Core Lab Has the Strongest Moat in the Industry

We have long believed that Core Laboratories CLB is one of the highest-quality oilfield services companies. For one, it possesses the strongest economic moat across our entire oilfield services coverage. The company’s foundational core analysis business in the reservoir description segment, in particular, has been virtually unchallenged over the past three decades. The business passes the Warren Buffett quality test, whereby even an "idiot" could probably run the business with some profitability.

Yet, Core Lab has long been managed with the utmost skill, in our view. The 1998 acquisition of Owen Oil Tools and subsequent repositioning of the business to offer high-quality solutions for fast-growing U.S. shale markets was a stroke of brilliance. The combination of topnotch management plus a strong underlying business has delivered unrivaled returns on capital over the past two decades.

The downturn in oil and gas activity beginning in late 2014 has depressed financial results for most oilfield services companies, and Core Lab hasn’t fully escaped the effects. Comparatively, however, the company has fared well because of its focus on lower-cost U.S. shale in its production enhancement segment as well as its pivot to U.S. shale and international mature fields in its reservoir description segment. Overall, we think the company’s financial results will recover within range of 2012-14 average levels, somewhat exceeding the rebound to be experienced by many peers.

Only Wide Moat in the Oilfield We believe Core Lab has a wide moat, consistent with its long record of generating high returns on invested capital. For its reservoir description segment, the company draws primarily on intangible assets but also on network effects. In the production enhancement segment, Core draws on intangible assets.

The reservoir description segment houses Core Lab’s traditional business: analysis of cores (essentially small blocks of rock) from oil and gas reservoirs to determine rock and fluid properties of the reservoir. Core Lab’s ability to accurately measure this data from actual oil and gas-bearing rocks is the linchpin for data gathering across the entire oil and gas sector. All other methods of data gathering, such as seismic or the various wireline logging tools, only measure proxy variables and thus must be calibrated using Core Lab’s analysis of cores.

In reservoir description, intangible assets in the form of patents, proprietary technology, and human capital provide the foundation of its moat. Additionally, the company benefits from mild network effects.

The patents and proprietary technologies pertain to Core Lab’s laboratory equipment used in core analysis, as well as techniques and software used to translate equipment measurements into the desired final data output. The technology surrounding core analysis has changed immensely over the past several decades, but Core Lab has consistently maintained its edge at the forefront of core analysis by introducing new laboratory technologies and techniques. Knowledge from decades of training on core samples is encapsulated in the design of the equipment and the analytical techniques, presenting a nearly insurmountable barrier to any company wishing to replicate Core Lab’s business.

The human capital embodied in the company’s unrivaled staff of scientists and technicians is able to serve as part of the intangible asset moat source (rather than merely accruing to the employees in the form of wage premiums) because of Core Lab’s brand equity among current and potential employees. Core Lab has long been very generous to its employees, both in terms of remuneration as well as the quality of their work experiences. Perhaps most important, the company has rarely laid off employees during downturns. All of this has contributed to a very low employee turnover rate of 6%, with a turnover rate among senior scientists of about 2%.

Additionally, Core Lab benefits from a data network effect via its multiclient reservoir studies and joint industry projects. In these projects, a large number of exploration and production companies pool their resources under Core’s leadership to better understand a large oil and gas field. The participating companies relinquish the rights to their data to Core in exchange for the knowledge gleaned from the project. While these projects typically only account for about one fifth of reservoir description revenue, Core Lab is able to monetize the value from the network throughout its entire reservoir description segment via its ability to develop better technologies and data analysis techniques as a result of the project.

In reservoir description, Core Lab’s greatest source of competition in fact comes from its largest customers, the major oil and gas companies such as Exxon, BP, and Shell. These companies have long had in-house laboratory units that perform analysis similar to Core Lab. On average, about one third of these companies’ coring work is done by Core Lab, with the rest done in-house. This ratio has been stable for at least a decade, with Core typically handling the more complex work. No E&P has been successful in taking core analysis fully in-house, and moreover they all rely on Core Lab to supply the equipment for their own in-house laboratories.

Generally, other oilfield services companies have refrained from competing with Core Lab. Perhaps the most important reason is that these companies are customers of Core Lab and rely quite heavily on Core in developing their reservoir evaluation product lines. For example, the wireline evaluation businesses of Schlumberger or Halliburton must collaborate closely with Core in order to calibrate their wireline equipment using Core’s real petrophysical data samples. These businesses are much larger than Core’s business, and the large service companies are reluctant to jeopardize their partnership with Core in order to make a run at Core’s much smaller (albeit very profitable) niche business.

In fact, these companies have to a great degree focused on technologies complementary to Core’s business. For example, Halliburton’s CoreVault service lowers the cost of collecting core samples in many applications. Given that Core Lab has no interest in collecting cores, only in analyzing them, a product like CoreVault could only be positive for Core Lab.

One large exception where the large oilfield services companies have sought to compete with Core Lab is in the development of downhole, or in situ, analysis tools. However, these tools compete only indirectly with Core Lab and offer the prospect of a much quicker performance of core analysis at the expense of a lower quality of measurement compared with using traditional laboratory equipment as espoused by Core. Such a trade-off can be appealing in situations where time is very valuable relative to the cost of decision-making quality, such as when drilling on a deep-water rig costing $1 million per day. We think these downhole tools are more likely to expand the available use cases for core analysis more so than displacing Core Lab’s work in existing use cases.

A reasonable parallel to relationship between laboratory and downhole core analysis lies in the advent of logging while drilling. While some in the 1990s touted LWD as being able to eventually supplant traditional wireline logging, traditional wireline has maintained solid growth since then as well as a still-dominant share of the logging market.

We believe Core Lab has a very strong narrow moat in its production enhancement segment. Production enhancement has generated profitability on par with reservoir description in recent years, and we expect profitability to be similarly strong over the next few years. Core Lab built production enhancement via a series of small acquisitions in the late 1990s, and since then the segment has yielded the company large amounts of value by focusing on niche, high-margin products and services greatly exposed to fast-growing U.S. shale. Overall, the segment taps into intangible assets in the form of a network of patents and proprietary technologies as the chief moat source.

Product sales generally account for two thirds of segment revenue, and perforating systems, designed to cut holes to connect wellbores with oil and gas reservoirs, account for most of product sales. The value of high-quality perforating systems increased dramatically with the advent of U.S. shale, and Core Lab has been able to take strong advantage of this by offering the highest-quality perforating systems in the industry.

Core Lab holds perhaps about a 25% global market share in perforating systems, but it holds a dominant position in premium charges for perforating systems, which carry very high margins. Core has held this position since the early 2000s, when it first developed the technology. Thus far, Core has largely been unchallenged in premium charges. The most logical competitor, U.S. shale and completions expert Halliburton, did establish a nominal competing offering in 2012 (MaxForce-FRAC) but hasn’t mentioned the product at all except for one 2015 case study.

The remaining one third of segment revenue is accounted for by diagnostic services, which consist largely of chemical tracer technologies used to track the flow of fluids through oil and gas wellbores and reservoirs. Core has been very successful in developing technologies that address the needs of U.S. shale, such as tracers which measure to what degree frac fluid or proppant is evenly distributed across the shale formation during the hydraulic fracturing process. Core probably has over half of the U.S. shale tracers market, and these products have carried margins on par with the rest of the segment.

Given the comparative lack of uniqueness of this product-focused segment (compared with reservoir description), as well as the segment’s dependence on a relatively narrow set of product lines, we stop short of assessing production enhancement’s moat as wide, as we do for reservoir description and Core Lab as a whole.

Lower Oil Prices a Risk Core Lab faces obvious risk from sustainably lower oil prices, which would lead to lower overall oilfield expenditure levels and thus lower financial results for the company. However, the company's focus on producing fields that essentially sit at the low end of the industry cost curve gives it more insulation than most peers against a weaker industry environment.

On a company-specific level, Core Lab faces the most significant risk surrounding its key sources of intangible assets underpinning its moat, such as its many patents, proprietary technologies, and human capital. Although our wide moat rating evinces a very high level of confidence in Core Lab’s moat, we cannot rule out the possibility that competitors could substantially replicate large portions of Core Lab’s technology and poach Core Lab’s highly skilled scientific staff.

As expected for a company that has long generated very high returns on capital, Core Lab has superb financial health. Unlike some similarly high-quality peers, management is not averse to debt--the company elected to build up net debt in 2015 in order to finance its hefty dividend and share buybacks. Net debt peaked that year at 2.2 times adjusted EBITDA. We expect net debt to fall to about 1 times adjusted EBITDA by the end of 2021, even as the company maintains its historical dividend of over $2 per share. The company’s very strong profitability, combined with its very low capital expenditure needs, means that under virtually no scenario should Core Lab need to tap the financial markets in the coming years.