The Rising Influence of Rising Affluence

[DewDiligence]

Pickering recommends CLB. (No link—contents c/o ‘Big Dog’ on SI.)

›Initiating coverage on Core Laboratories (CLB) with Accumulate rating

· ROCE [Return on Capital Employed] King - $110 price target on current numbers and expect target valuation to continue to move higher (steady growth story). The company maintains several enviable attributes including: leverage to secular trends (international oil and domestic horizontal drilling), niche product lines with defendable market shares, impressive FCF generation, industry leading ROCE [see #msg-59850719], and a proven / consistent management team [everyone in top management has been with the company since before the IPO in the 1990s and the corporate governance is impressive—see #msg-60689395]. Although our key hesitation is valuation, there aren’t many oil service companies with business models as defendable as CLB’s. We think the premium is justified and long-term investors will do well. We’re not expecting any one / few events to be catalysts taking CLB meaningfully higher. However, the growth in the business / earnings / FCF / cash return to shareholders makes this an outperformer in up-cycles and down-cycles.

· Valuation/Stock Thoughts – On our 2011 and 2012 eps estimates of $3.63 and $4.40, CLB trades 28x 2011 and 23x 2012 versus the peer group median (large and mid cap service companies) of 23x 2011 and 17x 2012. From a historical perspective, shares have averaged 18x forward year earnings. On EV / EBITDA, CLB trades 16x 2011 and 14x 2012 versus the peer group median of 9x 2011 and 8x 2012, respectively. Although shares are quite expensive compared to other service companies, we think the premium is justified given CLB’s growth profile, unique business model, and consistent return of cash to shareholders. When compared to another mid-cap niche service company Carbo Ceramics (32x 2011 and 25x 2012), CLB looks more reasonable. We have a target price of $110, ~25x our 2012 eps (slightly above the 5yr historical average) and 7% upside from current levels.

· Secular growth - CLB’s two largest segments are direct beneficiaries of two positive secular trends in the energy industry. Reservoir Description [52% of 4Q10 revenue] benefits from international oil growth and Production Enhancement [41% of 4Q10 revenue] from domestic horizontal drilling. For Production Enhancement, it is really quite simple…..more complex completions, longer laterals, and more frac stages equals more services (HERO, HTD Blast SpectraScan, SpectraChem). Reservoir Description is more people intensive growth while Production Enhancement growth is more manufacturing intensive. With 25+% EBIT margins in all 3 reporting segments, top line growth generated by CLB carries significant profit pull-through.

· Niche product lines with defendable market positions – CLB’s key competencies include understanding the reservoir and production enhancement services, both are crucial when developing large fields and maximizing returns. With regards to Reservoir Description, CLB’s main competitor is the customer itself. In other words, should a large IOC / NOC outsource core analysis or do the work in-house? CLB has clearly shown a high level of expertise and trust from its customers and the trend is towards outsourcing...good for CLB. On the Production Enhancement side, CLB’s products benefitting from the ongoing trends towards horizontal drilling include HERO/HTD Blast (perforating systems), SpectraScan (tracer to determine placement of proppant), and SpectraChem (products that determine the quantity of gel breakdown post frac).

· Industry leading ROCE – Given CLB’s capital efficient business model, CLB’s returns on capital employed averaged 33% over the past five years…notable compared to industry peers (excluding offshore drillers) that averaged 17% over the same time frame. Results are even impressive compared to small cap niche peers Carbo Ceramics and Oceaneering International which averaged 17% and 16%, respectively. Large cap competitors Schlumberger and Halliburton averaged 22% and 24% over the past five years.

· Proven / consistent management team – Not only has the management team from CLB talked the talk, but they’ve also (and more importantly) walked the walk. From 2006-2011, we estimate CLB’s eps will be up 162% (versus our coverage group average excluding offshore drillers of +32%). In addition, the company has returned ~$670mm to shareholders (~$14/sh) via share repurchases and dividends. As result, the stock is up 59%, 76%, and 334%, over a 1, 3, and 5 year period versus the OIH of +38%, -5%, and +12%, respectively. Given the tenure and results of CLB’s management team, we consider them one of the best in the industry. [Also see #msg-60689395].‹