Core Laboratories Inc. /DE/ Q2 FY2021 Earnings Call

Good morning and welcome to the Core Lab Q2 2021 Earnings Call. Please note that this event is being recorded. I would now like to turn the conference over to Mr. Larry Bruno, Chairman and CEO of Core Lab. Please proceed.

Thanks, Ian. Good morning to you in the Americas, good afternoon in Europe, Africa and the Middle East, and good evening in Asia-Pacific. We would like to welcome all of our shareholders, analysts, and most importantly, our employees to Core Laboratories second quarter 2021 earnings call. This morning, I am joined by Chris Hill, Core’s Chief Financial Officer and Gwen Schreffler, Core’s Senior Vice President and Head of Investor Relations. The call will be divided into six segments. Gwen will start by making remarks regarding forward-looking statements. We will then have some opening comments, including a high-level review of important factors in Core’s Q2 performance. In addition, we will review Core’s strategies and the three financial tenets that the company employs to build long-term shareholder value. Chris will then give a detailed financial overview and have additional comments regarding shareholder value. Following Chris, Gwen will provide some comments on the company’s outlook and guidance. I will then review Core’s two operating segments, detailing our progress and discussing the continued successful introduction and deployment of Core Lab’s technologies as well as highlighting some of Core’s operations and major projects worldwide. We will then open the phone for a Q&A section. I will now turn the call over to Gwen for remarks on forward-looking statements.

Before we start the conference this morning, I’ll mention that some of the statements that we make during this call may include projections, estimates and other forward-looking information. This would include any discussion of the company’s business outlook. These types of forward-looking statements are subject to a number of risks and uncertainties relating to the oil and gas industry, business conditions, international markets, international political climate and other factors, including those discussed in our 34 Act filings that may affect our outcome. Should one or more of these risks or uncertainties materialize or should any of our assumptions prove incorrect, actual results may vary in material respects from those projected in the forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. For a more detailed discussion of some of the foregoing risks and uncertainties, please see Item 1A Risk Factors in our most recent Annual Report on Form 10-K as well as other reports and registration statements filed by us with the SEC and the AFM. Our comments include non-GAAP financial measures. Reconciliation to the most directly comparable GAAP financial measures is included in the press release announcing our second quarter results. Those non-GAAP measures can also be found on our website. With that said, I will pass the discussion back to Larry.

Thanks, Gwen. First, our thoughts remain with all of those that have been affected by the global pandemic. While there are certainly reasons for optimism as the vaccines become more widely distributed throughout 2021 and as demand for oil and gas continues to recover, global case counts hit their highest levels since the beginning of the pandemic during the second quarter of 2021. Virus-related issues are still causing unpredictable schedules in our clients’ activities, travel complications and logistical hurdles for field services and product shipments, particularly outside North America. A number of countries across our global operating network such as Brazil, Indonesia, Malaysia, Kuwait and India, saw increasing case counts and many countries maintained, enacted, reenacted or expanded precautionary measures, travel restrictions and even lockdowns during Q2. Even as we progress through Q3, some countries are still at or near the highest caseload levels they have experienced over the course of the pandemic. Despite these hurdles, Core remains ready to fully service our clients’ needs. As discussed in our last earnings release, no operational impacts of the Q1 winter freeze were expected in Q2 and none occurred. We did however incur expenses related to temporary measures that had to be deployed at several facilities throughout Q2. These temporary measures are now concluded and permanent repairs have been completed. Looking at Core Lab’s performance in the second quarter of 2021, the company saw increased revenue, increased EBITDA, increased free cash flow, and increased EPS compared to Q1. At the same time, Core continued to execute on its strategic financial objectives by reducing net debt and improving its leverage ratio compared to the first quarter. Client activity in both business segments improved sequentially. Reservoir Description, having greater international exposure, did face some continuing pandemic-related headwinds and project delays during the quarter. Core’s Production Enhancement segment exceeded sequential top and bottom line expectations with U.S. energetic sales nicely outpacing the growth in completions. The company remains optimistic about the remainder of 2021 as activity in North America continues to show improvement and international activity builds momentum. Before we move on, I want to thank Core’s management team and employees for their hard work during the unprecedented challenges of the past 15 months. I also want to thank them for their dedication, loyalty and adaptability in meeting all of our clients’ needs and for the personal sacrifices that many have endured as we navigate the moment and prepare for a more active market. I will now turn it over to Chris for the detailed financial review.

Thanks, Larry. Before we review the financial performance for the quarter, the guidance we gave on our last call and past calls specifically excluded the impact of any forex gains or losses and assumed an effective tax rate of 20%. So, accordingly, our discussion today excludes any foreign exchange gain or loss for current and prior periods. Now, looking at the income statement, revenue from continuing operations was $118.7 million for the second quarter, up almost 10% from $108.4 million in the prior quarter. The increase is primarily associated with strong demand for our energetic products in both the U.S. land and international markets. While we expect the growth in U.S. land activity to moderate, we expect the current momentum for international activity to continue building for the remainder of 2021. Of this revenue, service revenue, which is more international, was $86.3 million for the quarter, up about 3% sequentially from $84 million last quarter. The increase in service revenue is partially associated with the disruption caused by the winter storm in the first quarter. However, as Larry stated earlier, additional growth in the quarter was tempered due to ongoing pandemic disruptions and restrictions in many regions outside the U.S. Product sales, which are equally tied to North America and international activity, were $32.5 million for the quarter, a strong 33% increase from the previous quarter. Nice growth in the U.S. land activity resulted in even stronger demand for our perforating and energetic products in the U.S. Additionally, international product sales were also strong as some larger orders were completed in the quarter. Moving on to cost of services, ex items, for the quarter was just below 78% of service revenue compared to 76% for the prior quarter. The increase in cost of services was negatively impacted as the company is in the process of restoring some temporary cost reduction measures previously put in place during the pandemic. As we progress further into the recovery with operational activity and our laboratory utilization improving and employee costs fully restored, our incremental margins on service revenues will improve and trend towards historical norms. Cost of sales, ex items, in the second quarter was 82% of revenue and has improved from 84% last quarter and for the last four consecutive quarters. As product sales continue to grow, manufacturing efficiency and absorption of fixed costs will also continue to improve. General and administrative expenses, ex items, for the quarter were $9.7 million compared to the last quarter of $7.7 million. Year-to-date, G&A is $17.4 million compared to $22 million for the same period last year. As we progress through 2021, the timing and extent to which we have restored and continue to restore employee compensation levels has also impacted our G&A expense for future quarters. Depreciation and amortization for the quarter was $4.8 million and pretty flat compared to the $4.9 million last quarter. EBIT, ex items, for the quarter was $13.2 million, up 10% from $12 million last quarter and representing an EBIT margin of over 11%. Our operating income for the quarter on a GAAP basis was $12.8 million. Interest expense was $2.5 million and down from $3.2 million in the last quarter, ex items, reflecting the decrease of our long-term debt at the end of last quarter. Income tax expense for the quarter was $2.1 million at an effective tax rate of 20%. The effective tax rate will continue to be somewhat sensitive to the geographic mix of earnings across the globe and the impact of items discrete to each quarter. However, we continue to project the company’s effective tax rate to be approximately 20%. Income from continuing operations, ex items, for the quarter was $8.5 million, up approximately 22% sequentially from $7 million last quarter. GAAP income from continuing operations was $8.2 million for the second quarter of 2021, which is comparable to last quarter. Earnings per share from continuing operations, ex items, was $0.18 for the quarter, also up 20% from last quarter. GAAP earnings per diluted share from continuing operations was $0.17 for the quarter. Moving on to the balance sheet, receivables were $93.2 million and increased approximately $7 million from the prior quarter. However, our days sales outstanding for the second quarter have improved to 64 days, which are down from 66 days last quarter. Inventory ended the second quarter at $38.9 million, down slightly from approximately $39.1 million last quarter. Inventory turns continue to improve with increased product sales. For the remainder of 2021, we continue to anticipate inventory levels to decrease slightly, however, less than previously expected, as we are now projecting to carry larger quantities of raw materials to help mitigate longer lead times in the supply chain and an increase in the cost of raw materials. On the liability side of the balance sheet, our long-term debt was $210 million at the end of the second quarter. And considering cash of $33.6 million, net debt was reduced to $176 million or a decrease of $5.8 million from prior quarter end. Our leverage ratio was 2.18 as of June 30, which is also down from 2.33 last quarter and is anticipated to continue decreasing. Our debt is now comprised of four series of senior notes. Of these notes, $75 million is coming due on September 30, 2021 and will be retired using excess cash and excess capacity on our $225 million credit facility. Currently, there are no borrowings and over $214 million in borrowing capacity under the facility. We will continue with our longer term strategy to delever the company. Looking at cash flow, for the second quarter of 2021, cash flow from operating activities was $9.5 million. And after paying for $2.9 million of capital expenditures for the quarter, our free cash flow was $6.6 million, up from $5.2 million in the first quarter. Capital expenditures for 2021 will continue to be aligned with activity levels and growth opportunities. The company continues to anticipate activity levels will improve in the second half of 2021 and we would also expect our capital expenditures to increase, but remain in line with historical levels while in a growth period. Core will continue its strict capital discipline and asset-light business model, with capital expenditures primarily targeted at growth opportunities and initiatives. This also marks another quarter where Core Lab generated positive free cash flow and we are projecting to continue generating positive free cash flow as we look ahead to the remainder of 2021 and beyond. We believe evaluating the company’s ability to generate free cash and free cash flow yield is an important metric for shareholders when comparing company’s financial results, particularly those shareholders who utilize discounted cash flow models to assess valuations. I will now turn it over to Gwen for an update on our guidance and outlook.

Thank you, Chris. For the remainder of 2021, the company will continue to execute our strategic plan with a focus on generating free cash flow and reducing net debt while maximizing return on invested capital. Additionally, as part of the company’s 2021 strategic focus, we will continue to invest in targeted, client-driven technologies that aim to both solve problems and capitalize on Core’s growth opportunities. The company remains well positioned to meet the needs of our clients with ample liquidity to invest in its global capabilities. These capabilities include our expanding proprietary databases, along with innovation in artificial intelligence and machine learning, which are the foundation of Core’s transformation digital technologies. With the rapid onset of COVID-19 variants and continued market disruptions, the pace of economic reopening has slowed. However, we remain optimistic about our growth opportunities throughout the remainder of 2021. As the momentum for international crude oil markets continues to build and U.S. activity continues to moderately progress, strong crude oil commodity prices, the lack of investment in international and offshore crude oil development and increasing crude oil demand continue to support a recovery of the energy industry over the mid- to long term. These crude oil market circumstances are resulting in an increase in the international rig count and heavy oilfield equipment coming under contract, which are leading indicators of a growing international cycle. With having more than 70% of our revenue exposed to international activity, we remain active on international projects. As additional field development projects emerge, wells need to be drilled and reservoir rock and fluid samples collected before Reservoir Description realizes a revenue opportunity. The expansion of the international market provides growth opportunities for the company into the second half of 2021 and beyond, with a particular focus on the South Atlantic margin, Mexico, and the Middle East. Considering the improvement in international activity and the U.S. land activity projected to grow modestly from the second quarter level, we project third quarter revenue to range from $122 million to $126 million and operating income of $14 million to $15 million, yielding operating margins of approximately 12%, with incremental margins, ex items, of 20% to 25%. As stated during the second quarter outlook in April 2021, as employee costs are reinstated into the company’s cost structure, incremental margins will be temporarily impacted. Once these costs are fully restored, we will expect our historical incremental margin performance or better. EPS for the third quarter 2021 is expected to modestly improve to approximately $0.19 to $0.21. Core’s third quarter 2021 guidance, when compared to our third quarter 2020 performance, represents double-digit international and company growth in revenue. In summary, we see activity levels and financial performance improving throughout the remainder of 2021. Core’s growth opportunities are directly related to existing long-term projects returning to normal workflows as well as expanding client activity and new market penetration, particularly internationally. The company’s third quarter 2021 guidance is based on projections for underlying operations and excludes gains and losses in foreign exchange. Third quarter 2021 guidance also assumes an effective tax rate of 20%. Now I will turn it back to Larry.

Thanks, Gwen. First, I’d like to thank our global team of employees for providing innovative solutions, integrity and superior service to our clients. The team’s collective dedication to servicing our clients is the foundation of Core Lab’s success and has been very visible during the current challenges. Turning first to Reservoir Description, for the quarter, revenue came in at $78.3 million, up 2.3% sequentially. However, operating income and margins were negatively impacted as the company is in the process of reinstating temporary cost control measures and pandemic-related project delays continue to weigh on operational efficiencies. International projects have progressed at a slower and less linear pace than anticipated thus far. By the nature of the business, Reservoir Description’s performance historically has lagged directional changes in client activity. Looking back to 2020, Reservoir Description margins averaged over 15% for the full year at a time when many industry players struggled to maintain profitability. As industry activity recovers, Reservoir Description will respond more slowly than oilfield service companies with direct exposure to well construction and other early cycle client spending. As we look ahead, we see the growing international rig count as a harbinger of an improving landscape for Reservoir Description, a trend that we project will play out over the next several quarters and throughout 2022. Now to some operational highlights. During the second quarter of 2021, Core Lab, under the direction of Reconnaissance Energy Africa Ltd, was engaged to provide laboratory analysis on conventional cores from exploratory wells in the Kavango Basin in Northeastern Namibia. The laboratory program for this ReconAfrica project is leveraging a number of proprietary and patented technologies, such as Core Lab’s RAPIDZoom service, to assess rock properties and identify prospective reservoir targets over a thick interval of predominantly marine strata. RAPIDZoom allows the scientists involved in the project to collaboratively examine the core samples at high resolution, revealing details on lithology, sedimentary structure and stratigraphic relationships, all while working from remote locations. The analytical program for these Kavango Basin cores also includes Core’s proprietary native-state electrical properties laboratory testing, which allows for both improved calibration of downhole electric logs and expedited assessment of oil in place. Core Lab is very pleased to be assisting the technical experts at ReconAfrica in their evaluation of potential reservoirs in this expansive onshore sedimentary basin. Also in the second quarter, Core Lab continued to see growing opportunities related to carbon capture and storage. Core’s immediate opportunities in this area are in evaluating the storage systems. Specifically, these include evaluating the geologic attributes of the rocks that form the storage container as well as the rock that forms the seal or the lid on the stratigraphic container. Core is also tasked with determining reactions that occur between the injected CO2 and the rocks as well as the flow efficiencies of CO2 as it passes through the pore systems of the rock. In addition, laboratory tests are needed to identify reactivity between the CO2 and any hydrocarbons and/or formation brines that are present in the pores of the rocks, where hydrocarbons are present in the storage rock, such as in depleted or partially depleted crude oil reservoirs, the impact of CO2 on the hydrocarbon system needs to be evaluated with laboratory testing. This testing will determine if the injected CO2 will positively impact oil production that is present an enhanced oil recovery opportunity, or negatively impact oil production by perhaps causing asphaltene precipitation and resulting in permeability impairment. Core is currently assessing CO2 injection and enhanced oil recovery opportunities for a client on a project in Western Canada. Using proprietary reservoir fluid miscibility and core flooding technologies, Core Lab is determining the interaction between the remaining crude oil in place and the injected CO2 in order to assess the economic feasibility of this potential EOR opportunity. This is just one example of the carbon capture and storage opportunities that are emerging for Core Lab. In all carbon capture storage programs, direct physical laboratory measurements of the rock and fluid properties will be an essential part of evaluating subsurface CO2 injection opportunities. Moving now to Production Enhancement where Core Lab’s strengths in both energetic systems and completion diagnostics help customers optimize their well completions. Revenue for Production Enhancement came in at $40.5 million, up over 27% sequentially, exceeding the company’s second quarter ‘21 projections. Operating income was $3.9 million, up over 100% sequentially. Operating margins were 9.5% for the second quarter of 2021, up over 380 basis points sequentially. During the second quarter of 2021, Core Lab saw expanding market acceptance of its innovative proprietary Pulse Wave technology. The Pulse Wave system was used to generate perforations in a complex injection well. Pulse Wave uses a unique energy transfer technology to trigger multiple unevenly spaced perforating guns in a single downhole trip. Traditionally, operators would place a series of inert guns between the live guns to create a continuous communication stream. This is a time-intensive process requiring multiple downhole trips. These types of configurations may lead to extended rig times and can have lower reliability. In the second quarter of 2021, a client expressed the need to complete a horizontal well with predetermined, unevenly spaced stages with an aim to maximize injection efficiencies. Utilizing the Pulse Wave system, perforating guns were loaded with up to 20 perforating charges per gun with intervals varying from 125 to 284 feet between each live gun. By using Pulse Wave to sequentially trigger the live guns, the system eliminated the need for hardwired gun-to-gun connections and thus multiple potential failure points. The perforation operation was performed as planned and resulted in the client saving over 30% on the cost of consumables, plus reduced rig time. The client was very satisfied with the high reliability and effectiveness of the Pulse Wave system. They are currently making plans to expand the use of Pulse Wave for future injection wells and potentially for reperforating existing hydrocarbon producing wells. Pulse Wave is just one of many Core Lab energetic technologies that were developed by our internal team of experts. Core’s cost-efficient internal pipeline of new technology offerings is a cornerstone of the company’s success. Stay tuned for more details on new, client-driven energetic solutions that are being developed by the Core Lab team. Also in the second quarter of 2021, Core’s completion diagnostic services were on display. Core’s PACKSCAN technology was used in an offshore South Atlantic margin development project to assess the effectiveness of an open-hole horizontal gravel pack. In offshore environments, operators often complete wells using a gravel pack. The goal is to gravel pack the screen annular space in order to stabilize the formation and control the entry of formation fines during production. The traditional method for assessing the competence of gravel packs is a standard density log, which measures the relative density across the gravel pack. To better assess the quality of the gravel pack, Core deployed its proprietary high-resolution PACKSCAN tool to detect even minor gravel pack anomalies. The PACKSCAN tool identified a void in the annular pack that would have led to screen erosion and, ultimately, a failure of the completion. After reviewing the PACKSCAN log, Core's diagnostic engineers recommended that the operator bring the well onto production at a lower rate, which would enable the annular void to be filled in from the ample reserve gravel that was in place above the producing interval. Based on Core’s recommendation by using this data-driven approach, the client decided to bring the well’s production on slowly, minimizing the risk of a very expensive completion failure. That concludes our operational review. We appreciate your participation, and Ian will now open the call for questions.

It looks like your first question comes from Connor Lynagh of Morgan Stanley. Please proceed.

Yes. Thanks. I wanted to talk about Reservoir Description. Obviously, international is the big driver there. We’ve gotten some fairly explicit guidance or at least long-term estimates of activity growth from some of the large-cap service providers out there. I’m curious, how should investors think about this on a structural basis? Would you say that you’re going to grow at a similar rate but at a lag, like you’re alluding to? Do you think it’s maybe a bit more muted because the well construction side of things is a bit higher growth this cycle? Just a high-level framework for how people should think about that.

Yes. Connor, good question. We try to get that message out. It’s often easy to just sort of look at the macro trends from some of the bellwethers in the industry and say, hey, everybody should be moving at the same pace. The heavy metal companies have to get into play before Reservoir Description gets its turn. The way I would clarify that further is to say we tend to lag the well construction side of the business. We will eventually catch up, and then we will exceed the rate of growth in well construction. That has historically been our trend, which will carry well into the next cycle.

Got it. That’s helpful context. One thing that is a bit different this time around, you guys have historically talked about a large portion of R&D being related to producing fields. And obviously, there is a fair bit of production offline in previously producing fields. So I guess, I’m curious, is there a significant portion of the revenue downdraft that you’ve seen that’s related to those producing fields?

No. I think you’re seeing it the right way. We still have clients that are out of the office, making it hard to predict when they will return. We have encountered situations in Asia Pacific where large clients shut their office for a couple of weeks due to lockdowns. The unpredictability of this recovery is challenging for us in terms of planning as projects may slip into the following quarter.

Okay, thank you very much. I will turn it back.

Thanks, Connor.

Your next question comes from John Daniel of Simmons. John, please proceed.

Thank you. No longer at Simmons. So, very quick question for you on the Kavango Basin and the offshore opportunity? Years ago, there was always some excitement about new shale opportunities in North America. I’m just curious, are we about to see this again or any color on that would be helpful?

Yes. This is an intriguing sedimentary basin onshore that has a lot of opportunity for various prospective productive horizons and traps. For details on the play or the prospect, it’s best to talk to our good friends at ReconAfrica. But we are glad to be helping them.

Okay. I have got two more quick ones for you, just on the Pulse Wave. How widespread is this product? Is it just recently introduced? What’s the opportunity set? And does it potentially cannibalize any of your existing products?

No. We have discussed it in prior releases over the years. People are recognizing the advantages of having tubing between the sections of live guns rather than a series of inert guns. Particularly where there is uneven spacing involved in a recompletion, this system presents real advantages. I think there are growth opportunities for us ahead.

Okay. Thank you. And then the last one is sort of just a big picture question. And this relates more to your North American operations. Are you in the camp that we see normal Q4 seasonality, thus potentially a dip late this year or do you see an acceleration as people prepare for next year?

From the feedback we're getting from our clients, we are not seeing alignment for a typical end-of-year slowdown. We see modest growth continuing. However, some last-minute rollovers leading to a dip late in Q4 is not unlikely.

Okay. Thank you very much.

Okay, John.

Our next question comes from Mike Sabella, Bank of America. Please proceed.

Hey, good morning everyone.

Hi Mike.

So, it looks like the guidance here has implied some pretty decent incrementals at the segment level in Q3 sort of beyond what the 20% to 25% that you quoted assumes, if we just assume corporate and other goes back to normal levels. Are we now back to an area where we can start expecting strong incrementals at the segment level or could we still see some noise in the near-term?

Yes, Mike. That’s a good observation. We did have some benefit in the second quarter that was sort of other income. That is usually tied to a handful of things not directly connected to operations. The incrementals are a little higher than forecasted for the total company. It is still in play for the third quarter, but some downward pressure remains as we restore employee costs and other temporary measures. As activity picks up, you will see us return closer to our normal incremental rates, which can be around 50% to 60% or more. This could begin to pick up in Q4 but will largely depend on activity levels.

Got it. Thanks. And then I was kind of hoping maybe we could just step back and maybe you give us an update on what the competitive landscape looks like in Reservoir Description. I know in the past, you’ve said it’s really your #1 competitor is the customer, whether they outsource or not. Is that still the case?

No major changes. Over decades during down cycles, companies tend to eliminate internal laboratory testing capabilities and outsource. That trend continues. There has been less in-housing over time as some companies have downsized internal laboratories, which sets us up nicely for the next cycle.

Understood. Thanks everyone.

Thanks Mike.

Thanks Mike.

In summary, Core’s operational leadership continues to position the company for improving client activity levels throughout the second half of 2021 and into 2022. While there are still operational uncertainties in the near to mid-term, many opportunities lie ahead. We have never been better operationally or technologically positioned to help our global client base optimize their reservoirs and address their evolving needs. We remain uniquely focused and are the most technologically advanced, client-focused reservoir optimization company in the oilfield service sector. The company will remain focused on generating free cash and returns on invested capital. In addition to our quarterly dividends, we will bring value to our shareholders via growth opportunities driven by both the introduction of problem-solving technologies and new market penetration. In the near-term, Core will continue to use free cash to strengthen its balance sheet. So in closing, we thank and appreciate all of our shareholders and the analysts that cover Core Lab. The executive management team and the Board of Core Laboratories give a special thanks to our worldwide employees that have made these results possible. We are proud to be associated with the continuing achievements. So, thanks for spending time with us, and we look forward to our next update. Goodbye for now.

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.