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David Einhorn’s Short Thesis on Core Laboratories (CLB) – SOHN Conference

Greenlight (David Einhorn) Sohn Investment Conference Presentation, May 8, 2017

“When a company raises fresh money from new investors to sustain the income requirements of existing investors, there is a name for that.”

Core Laboratories (CLB)

  • @ $113.43/share, $5B market cap and $5.2B enterprise value
  • Oilfield service business that helps energy companies analyze their reservoirs and increase their oil and gas recovery
  • Two segments: Reservoir Description and Production Enhancement
    • Reservoir Description: asset-light, lab-based business that analyzes reservoir rocks and fluids (71% of Revenue and 89% of EBIT in 2016)
      • Considered the technological leader in the field
      • Major oil companies rely on Core for analysis of their most complex reservoirs, where Core has earned a reputation for being best in class
      • Revenues and margins have been fairly stable because it specializes in multi-year projects, especially offshore and deepwater
    • Production Enhancement: provides tools and services related to well completion and production (29% of Revenue and 11% of EBIT in 2016)
      • Business sells perforating guns and charges primarily to frackers and offer well diagnostic services to E&P companies
      • Guns and charges are a competitive market in which Core competes against Titan, Schlumbuerger, and others
      • 2/3+ of this segment’s revenue comes from products rather than services which makes this segment a typical commodity price-sensitive OFS

Valuation

  • On consensus estimates, stock trades at 35x next year’s earnings and nearly 29x 2019 estimates
  • Trades at a massive premium to its OFS peers – more than twice the multiple of prior peak earnings
  • Two reasons bulls give to justify CLB’s valuation are Core’s seemingly secular growth and its industry-leading ROIC
  • Core is a non-capital-intensive business; analytically, the ROIC in a non-capital-intensive business is irrelevant because you can’t reinvest your profits to grow your earnings at the stated ROIC
    • Core could have twice as much lab equipment without gaining any new customers – it is flawed to value the stock based on its “industry leading ROIC”
  • As for the secular growth, think this is a misunderstanding that dates back to 2009 and still persists today
    • Last cycle: when oil price briefly collapsed in 2008, revenue of most OFS companies collapsed along with it; Core’s revenue fell too but only barely and much less than others in the industry; Core managed to maintain sales and even grow margins and subsequently, revenues and margins continued to climb
    • Core’s stability through the down-cycle followed by growth in the recovery gave the false impression that Core is a secular growth company
    • Analysts began hyping the company as a secular growth story generally immune to oil price volatility and investors agreed and re-rated Core to a non-cyclical growth stock multiple
    • Analysts were so convinced that at year-end 2014 after oil prices had already been cut in half, still projected that Core could maintain earnings through the downturn
  • Analysts and their projections were wrong – a 74% decline in earnings over 2 years should have made analysts and investors reconsider the narrative but they have not; they continue to value the company as a secular grower

Right place, right time?

  • In reality, Core is a cyclical business whose particular product suite was less affected by the 2009 downturn than other companies in the industry
  • Like all OFS businesses, Core has two primary revenue drivers: price of oil and end markets where investment dollars are being spent
  • Reading the annual reports, Core happens to be steeped in the hottest parts of the energy market in any given year
    • 2007: “Core will continue to emphasize execution of its time-proven strategies to produce additional growth internationally and in the natural resource plays of North America, which includes the Canadian oil sands, as well as tight-gas sand and gas-shale reservoirs”
    • 2009: “Over the past seven years, we have focused on international crude oil developments to capitalize on our peak-oil theory… The Company has focused on international development and production-related crude oil projects almost to the exclusion of more cyclical, exploration-related activities”
    • 2011: “Our continued focus on international crude-oil-related developments and unconventional oil from shale reservoirs enabled Core’s earnings per share growth to outpace almost all energy-related entities and industrial companies”
    • 2012: “The Company’s laser focus on international crude oil related developments, especially those located in deepwater, continue to serve our shareholders well… Core Laboratories will continue to laser focus its attention on worldwide deepwater developments, and that will position us very well for success and growth over the next decade”
    • 2013: “The Company’s laser focus on crude-oil developments, especially those in the deepwater and unconventional tight-oil plays that are primarily in shale reservoirs, continue to serve our shareholders well, as over 80% of Core’s revenue is now derived from oil-related projects. This percentage is likely to continue to grow as development of unconventional tight-oil shale reservoirs gain traction, not only in North America, but in the UK, Russia, North Africa, the Middle East, China, and Australia, among other places”
    • 2014-2015: “Our continued focus on worldwide crude oil related and large natural gas liquefaction projects, especially those related to the development of deepwater fields off West and East Africa, the eastern Mediterranean region and increased activity in the Gulf of Mexico”
    • Reading Core’s annual reports is like opening a time capsule preserving the history of energy market hype

Where Core actually makes money

  • GAAP reporting understates Core’s foreign exposure because when Core sends fluids from a well in offshore Angola to its labs in Houston, it counts it as US revenue
  • In earnings calls and company reports going back to 2009, Core says 70% or more of its revenue originates from reservoirs outside the US and last year it was closer to 80%
  • Core is best positioned in the most complex reservoirs so it is no surprise that deepwater drilling is its most important end market
  • Core is a company whose prime customers are big companies in big fields outside the US
    • Fundamentally, Core is tied to capital spending outside of North America
  • International crude-oil projects come with multi-million dollar budgets and typically last for several years; when oil prices collapsed in 2008, capex outside North America barely fell
    • Oil quickly recovered in 2009 and hovered around $100 for the next four years which led to a flurry of international capital spending
    • Because Core’s business is tied to this, its revenue held up in the down-cycle and then grew in the recovery right along with capex outside North America
    • In this down-cycle, oil prices have fallen further and stayed down longer – foreign capex has collapsed and this time, so have Core’s revenues
  • Unlike its more US-focused peers, Core was riding the internal capex cycle all along. It was never a secular growth story

Offshore Drilling / Offshore Servicers

  • With today’s oil price outlook, there are fewer multi-million dollar, multi-year, international deepwater projects that benefitted Core in the last cycle
  • Companies with heavy offshore exposure are clearly underperforming and market understands the outlook
  • Offshore spending, which today generates close to 50% of Core’s revenues and even more of its profits, is likely to decline for years to come
  • Leaders of Schlumberger and Halliburton point out that only North American shale investment is growing
    • North America isn’t a big opportunity in the high-margin Reservoir Description segment as shale doesn’t have complex reservoirs so there’s little need for the ultra-high tech services that Core specializes in
    • 1,000 ft core from deepwater offshore West Africa is a $2-3MM opportunity and a similar core in North American shale generates 1/10 the revenue
  • Unfortunately for Core, its opportunity in shale is mostly in the lower margin Production Enhancement segment where it sells big guns in a competitive market

Looking ahead

  • Analysts are calling for a V-shaped recovery in Core’s revenues over the next 4 years
  • Think Core is likely to miss estimates – with its dependence on offshore and international capex, Core should underperform some of the same North American oriented peers that it outperformed last time
  • On our estimates, Core is trading at over 36x 2019 earnings
  • A generous valuation would be a market multiple on mid-cycle earnings of $3.50 which we don’t think Core is likely to obtain until at least 2021 – gives a fair value of $62 or 45% below today’s price
  • At current prices investors are paying a peak multiple for earnings that are poised to disappoint
    • Investors aren’t the only ones overpaying: over the past upcycle, Core bought back stock every quarter regardless of share price and operational outlook
    • Core even resorted to drawing on its revolver to fund more buybacks as late as 2015
    • By mid-2016, Core was forced to reverse course and sell equity to avoid tripping covenant that could have put its dividend at risk
    • From 2012 through 2015, Core issued roughly $230 million in debt to purchase stock at an average price of $144/share then in 2016 sold $200 million in stock at $118/share to repay that debt
  • For the last 5 quarters, rather than cut the dividend, company has paid out more than it has earned and funded the shortfall by selling stock

David Einhorn is the founder of Greenlight Capital, a long/short hedge fund with an estimated AUM of over $10 billion as of 2015.

Image Source: Greenlight Capital SOHN Conference Presentation, May 8, 2017
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