Staying the Course with a Core Labs Short

One of my ongoing shorts has been Core Labs. I took on the position after reading David Einhorn’s thesis. One of the blogs I like to read is csinvesting, by “John Chew”, a treasure trove of value investing knowledge. John posted the Einhorn thesis for discussion back in May. I initially disagreed with Einhorn but after researching some of the points Einhorn brought up, I came around to his idea and went short the stock. I discussed the Core labs presentation in a comment on that blog, so I’ll repost my thoughts here:

I did my own work on this, and came to an analysis that it wasn’t an easy short because it could be trough earnings, and that reinvestment at its high ROIC would make the upside scenario too dangerous.

I did analyze the two business segments, but mistakenly thought that Production Enhancement was the area that would suffer going forward, because, like many analysts, I thought the Reservoir Description business would benefit from secular growth. I thought that this would provide a floor for earnings going forward, and that any upside from Production Enhancement revenues might make the earnings meet analyst guidance.

Einhorn did a fantastic job here of highlighting the precarious nature of their core business, Reservoir Description, because of its dependence on international offshore revenues. Furthermore, he made a great point that these complicated projects are planned out years ahead, so the revenues in Reservoir Description would not show any decline from the drop-off in Offshore until a few years after the drop in oil prices. This is particularly deceptive if you look at numbers from the 2008-2009 oil price drop, or even the drop-off in revenues 2014-2015, because it takes a while for all the pre-existing offshore projects to roll off.

It pains me a bit to say it, because I was a shareholder in Core Labs in the early 2010’s – I talked to David Demshur before and he was a great guy, and I really believed in the bull argument for this stock – but I do happen to agree with Einhorn after reading through his presentation. If the crown jewel of Reservoir Description is truly correlated to international and offshore, it might be more vulnerable than most analysts expect. Since the growth path forward will be dependent on Production Enhancement, which ought to have a lower ROIC than Reservoir Description, the upside risk may not be as high as I originally thought.

On a side note, I disagree a bit on his characterization of Demshur – while he may be promotional at times, I don’t think he intentionally was seeking to mislead investors.

As PW noted, one of the important things I learned is that ROIC is only as good as your reinvestment opportunities. After all the Buffett quote is that the best business is one that employs LARGE AMOUNTS of incremental capital at very high rates of return, not one that uses all of its incremental capital (and then some) to pay a dividend.

I shorted at $102. Since then, Core Labs has declined significantly in price, but I’m still holding the short position.

I believe Core Labs is priced as if earnings were about to accelerate back to 2012-2014 levels. Earnings are running in the $60-70 million range, with FCF in the $100 million range. The stock currently has a P/E multiple of 55 (minimal net debt, so P/E is probably fine to use). Even if you believe Core Labs is an incredible business with a high ROIC, if the company cannot reinvest and cannot grow, an appropriate multiple is probably around 30.

I think Core Labs will have trouble growing earnings because the major shale basins are running into production problems. They are reaching natural limits on lateral length and suffering from a phenomenon called “frac hits” which is dropping production and impacting the economics of infill drilling in shale wells. Core Labs is pivoting to Enhanced Oil Recovery techniques, but these techniques have really only been tested in the Eagle Ford reservoir, so it will take some time to prove this technology in the Permian. In the meantime, E&P’s still aren’t investing in major offshore projects, so the Reservoir Description segment ought to continue to suffer or remain stagnant.

Rig count growth is moderating and may actually decline in the latter half of this year, especially if E&P’s continue to suffer from frac hits in infill wells. This ought to keep Production Enhancement revenues steady at best, or declining at worst. Unless there is rapid adoption of EOR in the Permian and other basins, I don’t think Core Labs can increase earnings.

If earnings don’t increase quickly, then the stock will have to reprice. At 30X earnings, the stock should trade in the low $50’s. I will continue to hold until I see signs of rapid adoption of Enhanced Oil Recovery techniques, a pickup in deepwater drilling, or the stock hits my target.

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