial guidance revision were released April 23--more than three weeks into the month. It is reasonable to expect that management had a sense of how April was turning out when it released its first guidance revision. In our conversations with the company, however, we learned that its executive team relies on feedback from operations managers and business unit presidents to assess intraperiod sales activity until a month-end tally is issued. To the best of our knowledge, Core has no quantitative short-term reporting system (such as a weekly sales report from its accounting system or business intelligence dashboard) in place. We find this troubling, since Core "meticulously tracks" core-taking activity at the industry level and, at its essence, is a company predicated on making decisions with data, rather than educated guesses. Had management previously instituted more timely methods of assessing sales activity, waited a week to determine whether the April sales figures confirmed its hypothesis of winter weather depressing activity, or given greater consideration to the possibility of error in its forecast and provided a wider range of outcomes, we believe it could have avoided the second guidance revision. We suspect that management took much greater caution in forming its most recent outlook, since the change lowered expected 2014 revenue by $55 million-$75 million, or more than 10 times the size of the original adjustment.

The management identified two primary causes for the lower sales, both in the reservoir description business unit: (1) core analysis projects in the Gulf of Mexico experiencing delays, which shifted multiple projects into the second half of 2014 and 2015, and (2) a slowdown in core and fluid activity related to several U.S. unconventional plays as producers shifted from initial drilling to development mode.

In the Gulf of Mexico, Core was anticipating nine major projects related to core and fluid analysis: three in the first half of the year and six in the second. All of the projects scheduled for the first half of the year were postponed, and the company now expects that it will perform five of the projects in the third and fourth quarters, with the remainder being pushed into next year. Even if there are delays beyond management's current estimates, the revenue associated with these projects is unlikely to be lost entirely.

With major core analysis projects, delays can come from multiple sources, but according to Core, these projects are rarely canceled. If a problem arises during drilling, coring can be deferred until issues are addressed, at which time a short sidetrack can be drilled to take the core. Alternatively, there could be no problem at all with drilling, but the client elects to pull core sections from alternating depths across several wells to get a better sense of the entire reservoir, rather taking the entire core from the first well drilled. In this case, the start of the project is deferred until all of the cores are taken, which consequently affects when Core is able to perform its analysis and recognize revenue.

Onshore North American unconventional activity is experiencing a lull, after producers in more established plays, including the Marcellus, Bakken, Niobrara, Montney, and Eagle Ford, reduced the quantity of cores and fluid samples it sent to Core for analysis. Attrition of analysis work as a play becomes better understood is to be expected. Well results become more consistent, and costs reach a threshold where there is diminishing room for improvement, decreasing the demand for additional analysis of the formation. What is unfortunate for Core, however, is that this maturing stage was reached by so many plays in such a short span of time. While management should have anticipated an eventual decrease in activity in these plays, we acknowledge that pinpointing the timing is difficult. The nature of these projects is fairly short term (around six weeks from start to finish), and the work is not under contract (for example, producers do not guarantee a specific number or feet length of cores to be delivered to Core for analysis over a specified time frame), so there is not a significant backlog to presage changes in activity. This increases the need for more-frequent reporting of activity, in our view.

Because Core discloses total revenue by geography and separately by business unit in its annual and quarterly reports, but does not reconcile the two, it is difficult to analyze the actual impact of fewer reservoir description projects in the United States. The timing issue is a blow to revenue and calls into question the ability for continued revenue growth. But we also think it is important to recognize that reservoir description activity from U.S. unconventional plays and the Gulf of Mexico is not as meaningful to the entire reservoir description business unit as the firm's reporting may suggest, because of GAAP reporting requirements.

According to the firm's reporting of revenue by geography, the U.S. makes up nearly 50% of revenue. Often, Core performs analysis and then subsequently invoices clients and books revenue within the U.S., but the core and fluid samples are not from fields located in the U.S. As a result, a decrease of revenue from U.S. unconventional or the Gulf of Mexico appears to have a much greater impact than is actually the case. After discussion with management, we believe 80%-85% of Core's reservoir description comes from international oil fields, and we estimate that the affected revenue streams from U.S. unconventional and the Gulf of Mexico actually make up only about 10% of Core's revenue, or about $100 million-$110 million. With revenue guidance decreasing by $65 million (using the midpoint), this could suggest that revenue associated with reservoir description of U.S. fields fell 60%-65%. If so, recovery of this revenue would be expected to take considerable time.

We do not think the slowdown signals permanent deterioration of the reservoir description business unit, however, because 80%-85% of revenue comes from work performed on cores and fluid samples that originated outside the U.S. In the U.S., activity levels in the Permian are going strong, and the firm said it now has more than 70 participants in its reservoir characterization study. Furthermore, activity will be picking up in a number of emerging U.S. shale plays, including the Tuscaloosa Marine Shale and SCOOP in the Woodford of Oklahoma. The availability of work on these plays is reasonably certain and expected for the latter half of the year. There is also a second phase of activity related to analysis to promote enhanced oil recovery. The catch is that the better Core did in its initial studies, the longer it may take producers to seek additional analysis. With shale plays realizing 5%-12% estimated recovery rates (according to Core), the demand for additional work will come, but the timing is uncertain.

Sources of Core's Wide Moat Still Intact
The main source of Core's wide Morningstar Economic Moat Rating stems from intangible assets in the form of its geologic databases, proprietary processes and products, and scientist workforce. Any weakening in Core's moat would come from three causes: similar product offerings by competitors creating pricing pressures, a shift in client attitudes toward the value of Core's offerings, and workforce attrition.

Pricing pressure from competitive offerings is highly unlikely. Core possesses decades' worth of geologic data accumulated from oil fields around the globe. The time and capital required to duplicate these databases, if possible, represent a nearly insurmountable obstacle for competitors. A shift in client attitudes, while more feasible, is also unlikely. Core's products and services are aimed at improving recovery rates and project economics. With oil above $100 per barrel and many oil producers raising concern about their returns on capital employed, better recovery and economics are paramount to the producers' future success. As long as the science behind Core's work produces results, we think client demand will remain steady. Core's workforce is stable as well. Attrition of the firm's scientist workforce is in the low single digits because employees like working for Core. Management has indicated that when staff does leave, it is generally for a position with one of the international oil companies. What they often find is that the nature of projects is much less diverse. Management believes that the variety of projects in which Core is engaged helps prevent burnout and retain staff.

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In its guidance update, Core did acknowledge that it was experiencing static demand and pricing pressure on some of its more basic and dated technology related to perforating charges. We believe this is normal over a product life cycle and do not think this foretells broader implications for Core's wide moat, as the impact is limited to less than 10% of total revenue, the firm's margins remain elevated and were unchanged in the guidance revisions, it has several more-advanced perforating product lines that are experiencing strong demand, and it is introducing a new perforating system technology in the second half of 2014.

Even with the disappointing cut, we found nothing in Core's guidance update that signals to us an impairment of intangible assets. The other source of Core's wide moat, a network effect driven by multiclient reservoir characterization studies, is unaffected by recent events, and we find no evidence of diminished producer interest in signing up for studies or competing studies from other firms to cause us to reconsider our wide moat rating.

Could a Wider Range of Guidance Better Serve Investors?
If the issues driving the lower guidance are mostly timing issues, and the assets driving the cash flow and return-generating capacity of the business are still intact, then why is there a problem? We've identified the need for closer monitoring of activity between month-ends, but we also think an issue is that guidance exhibits an overconfidence bias--the mistaken belief in an ability to forecast accurately, leading to too narrow a range of possible outcomes. Coming into 2014, management provided investors with full-year guidance in a range of 1.8% for revenue (from low to high) and 4.2% for earnings per share. These ranges were too narrow, in hindsight, but narrow ranges are not uncommon for Core.

Providing wider ranges might lead some analysts or investors to the conclusion that the short-term business results contain greater uncertainty, but this is a far better option than the negative consequences of a series of guidance revisions. For this reason, we increased our fair value uncertainty rating to medium from low. We believe the reliability of results (including the potential for upside surprises) is overstated with management's narrow guidance ranges, and investors should require a greater margin of safety when considering a position.

What Is the Right Valuation for Core Labs?
Core's competitive position is so strong that it has no direct rivals and consequently no reasonably comparable firms to help investors benchmark its valuation multiples. Despite industry-leading margins and return on invested capital, Core often seems overvalued when compared with so-called peers, or the oilfield service industry as a whole.

We believe a discounted cash flow approach is the most appropriate method of determining Core's intrinsic value. In the context of historical performance, our forecast calls for reasonable, if not conservative, growth of revenue and free cash flow. And compared with peers, Core's financial performance has exhibited far less cyclicality, so therefore we believe a lower assumed cost of equity is appropriate.

Our cash flow forecast has three primary considerations: revenue growth, operating margin, and free cash flow growth. Our revenue forecast for 2014 calls for 4% growth, in line with management's updated guidance. In 2015, we assume growth of 9.5%, in line with 2013, and we taper our annual growth rate to just under 7% by the end of our 10-year forecast. Overall, our forecast calls for average annual revenue growth of 7.8%, 270 basis points below the three-year historical average.

Our operating margin assumption is 32% in 2014, rising to just under 35% by the end of our forecast. While these margin levels are unprecedented historically, the trend is not. We believe revenue will continue to rise faster than costs, as it has in the past--from 2008 to 2013, Core's operating margin rose from just under 27% to 31%.

Lastly, the firm's ability to generate free cash flow is driven by the levels of working capital and capital spending. For capital spending, we assume 3% of sales. If anything, this overpenalizes Core's free cash flow. The absolute level of capital spending has stood at $30 million-$31 million since 2008, with the exception of 2009, when it fell to $17 million. We forecast capital spending to rise from $34 million in 2014 to $66 million by 2023. We model our working capital assumptions similarly, as a fixed ratio across the span of our forecast. Once again, we believe this assumption adds a degree of conservatism to our forecast, as Core has historically used its working capital position to increase cash flow.

The other significant driver of our valuation is the discount rate we apply to our cash flow forecast. At Morningstar, our cost of equity assumptions seek to estimate a firm's systemic risk. We believe the three most significant indicators of systemic risk are revenue cyclicality, operating leverage, and financial leverage. With industry-leading operating margins and capacity to pay off debt, Core's only significant systemic risk exposure is revenue cyclicality.

Our cost of equity assumption for Core is 8%. We believe Core will exhibit below-average cyclicality compared with peers, and indeed below-average cyclicality among energy firms more broadly. Over the past 10 years, the standard deviation of Core's revenue was lower than all other oilfield service firms' and less than half of the group average. When measuring the consistency of a firm's ability to generate free cash flow relative to its asset base, Core is actually more volatile than the peer group, but only because it has steadily increased free cash flow relative to its total assets, while the other oil service firms have oscillated within a fairly narrow range. We interpret this as an indication that Core needs far less growth in its asset base to increase its free cash flow, putting it at lower risk of ever needing to draw on external capital to produce growth.

Core holds an extremely wide moat and operates in a very attractive niche of the oilfield service industry. Growth is moderate, but the firm continues to expand its margins and its ability to generate free cash flow, which we believe will be supported as producers increasingly target reservoirs with higher costs and complexity. Management's gaffes on guidance create a buying opportunity for an enterprise that has consistently delivered the highest margins and return on invested capital in the industry. Despite lower revenue growth expectations for 2014, we expect free cash flow to increase 9% in 2014 and at an annual average rate of 8.5% over our 10-year forecast. Finally, a discounted cash flow analysis supports the premium valuation that investors have historically awarded the firm. Perceived high valuation multiples should not rule out Core as an investment consideration.