Core Laboratories Inc. (CLB) Earnings Call Transcript & Summary

I'm Sean Meakim, the Oil Services Analyst at JPMorgan. Welcome to the Fifth Annual JPMorgan Energy Conference. I'm here with Chris Hill, Chief Financial Officer for Core Laboratories. Core is a leading third-party provider of core and fluid analysis and partners with operators to enhance production through smarter well designs. Chris has been with Core for more than a decade, holding a number of finance roles, including Investor Relations a while back and most recently as CIO until he took over the role as CFO 2 years ago. So Chris, welcome. Thanks for being here.

Yes. Thank you, Sean. And thanks to everyone that's joining us here this morning.

So we'll do a fireside chat format here. And maybe as CFO, is how you spend all your time, but clearly, investors tend to come to Core to get the macro view. And so maybe just start, just given the dislocations in the oil market last few months, can we just get the Core view, kind of the macro around oil prices, E&P spending, the impact on production, just kind of the near term, what you are seeing out there?

Sure. I don't think we're seeing anything that's really different from a lot of the commentary and maybe some of the consensus that's kind of built up around what's going on. I think everybody agrees, the U.S. land market has been hit pretty hard, right? So the rig count has come down very quickly, the number of wells that are being completed. So we monitor that frac spread index just like I think a lot of people do, gives you a feel for how many frac crews are out there. We saw that come down pretty sharply and quickly in Q2. So I think it started even in Q1 in March that started. You could see that starting to fade, and then it continued on a sharp decline. So Q2 is going to be -- that's going to show up in Q2 for our Production Enhancement segment, which is a lot more tied to that -- those activities. But for -- I think for international projects, at least for us, I don't think it's as much as where the commodity price is today as it is more associated with disruptions from the global pandemic around COVID-19, right? So a lot of travel restrictions, border restrictions, just organizations and companies trying to get there, hey, how are we going to work with all the social distancing measures and protocols that need to be put into place. So definitely some delays and it's difficult to really determine exactly when things will start to open up even for projects that are going to continue on through the sort of low commodity cycle here we've got going on. So on the other side, more Reservoir Description, but think about that business is tied heavily to production. So not exploration, development drilling, necessarily completing of wells, but the production that's coming out of the ground. So a lot fluids analysis testing that is done around that. And honestly, even in a low commodity price market, a lot of that analysis needs to be done and will continue. So that group will be more resilient even if you do see some falloff in the international, let's call it, E&P capital spending.

So thanks for that. And so I wanted to also start thinking about the update -- or kind of an update on what you've actually seen in the quarter from a disruption perspective. So maybe could you just parse that out a little bit and talk about how things have evolved through the quarter relative to maybe what you would have thought when we were on the first quarter call? Now we've had some more time. To some degree, some markets have opened up more, some areas are more back to business, others have stayed closed. Just it would be great to get a better sense of how that's evolved through the second quarter.

Sure. So Core Lab, we're in over 50 countries. We have 70 offices. We actually continued to operate throughout the whole pandemic. So it did require us to go through and put all kinds of social distancing type procedures and protocols in place for the office and the laboratories, all kinds of space shifting and things like that to try to space employees out and limit their contact with one another, et cetera. So I do think we did see some disruptions. There were some countries that actually shut down for periods of time. It kind of started more western and then kind of started working its way -- or eastern, and started working its way more western to the U.S. So I think everybody in the U.S. didn't feel it as much until we started getting into the second quarter. But this was really impacting some of the countries sooner than that, right? So we've talked about the way they shut their whole country down for a couple of weeks back at the end of March, and they had to do that again. I think they had some surge in stuff there, and they had to shut it down for another couple of weeks during the second quarter. So it is kind of touch and go around the globe on exactly what sort of up to open and how that's progressing. I think in general, things are getting better and we're getting closer to where companies are going to start to open things up. So we -- even during this quarter, we could be in a position. I think we're still planning, at least to some degree, for our crews starting to go out to well site jobs on projects in the international locations. Some of that has been delayed a little bit. We thought we'd get back to it near the end of May. Some of that's kind of pushing into June. But companies are getting things in place, setting procedures. You might have to quarantine for a couple of weeks before you get put on a plane to go fly somewhere and then quarantined again. But they are putting procedures in place and trying to get everybody back to the well sites and back working.

So then does that give you confidence in terms of potential for some recovery in the back half relative to what you see in the second quarter?

I think recovery comes in a couple -- maybe a couple of different forms. Sticking to that U.S. market, if you see the demand for crude oil start to come back and strengthen as we kind of move through the rest of the year, I think that will bode well for our Reservoir Description group. Think about those fluids analysis again. That will dictate some of those activity levels there. I think with respect to the bigger, larger projects, and we -- we're allowed to talk about a few of them. The [ time ] has given us permission [ to ] think about that Exxon Guyana work, the Apache Suriname. They have publicly said those projects will continue on. So it's really more about getting those protocols like we talked about in place, so they can get people back to work, and then we'll be back to work right along with them. On the U.S. land market, that one's probably a little harder to predict. There's some commentary. If we get oil stable at $40, you might start to see some rigs and frac crews to actually go back to work. So it seems like we're heading in that direction, but I think we're kind of cautiously optimistic, if that's the right word to say. Yes.

That's very fair. So thinking about FIDs, there were some pretty good expectations coming into the year, nothing outstanding, and a lot of that's likely to get deferred. Just are you seeing deferrals? Have you seen any cancellations? Anything you would parse out between short versus long cycle? Just curious to get your overall take around how that -- how those customer discussions are evolving this year.

So the positive thing is the long projects, the long cycle projects, these offshore projects that are very meaningful for clients and for us, none of those have been canceled. So delayed, but not canceled. I would say some of the smaller onshore projects, if you think about like places like the North Slope and things like that, where there really is sort of a seasonal window, some of that stuff that got delayed, that's going to have to fall into next year sort of season. So -- but those are meaningful projects, but not the big offshore ones that we talked about. With respect to new FIDs, I think we probably will see a pause here as companies really are just trying to reassess everything, kind of see where the market is, not just today, but where we're going to be over the next, let's call it, mid-term, 2 to 3 years. But you might see, it's amazing, companies are still evaluating things that were ongoing, but I wouldn't be surprised if sort of previous plans are now sort of put on hold as they reevaluate.

Of course. Can we talk a little bit more about the cost-out initiative? So $7 million [ pending ] pulled out of R&D in the second quarter, $4 million in PE, those are your quarterly numbers. Just where do you expect to be exiting the quarter? How much is left for the back half in terms of taking cost out of the business? Great to hear about that progression.

Sure. So what Sean is talking about is, we did quantified some of the cost reductions that had already been approved and really put in place for the most part when we were doing our call back in late April. What I can tell you, so like you said, $11 million a quarter, I don't think we'll get all of that in Q2, but definitely in Q3, and those [ plans ] have been expanded since then. I think we will update everyone, at least on the Q2 call, on how those have been expanded and quantify that again. I think people want to know that. So they've been expanding. I would say they've been materially expanded. So those will be really more fully, let's say, realized in Q3. I think Q2 is a challenge just because of production enhancement. If you think about that segment, how quickly activity levels fell off, it's really difficult to kind of get the costs out quick enough to respond to that. But we've said going forward, once we get through Q2, we feel like we're going to rightsize the business for whatever activities out there and try to breakeven EBIT for Production Enhancement. That's a pretty good goal for us. I think any service company that's got some as much, let's say, activity tied to the North American land region. Our international business in that group is actually going to do pretty well. It's not as tied to exploration and development-type activities. There's some really significant and longer-term plug and abandonment contracts that go there. So those are pretty material part of the international side of Production Enhancement.

Right. So let's dig into the segments a little more. We'll start with RD, Reservoir Description. How should we think about the top line trajectory relative to the decline in E&P spending? And I'm thinking about within the business, ROC analysis, as you mentioned, probably more delays, deferrals, challenges there. In fluids, we are shutting in a lot of production for at least near term. Does that -- how does that impact revenue for that business in the short run? Does it create like a burst of revenue on the other side of it as things get turned back on? Just curious, is this something -- it's typically a pretty steady business in terms of the fluid analysis and so this is a bit of unusual circumstance. It would be great to better understand how that -- how those moving parts should work as we move through the next few quarters?

Right. Sure. And going through this last downturn to think about 2015, '16, '17 and even '18, if you think about international, global, it really has been sort of a depressed market over the last 5 years or so. And Reservoir Description kind of bottomed down around $100 million a quarter in revenue. So that was sort of a good framework to think about. There really wasn't a lot of E&P spending going on at that particular time. So we kind of said, "Hey, that's kind of what you can count on from a production, from these producing field." That's kind of a nice steady base of revenue. We'll dip below that here for Q2. Just think about what's going on, the decrease in demand, the pull back in production, the shut-ins that you've talked about. So it will be something less than that, but it is going to be a lot more resilient than companies that are sourced, the revenues are sourced purely from sort of E&P capital spending, right? So we'll kind of see where that bottoms out, it will be lower, but it will be a lot more resilient. So you mentioned the fluids business, that 65-plus percent of those revenues. So it is -- the fluids have been a growing part of that segment over the last 5-plus years, and I think that trend continues. And think of those producing fields around the globe as really kind of the client for that. We're on projects in and out of those fields over the life of those [ deals ].

Right. So as we then tie that into profitability, just how do you think about decrementals, 2Q, back half of the year? As we get to the back half, you have realized a lot of those incremental costs will be -- cost-out initiatives, there will be some more we'll learn about soon. Just how do we think about decrementals for a business that generally has pretty high fixed cost?

Sure. So we have -- we've talked about the cost reductions. So those are going to mitigate the decrementals, and we would suggest they're going to mitigate them pretty well, right? So I think in the past, we've had some steeper decrementals. But again, we were viewing those as more short-term disruptions and kind of activity levels. So we didn't necessarily take as many costs out as we've done this time. These are deeper cost cuts, so they will help mitigate those decrementals. I'm not going to give you a number. But I can tell you, I wouldn't use high decremental margins to try to model Core Lab, at least not too -- I wouldn't be using the 50%, 60%, 70% decrementals because I don't think that's realistic when you start thinking about how much costs we've taken out. And then there's the direct variable costs that will just come out as revenues come down. Services, you can back off 25%. That's -- those are direct variable costs. On the product side, it's closer to 50%. Sometimes it's a little more, sometimes it's a little less. But that will give you a feel for what decrementals might look like.

That's really helpful. And then just thinking about a little bit further out. So beyond the near-term disruptions and maybe what's kind of trough of the cycle. As you look out to next cycle, how would you think about the makeup of Reservoir Description? Can we see the ROC part of the business become a significantly bigger portion than it has, and we've been kind of in this -- what was 60%, or 65-plus percent of the business now coming from fluids, what can the ROC part of the business look like next cycle? And then from a technology perspective, what would you highlight as being some of the building blocks to getting that business bigger?

Absolutely. So there is some commentary out there about what the next sort of cycle might look like and where companies, operators might start to focus their spend. And I think everybody is a little soured on sort of the U.S. market, land market and maybe that is not going to be -- it come back to the same level. It may not be that incremental barrel for the globe going forward. So there is some commentary that, you know what, companies might shift back to where they used to look for these incremental barrels and actually these international projects. So if you start to see that, and that's more robust than it has been the last 5, 6 years. Think about 2010, '11, '12, '13, as you started to have ramp-up and you see how Reservoir Description performed during that period, that's sort of the opportunity that could be out there if we have those kinds of investments going into active projects. So that does feel -- that's a bold case for international and for Core Lab's Reservoir Description group for sure. But there's commentary sort of building around that kind of thing. I think we continue to add to our portfolio of services. We've talked about the NITRO services and things. These are additive services that the clients are adopting and really like, but they are not replacements for what we've done traditionally with the physical measurements that are done in the lab, so that operators can really quantify their reserves and calculate and estimate what those are. The estimating tools that are out there are great. It gives you information quicker, but you have to go back to those traditional sort of physical measurements. So it's kind of a larger portfolio. Hopefully, that means revenues can even grow at a faster pace than what we saw historically when we've had a nice upcycle in the international market.

And can we talk about pricing a little bit? I spent a lot of time on the road with you guys through the downturn and what was this most recent upcycle. Consistent feedback has always been the price book is the price book, both in good times and in bad. And so how sustainable how has that proven to be? And what do you expect looking forward in terms of the price book for Reservoir Description?

Yes. That's been our philosophy and approach to pricing. We've got a price book. If you think about who are really our truest, biggest competitors have been, it's been our largest clients that have internal capabilities. So we've always tried to price our services where we think we're doing it cheaper than that, although they can do it internally, and we've maintained that. I would tell you that historically, I mean, our biggest cost is our people. So as we give merit increases and things like that, we're trying to pass that on in the form of price increases. But we don't significantly increase the prices when activity levels are high. And so discussions are different when we're in a downturn like this, we never had those price increases. I would tell you, we probably haven't been able to push through inflationary-type costs over the last 5 or 6 years. So when we get into a more, let's call it, stable or balanced market, then maybe some of those inflationary costs can start to get priced in and the clients will accept those and understand those.

Right. That's fair. So in terms of Production Enhancement, maybe can we just dig in a little bit deeper? I'd love just to get any more granularity you can offer on some of the different parts of the business. So products versus services, how that's trending, North American onshore versus international? Are we tracking -- how are we tracking relative to frac activity in the U.S.? As you said, you can track those pretty closely, so we -- it would be great to hear a little more of the moving parts within Production Enhancement, what you see here as we go through the quarter.

Sure. And so when you think about Production Enhancement as a segment in total, and if you go back into, let's say, mid-2019 and even beyond, it's been about 1/3 services, 2/3 products. What I would tell you, though, is that in a depressed market or like we've been in and the services side of that is more discretionary than the product side. I mean, you have to perforate the well and et cetera. You don't have to run the diagnostic services necessarily, right, unless you're having issues and need some answers, right? We would say our best-in-class customers are running those diagnostics to try to improve what they're doing, but it's not required. So those get hit harder when all of a sudden, you have a drop like this. So if you think about the leg down in Q4 of last year and then also a little leg down in Q1 of this year for U.S. land, our diagnostic services got hit harder than the product side. So in Q1, it's more like 25% services, 75% products. So think about that going forward when you try to think about what -- how those businesses might be reacting, I think it will be a little difficult, more difficult for the diagnostic services to sell those value-add services in this kind of market. On the product side -- and another step, we're about 1/3 international for both businesses. It lines out that way, 2/3 kind of tied to U.S. land. I would say, again, with the leg down in Q4 and leg down to Q1, it was probably more like 45% international, 55% U.S. land when you look at Q1 results there. So if you got to think about that as you're trying to think of how those markets are going to react going forward. The international side of that business or the product side, again, we've got some pretty sizable contracts associated with [ D&As ] that don't try to model that international activity just on expected sort of drilling and completion activity, it will be a little more resilient than that going forward. On the services side, I think there's opportunities out there for us. But again, it's kind of a tough environment right now. So we're -- I would say we're cautiously optimistic, but it's a difficult market out there.

Yes, for sure. So then similar questions were asked on R&D. You alluded to it kind of an overall Core perspective, but just how we think about decrementals for this business? Again, it's pretty high fixed cost. You are taking cost out. How do you see that bridge from second quarter to the back half of the year?

Yes. I think you have to take a view on kind of where Q2 is, is it going to get worse or is it going to kind of maintain and hold going forward? So I think there's some mixed views, and there is a lot of uncertainty. I'm just going to be frank with -- Sean, it's kind of hard to tell exactly. But I think that business is going to do better, obviously, than Production Enhancement. And I think we're going to demonstrate over time that, that business is going to be more resilient. It's going to stay profitable, and it's going to be -- somebody's asked us and well, "How low could the margins go?" And I said -- we said it's not a goal, but we said, I can't see those margins ever dropping below 10% in margins. I think it's going to be better than that even throughout the remainder of the year. So as demand comes up and production starts to come back online again, even though drilling and completion activity may fall off, if demand for -- and production comes back up, those are going to kind of offset one another if you move into the back half of the year. So...

That's right. So that's -- so for R&D, I think that's very clear. And then for Production Enhancement, similar question in terms of, is 2Q likely the bottom? And just kind of what are the parameters around kind of bottoming in 2Q and then looking at the back half of the year?

I can tell you, I hope Q2 to the bottom. You can't -- the only -- and it's kind of a joke, but you can't go below 0, right, in U.S. land activity. So it's kind of like -- it's pretty close to that, I would say, if you look at the frac spreads, and look at what the rigs may be out there running at their turns through contracts, but I don't think they're completing a lot of wells right now. We actually saw a little bit of a tick up, at least in the index. So they're modeling that maybe it did kind of bottom and then it come up a little bit and still, we're still way deep in the basement. But if we get to 100 frac spreads from where we were, let's say, 50 at the bottom here or even sub-50, then that group, we would be more confident about reaching our breakeven goals going forward in that segment.

Got it. Very helpful. So within Production Enhancement going into the downturn, you had some pretty significant changes in competitive dynamics. Can we just talk about how this change in activity is impacting your ability to get the GoGun in the market in terms of trying to get back what you would consider your rightful share in the market? Just how those -- the customer preferences around products, how that's changed? The integrated solutions? And then just how do you see this market relative -- looking at your competitive peers in the coming cycle?

Right. So it's important to remind everybody that we weren't in -- when you think about that perforating gun system market, we weren't players in all the different components and definitely not these preassembled guns that had hit the market, let's call it, the last 3, 4, 5 years in a bigger way than they have in the past. We had always focused on our shape charges. We are the leader in the industry in that. And we'd like to reference that, just to demonstrate, hey, we're not losing market share on our charge business. Other parts of the market are growing with some public companies that are out there. These pretty simple guns have grown, they've uptake. We weren't participating in that until the last year or so, right? So we have continued to develop. And we introduced our pre-assembled gun earlier in 2019. We have continued to roll that out. Obviously, the marketplace is a lot smaller now. And we've continued to evolve that and develop it into generation 2, kind of generation 3 for us. So those things are progressing. We have not slowed down on our development and continued push out of those products. It's just the markets are lot -- obviously, a lot smaller on that. So I think that particular sort of group of competitors are all going to be challenged in the market that we're looking at today.

Yes, that's absolutely fair. So let's maybe move to cash flow and the balance sheet. Just maybe to start, it would be good just to summarize sources and uses of cash. There's a lot of moving parts in the second quarter and for 2020 overall. On the 1Q call, you're certainly confident in terms of your ability to generate cash and applying that towards the revolver to make some headway on reducing the amount outstanding there. We maybe just start with that, just kind of summary where you see sources and uses of cash for the year.

Sure. So we have talked about even going through a very difficult down cycle like this, Core Lab is going to remain profitable if we are going to generate free cash flow. I think if you look at the costs that we've taken out, you can start to model that and you can see why we say that with confidence. And we have talked about free cash flow. You can see, we cut the dividend down to nothing basically. And we've got our CapEx plan back as well to around $11-ish million, let's say, for this year. And with that, I think you're going to see any excess free cash flow dedicated and focused on reducing our debt levels. But we do have restrictions, financial covenants under not just our private placement notes that are out there, but our revolver, the revolver is a little tighter on the leverage ratio. It's limited to 2.5x. We were at 1.93 at March 31. So it is going to be tighter as we move deeper into this down cycle. But we are in constant discussions with our bank group about whether or not it makes sense for Core Lab to get an amendment, to get some relief under that or not. But I can tell you the banks have been under a lot of stress from other companies that are in borrowers' positioned than Core Lab, whether they've already busted their covenants or need liquidity. So you kind of have to let that play out, you don't really want to get caught up in that group as you approach your bank. So we have a good open communication with them. So probably more to come on that as we move throughout the rest of the year. Sources of cash, when you will see some working capital come down, obviously, receivables, I would tell you, our DSO should be pretty much in line with what we've seen in the last few quarters. We do a great job managing that. There's probably some slight change in client behavior on payments that are a little slower than they were before, but I don't see that as a material change. We kind of saw that in Q4 and a little bit in Q1. So it seems to be playing out that way where they're holding a little more cash at quarter end. Inventory, I think, will be that when you think of working capital and sources of cash, that's going to be the tougher challenge for us because it is tied to that North American market and it just fell off so quickly. Those are long lead time, time suppliers, if you think about steel and electronic components for the switches and things, so you can only slow that down so much when you've already committed to it. So it's going to take us a while to work through the inventory. We were building that up, as we got ready to really launch the GoGun in a material way, we've been ramping up our manufacturing capabilities. So think about getting lots of steel and lots you have to build some inventory to service that kind of those types of volumes. But now we're in a different situation. So we'll -- it will take us a little while to work through some of that. So cash from operations is going to continue, and then we cut back on CapEx. So you will continue to see Core Lab generate free cash going forward without even the [indiscernible] working capital. So once we [ may do ] that and working capital kind of settles, we're still going to be generating positive free cash flow.

That seems like a good place to leave it. And so we're running out of time. But Chris, on behalf of JPMorgan, thanks again for joining us today. Great to see you. Great to spend time with you. And thanks, everyone, enjoy the rest of the conference.

Yes. Thanks, Sean. Thanks to everyone.