Core Laboratories N.V. (CLB) Q4 2016 Earnings Report, Transcript and Summary

Good morning and welcome to the Core Laboratories Fourth Quarter 2016 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to David Demshur, Chairman, President, and CEO. Please go ahead.

Thanks, Kerry. Well, good morning in North America, good afternoon in Europe, and good evening in Asia Pacific. We’d like to welcome all of our shareholders, analysts, and most importantly, our employees to Core Laboratories’ fourth quarter 2016 earnings conference call. This morning, I am joined by Dick Bergmark, Core’s Executive Vice President and CFO; Core’s COO, Monty Davis, who’ll present the detailed operational review; Chris Hill, Core’s Chief Accounting Officer, and Gwen Schreffler, Core’s Head of Investor Relations. The call will be divided into five segments. Gwen will start by making statements regarding forward-looking comments. We will then review the current macro environment, updating worldwide crude oil supply thoughts as related to net decline curves, and then comment on Core’s three financial tenets, which the Company employs to build long-term shareholder value. Chris will follow with a detailed financial overview and additional comments regarding building shareholder value, followed by Dick Bergmark commenting on Core’s first quarter 2017 outlook and a general industry outlook as it pertains to Core’s prospects. Then Monty will go over Core’s three operating segments, detailing our progress and discussing the continued successful introduction of new Core Lab technologies, and then highlighting some of Core’s operations and major projects worldwide. Then, we’ll open the call for a Q&A session. I will turn it over to Gwen for remarks regarding forward-looking statements. Gwen?

Before we start the conference call 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 market, 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 respect 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, see Item 1A Risk Factors in our Annual Report on Form 10-K for the fiscal year ended December 31, 2015, 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 fourth quarter results. Those non-GAAP measures can also be found on our website. With that said, I’ll pass the discussion back to Dave.

Great. Thanks, Gwen. I’d like to take a look at our current macro views followed by comments on our three financial tenets. Core believes that the worldwide crude oil markets are currently undersupplied as indicated by several consecutive months of declining worldwide crude oil inventories. And we believe the projected December draw will be the fifth consecutive month in a row. Projected OPEC cuts of 1.344 million barrels of oil per day and other cooperating countries pledging to cut another 600,000 barrels of oil per day will lead to extended worldwide inventory declines and a continuing rally in oil prices and energy prices in 2017. As Core has continually stated, the Middle East was producing oil at unstable levels, and we are sure that some of these cuts will more than welcome by several Middle Eastern producing countries. All that Core did was listened to the reservoirs and not rhetoric. Also importantly, U.S. crude production peaked at 9.7 million barrels a day in March of 2015 and then declined approximately 1.3 million barrels a day into December of 2016. At that time, Core calculated a U.S. net decline curve rate of 11% per annum. U.S. crude supplies have increased on a net basis for October and November in response to increased activity levels, largely in the Permian Basin. However, conflicting data sets and completion statistics, especially in the large crude supply increase reported by EIA in October, especially from the Bakken, make calculations and projections for U.S. land production too difficult and uncertain to offer at this time. In 2016, production gains in the Gulf of Mexico were disappointing. Originally projected by Core Lab to add 200,000 barrels of production per day during 2016, the production added was essentially flat to up slightly year-over-year, owing to larger than expected activity declines and less production addition from legacy deepwater projects. 2017 is off to a better start as BP’s Thunder Horse South complex completed ahead of schedule and under budget is set to add 40,000 barrels of new 2017 production. Globally, Core estimates that the net decline curve rate is currently approximately 3.3%. Applying the 3.3% net decline curve rate to the worldwide crude oil production of approximately 85 million barrels a day means that the planet will need to produce an additional 2.8 million barrels of new oil by this date next year to maintain current worldwide productive capacity totals. With limited long-term sustainable spare production capacity coupled with the aforementioned production cuts, Core believes worldwide producers will not be able to offset the estimated 3.3% net production decline curve rate in 2017, leading to a further decline in global crude oil production. Also, weighing on future production capacity is the fact that operators discovered less than 4 billion barrels of new oil in 2016, while the globe consumed over 55 billion barrels. Therefore Core believes crude markets more than rationalized in late 2016 and price stability followed by price increases, some occurring as we speak, are returning to the energy complex. Remember, the immutable laws of physics and thermodynamics mean that the crude oil production decline curve always wins and it never sleeps. On the demand side of the crude oil market, new IEA estimates have increased worldwide demand in 2017 by approximately 1.4 million barrels of oil per day over the 1.3 added in 2016. The U.S. is now using approximately 10 million barrels of gasoline per day and 20 million barrels of total demand of hydrocarbon near record levels. Recent Chinese imports coupled with strong demand out of the India are near all-time highs. In addition, China the world’s largest energy consumer is probably in terminal decline as year-over-year production has dropped more than 400,000 barrels a day to 3.8 million barrels a day in 2016 that is near a six-year production low. Other countries posting significant 2016 production decline, which will continue into 2017 include Mexico, Venezuela, Colombia, Angola, Kazakhstan and Oman amongst others. As projected by Core in early 2016, the third quarter of 2016 marked the bottom of the V-shaped recovery which is now underway. This recovery should continue to strengthen with higher commodity prices and subsequent activity levels as 2017 progresses. Now, to review the three financial tenets by which Core used to build shareholder value over our 21-year history of being a publicly traded Company. And so definitely, Core is currently celebrating our 80th year of technological innovation. During the fourth quarter of 2016, Core generated free cash flow that exceeded net income for the 10th consecutive quarter as free cash flow has exceeded net income in 11 of our past 14 years. Free cash flow for 2016, was a 121 million, equal to 190% of net income, clearly one of the best in the oilfield service industry. Moreover and more importantly, Core converted over $0.20 of every 2016 revenue dollar into free cash flow, again leading all oilfield service companies. Free cash flow matters to Core Lab shareholders. During the fourth quarter of 2016, Core once produced oil field leading return on invested capital for the 29th consecutive quarter. As activity levels continue to increase in North America and with deepwater and international markets bottoming in the first half of 2017, Core expects return on invested capital to expand in 2017. Return on invested capital matters to Core Lab shareholders. And finally, during the fourth quarter of 2016, Core returned over $24 million back to our shareholders via our quarterly dividend. Core will continue to return all excess capital back to its shareholders in future quarters via quarterly dividends and is expected to start repurchasing additional shares in 2017. The return of excess capital matters to Core Lab shareholders. I will now turn the call back over to Chris for a detailed financial review. Chris?

Thanks, David. Looking at the income statement, revenues were $149.5 million in the fourth quarter, higher than our guidance and up about 4.2% sequentially, which was led by the 13% sequential growth in our land-based U.S. operations and production enhancement. For the full year, revenues were $594.7 million, so down about 25% but a nice outcome, considering the average global rig count was down almost 35% over that same period. Of this revenue, service revenue, which is more international, was a little over $115 million for the quarter and up about 1% sequentially, despite the challenging international and deepwater market where average rig count continued to decline over 1% this quarter. Product sales, which are more tied to North American activity, were $34.4 million for the quarter and up 17% sequentially, which again outperformed the 2% increase in completion in the U.S. during the fourth quarter, indicating an improvement in our market penetration. Moving on to costs of services for the quarter are 72% of service revenue, remaining consistent with the last couple of quarters. For the full year, costs of services averaged about 70.5% of our service operating -- and our service operating margins continue to be some of the strongest amongst oilfield service companies. Cost of sales in the fourth quarter was 87.5% of revenue, an improvement from the 91% last quarter as our operating leverage and the absorption of our fixed cost improves with higher levels of revenue. G&A for the quarter was $8.8 million, up slightly from the $8.4 million last quarter and came in a little over $39 million for the full year. For 2017, we expect G&A to be around $42 million to $44 million as we would also expect to expand some of our employee compensation programs. Depreciation and amortization for the quarter, $6.6 million, which is comparable to the last several quarters. For the full year 2016, depreciation and amortization expense was $26.9 million, so down slightly from the $27.5 million in the prior year. Looking forward to next year, we would expect capital expenditures and associated depreciation expense to increase as the year progresses and be in line with our operations and the capital projects to support those operations. Other expense was negligible for the fourth quarter. The guidance we gave on our last call and past calls specifically excluded the impact of any FX gains or losses and assumed an effective tax rate of 6% for the fourth quarter. So, accordingly, our discussion today excludes any foreign exchange gain or loss for current and prior periods and is adjusted to be guided tax rate of 6%. So, to conform with our guidance, EBIT, ex-items for the quarter was $21.9 million and continues to represent the best in class EBIT margin of 15%. Full year 2016 EBIT, ex-items, was $88 million and also generated industry-leading margins of 15% for the full year. Income tax expense has been and will continue to be sensitive to the geographic mix of earnings between the U.S. and other regions of the world. Our effective tax rate guidance for the fourth quarter was 6%, creating an income tax expense of $1.2 million for the fourth quarter. Our GAAP annual effective tax rate was a little over 14%, which resulted in the actual effective tax rate of 19% for the fourth quarter. We expect our effective tax rate in Q1 of 2017 to be approximately 14%. Net income, ex-items, for the quarter was $18.3 million up $16.7 million in last quarters; and for the full year 2016, ex-items, it was $66.2 million. GAAP net income was $15.5 million for the fourth quarter and $63.9 million for the year. Earnings per diluted share, ex-items was $0.41 for the quarter compared to our prior guidance of $0.38 to $0.40 per share. EPS for the full year ex-items was $1.52. GAAP EPS for the fourth quarter was $0.35 and a $1.46 for the full year. As we move onto the balance sheet, I’m only going to highlight the items that have materially changed from the previously reported balances. Cash was $14.8 million compared to the $17.2 million last year. Receivables stood at $114.3 million and as a result of revenue continuing to increase as the quarter progressed, are up about $6 million this quarter, but down over $31 million from $145.7 million at prior year-end. Our DSOs continue to be strong at 65 days for both the quarter and the full year 2016, so a slight improvement from the 66 days in 2015 and a testament to not only the quality of our customer base but the Company’s continued focus on managing all aspects of the business during this challenging environment. Inventory finished the year at $33.7 million, so down about 10% or $3.6 million sequentially and down over 19% from its peak earlier in the year as we continued reducing inventory levels and improved inventory turns in the second half of the year. We anticipate inventory turns will continue to improve into 2017, and our inventory levels are expected to remain at similar levels. And now, on to the liability side of the balance sheet. Our other current liabilities of $70.3 million are up about $9 million from last quarter due to an increase in tax payable, unearned revenue and employee compensation. Our long-term debt at year-end was $218 million, so up slightly from $208 million at last quarter-end, and from which the proceeds were used to fund CapEx projects and a slight growth in working capital. Our debt is comprised of our senior notes and $150 million as well as $68 million under our bank revolving credit facility. Shareholders’ equity ended the year at a $155.3 million, so up from prior year-end balance, primarily due to the equity issuance in the second quarter of 2016. Capital expenditures for the quarter were $3.6 million, an increase from prior quarters but in line with operational activities. For the full year, they were $11.4 million, so down about 50% from $22.8 million in 2015. However, the Company anticipates that its capital expenditure program will expand in 2017 and in line with increases in business activity, possibly reaching the $15 million level. And as I have stated earlier, Core Lab has the ability to increase its investments in support of the strengthening activities. Looking at cash flow, in the fourth quarter, cash flow from operating activities was $23.2 million and after paying for our $3.6 million in CapEx, our free cash flow in Q4 was $19.6 million. For the full year 2016, cash flow from operating activities was just shy of $132 million while free cash flow after paying for our CapEx program was $120.5 million, representing over $0.20 for every dollar of revenue. Our free cash flow conversion ratio, which is free cash flow divided by net income, continues to be one of the highest in the industry at almost 190% for 2016. We believe this is an important metric for shareholders, when comparing Company’s financial results, particularly for those shareholders who utilize discounted cash flow models to assess valuation. In 2016, our free cash flow was higher than our net income as it has been for 11 out of the last 14 years. I will now turn it over to Dick for an update on our guidance and outlook.

Thanks, Chris. All right. For the first quarter, revenue, EPS, earnings, guidance, the backdrop is similar to past recoveries. We expect our revenue growth to ultimately outperform the increase in industry activity rates by 200 to 400 basis points. We also expect to generate incremental operating income margins of up to approximately 60% early in the activity recovery phase, followed by our historical incremental operating income margins of approximately 35% to 45%, well into recovery phase. Our North America revenue is correlated with completion and stimulation events and large scale reservoir rock and reservoir fluid characterization, rather than immediately correlated with increasing rig counts. So, wells need to drilled and subsequently completed, stimulated, cored, or have reservoir fluid samples collected before we can realize a revenue event. We are clearly benefitting from increased U.S. onshore activity and expect revenue and operating income to increase further in 2017 as international and offshore markets improve with additional major capital project announcements. These activities should drive our revenues higher in consecutive quarters throughout 2017, also expanding incremental and operating margins. As we projected earlier this year, our third quarter results established the bottom of the expected V-shaped recovery that we believe will continue into 2017. We believe that the global crude oil market is currently undersupplied. This is indicated by a recent IEA worldwide crude oil inventory data that has declined over the past four months and is projected to decline for the fifth straight month in December of 2016. Projected OPEC production cuts in early 2017 of 1.3 million barrels of oil per day along with other operating countries, which does include Russia pledging to cut another 600,000 barrels a day, should lead to an extended worldwide inventory decline, which could create a continuing rally in energy prices throughout this year. As customary, we expect traditional, typical seasonal sequential industry activity patterns will cause the first quarter of 2016 be similar to the preceding quarter. Within that context, we expect activity levels to further increase in North America, but international and deepwater markets to be flat or slightly down, placing our Company-wide revenue at approximately $150 million. Reservoir description operating margins are expected to remain near 18% while operating margins for production enhancement are expected to expand a low double-digit with Company-wide operating margins expanding slightly. Assuming those operating margins, we project first quarter 2017 operating profit to be approximately $22.5 million, which is slight increase over the prior quarter. Using that first quarter operating scenario, we project an EPS of $0.42 if the same assumed 6% effective tax rate is used as in the fourth quarter of 2016, for comparability purposes. However, given that the effective tax can vary, based on the jurisdiction or income as earned, we believe an effective tax rate of 14%, as stated during last quarter’s call in Chris’s comments, is more or likely in the first quarter of 2017, as a result of the shift in activity to the U.S. On a GAAP basis, we project EPS in the first quarter of 2017 to be $0.38, which compares favorably to the GAAP EPS of $0.35 earned in the fourth quarter of 2016. First quarter 2017 free cash flow is expected once again to exceed net income or expects to continue to make opportunistic repurchases of our shares using that free cash flow in excess of our dividend payments. Okay, with that review of our guidance, I’ll turn the conversation over Monty for operational discussion.

Thanks, Dick. For the fourth quarter of 2016, Core generated revenue of $150 million, which yielded $22 million in operating earnings, excluding FX and a 15% operating margin. Core Lab employees around the globe are adding value for our clients, employing Core Lab technologies. EnergyPoint Research’s annual survey of oil and gas leaders released yesterday [ph] for the second year in a row, Core Lab was ranked as the top oilfield services provider overall and in numerous categories. This is a great recognition of the service and technology that our employees provide to our customers. We thank all of our employees for working diligently to help our clients achieve their goals. Reservoir description revenue of $99 million produced operating income of $18 million with operating margins of 18%. During the fourth quarter, enhanced oil recovery, laboratory investigations on unconventional oil bearing reservoirs continued to be designed and initiated for several large oil companies with development operations in the Permian Basin and South Texas regions of the United States. Both areas exhibit low hydrocarbon recovery factors which have been interpreted to be the result of excessively high initial drawdown pressures and associated pressure dependant permeability loss, early pressure drop below the bubble point and preferential gas phase mobility. In one approach to these analytical programs, reservoir conditions EOR laboratory testing is conducted on unconventional reservoir samples using cyclic gas injection to validate methods for improved oil recovery. Newly designed automated laboratory systems are being utilized to cycle miscible fluids into the rock metrics to quantify additional hydrocarbon recovery through multiple testing cycles. This testing is also used to determine how recovery factors vary in response to a range of cycled gas compositions and in different stenographic horizons. Core’s proprietary reservoir conditions high frequency nuclear magnetic resonance testing is incorporated into this test regime. This unique service allows our laboratory experts to better identify and characterize fluid movement and the rock metrics during the cyclic gas injection and to identify changes in the physical properties of the hydrocarbons during each test cycle. Produced hydrocarbons are captured and compositionally analyzed to further understand reservoir fluid, phase behavior and the ultimate enhanced recovery mechanism efficiency. Hydrocarbon recovery efficiency in the laboratory tests is influenced by several factors including rock type, pore geometry, fluid saturation, crude oil and natural gas properties as well as the selected cycle fluid. The lab data generated through detailed PVT and Core testing can assist in the determination of optimum fluid cycling procedures for subsequent field tests. Laboratory testing shows a range of results. In many cases with proper design, oil recovery in these laboratory experiments can be improved from high single digits into low mid to mid teens or better. Production enhancement revenue of $43 million grew 15% sequentially over Q3. Operating earnings of $3 million yielded operating margins of 7%, more than double Q3 margins. In the fourth quarter, Core’s production enhancement segment experienced the highest use of our HERO PerFRAC perforating system. As operators search to optimize the pumping of their fracing jobs, they have begun to understand importance of a uniformed perforating hole size throughout each frac stage. Core’s HERO PerFRAC system provides an industry-leading consistent hole size around the wellbore, which results in all stage perforations breaking down during the pumping operations and uniformly contributing to the placement of fracture proppant at consistent hydraulic pressures. In the horizontal well, conventional perforating system produce smaller holes on the high side and larger holes on the low side. When the pumping operation takes place, the proppant placement occurs through the largest holes, limiting contribution from others, resulting in a 65% or less perforating efficiency. Core’s HERO PerFRAC family of charges can -- will allow the frac engineer to select the range of hole sizes with minimal standard deviation throughout the frac stage. Pumping frac proppant through equal size holes minimizes hydraulic horsepower and utilizes 100% of the perforations throughout the stage, facilitating the uniform placement of a proppant while experiencing minimal wellbore tortuosity. Our clients save money on completions and achieve a higher EUR. Reservoir management revenue of $7 million was up 23% over Q3, generating $1.2 million in operating earnings and 18% margin. In the fourth quarter, reservoir management saw an increase in study sales from Q3 2016 and also an increase of the value of these sales. This resulted in greater revenue and a major increase in EBIT versus Q3. In U.S., products focusing on the Permian Basin outweigh sales for the studies of other plays by almost 2 to 1. The Permian plays continue to drive the high margin -- high levels of merger and an acquisition activity in the industry as operators move to consolidate their land positions in favorable areas in the Midland and Delaware basins of West Texas. Outside North America, study sales dramatically increased in Q4 with five projects sold versus one project in all of Q3. All of these studies of offshore plays are in the Atlantic Margin from West Africa to Brazil. It is encouraging to see this increase in offshore activity as it indicates operators have not abandoned the big plays and still see the merit in continuing to develop these opportunities. Outside of study sales, reservoir management continues to develop new technologies and services to help our clients reduce their cost and increase their productivity. In 2016, new methods for geomechanical profiling to optimize completion practices and petrographic analysis to streamline reservoir characterization gained acceptance from our clients. Kerry, we will now open the call for questions.

We will now begin the question-and-answer session. [Operator Instruction] Our first question comes from Ole Slorer from Morgan Stanley. Please go ahead.

So, it looks like we are kind of defining prospect [ph] for the Company with production enhancement in full flow and the rest of our description kind of consolidating around international trends. You guided down a bit in the first quarter on reservoir description, I suppose part of that is also maybe seasonal. But, could you talk a little bit more about how your incoming call volume is trending there at the moment? You highlighted that you expected a series of FIDs this year to benefit, and you highlighted Mad Dog and Tengiz. But could you give a little bit more color on exactly how the inbound activity or outbound response is now compared to let’s say maybe six months ago?

Okay. Good question, Ole; good lead off. First off, we did not guide down now in Q1; what we did was we provided guidance in Q1. That’s the first time that we had done that. I think our guidance was a little bit lower than what was out there from the analysts, but it was our initial guidance for Q1…

The revenue decline, downtick in reservoir description in the first quarter?

That’s typical seasonal pattern, Ole.

Okay. That was my question; to what extent is that seasonal and to what extent is it -- okay.

Yes. There is some seasonality in there that we’ve seen certainly in the past. But looking forward in 2017, we do and the inquiries that we’re getting are strongly suggesting that we have or will see a bottom in international activity first and actually you may have seen that, followed by offshore and deepwater. If you just look at some of the most recent press releases and there was one this morning on Exxon Liza which will be FIDed sometime in 2017. Projects like this are good news for Core Lab. We’re doing the full battery of rock analysis there, and we’re following up with the detailed reservoir fluids suite of projects that will continue over the year. Chevron Tengiz is going to be very active. We believe that outside of Mad Dog Phase II in the deepwater Gulf of Mexico, we will see other FIDs there in the deepwater Gulf of Mexico that will benefit Core. So, from the international theater, we believe that as the year progresses that we will see reservoir description revenue increase bolstered by that from the offshore and deepwater. And for the Company, we saw the bottoming of the V in Q3; we’ll probably see the bottoming of reservoir description in Q1.

Very clear. Having visited with a few of the IOCs in Europe just recently, I came away kind of feeling very sharp contrast with what I’m hearing at [indiscernible] services from the IOCs in the U.S. where there seems to be a very big focus on shale, while in Europe my sense is that there is a steam of [ph] FIDs that that could be sanctioned, particularly maybe in the Barents Sea how would that effect you positively -- what’s your view on that?

Yes. We would certainly agree that you got companies like Statoil who is a great client of Core Laboratories, looking to increase production in FID, several projects this year from which we’ll benefit with; Total as well. So, we would agree that they are going to be more aggressive in FIDing offshore and deepwater projects. But, I think in the Q back here in the U.S. and some of these projects, I think we’re getting strong indications that we will see additional FIDs in some of the projects we mentioned, you look -- to look at Anadarko, Shenandoah, there are other projects that are in that FID queue that certainly will benefit Core Lab.

Good clarification there, Dave. On your comments about your initiative together with Pioneer could -- and hearing also from another big operator in the Bakken yesterday that they’re experimenting with a range of different completion types and higher sand volumes seem to be general theme yet again. What is -- you talk about miscible gases. What’s going on in this side of your business? And are customers again willing to pay up for technology? And the past three years, it seems [indiscernible] quality and prices and everything. And to what extent are you sensing the change now with a slight also change in the customer base in North America…

Yes. Ole, I would bifurcate the North American clients into those that are technologically sophisticated clients. And in that hand, certainly we would put Pioneer, Occidental, Apache, certainly -- Concho Resources certainly would be another. These companies have been and continue to be innovative, like the project that we’re working on at HRL, formerly known as the Hughes Research Laboratory, and Pioneer where we are using machine learning expert guided analysis to pinpoint more highly productive areas within the acreages owned by Pioneer, which we’ll be able leverage to some of these other technologically sophisticated clients…

So, what do you expect the impact of that to be?

For Core Lab, additional revenues that have higher margins and incremental margins, because these projects are really at the cutting edge of the technology and instrumentation that are available today and for a number of these projects for instance like Apache in the Southern Delaware Basin. Certainly, we had to manufacture that equipment because we were using NMR technologies at the frequencies not produced by any other equipment maker. So, we went ahead and made that equipment ourselves. So, the impact it’ll have in reservoir description will be higher revenues that also contain higher margins. So, a number of these projects that we’re working on like the one with Pioneer and HRL, we can process more data more quickly leading for them to make quicker decisions on what areas they’re going to complete and what types of stimulation packages they’re going to use. We would still agree that longer laterals and more proppant is a blueprint for higher returns and higher EURs. However, you went [ph] out of the length of the lateral that you can drill based on the metallurgy on some of these coiled tubing that’s available. So, we will see denser completions using some of the new technologies, certainly seeing the use of sand go up. And that sand could be either Northern White or some regional sands that are available, looking at the use of 100 mesh size and maybe finer grade sizes depending on which stage of the frac that they’re pumping. So, a lot of exciting technologies that will bear fruit here, over the next couple of years. In Core Lab, we think we’ve got the pulse right on this.

That sounds very exciting, just one final one. You mentioned finer grades, I think any signs that there [ph] is return of higher pressure systems resistant products like ceramics or is it all sand? And you’ve mentioned I think going the other way, the regional sand. And any signs to going the other way?

I would say in some deeper penetrations, just due to pressure requirements, there is still going to be a need for ceramic. But at this stage, we would say sand, sand and more sand. And 100 mesh and finer sand is something that the industry will probably turn to because we can see it here in our laboratories that that is probably the way to go.

Our next question comes from Gregory Lewis of Credit Suisse. Please go ahead.

Dave, just following a little bit, up on Ole’s questions about FIDs. We’re hearing or seeing that it looks like there is going to be at least in the near term it’s going to be more a Brownfield story where the Greenfield projects maybe following in late 2018 or 2019. How does that play into the reservoir description, I mean as we think about if Brownfield really leads the way in 2017 and first half of 2018 in terms of the workload?

Yes, Greg, right now, we are indeed doing a number of Brownfield projects, a lot of that related to the phase behavior relations of the reservoir fluids. So, if you look at some of the comments that we’ve made in past quarters, if we look at reservoir description, actually now more than half of that revenue is coming from the reservoir fluid analysis and less than half of that coming from the rock analysis. This is an indicator that we are working on some of these Brownfield developments and some of these Brownfield developments will see expanding, like for instance a good example of that is Thunder Horse South and also Mad Dog Phase II. So, we look at these as being more Brownfield. And would agree right now they’re playing an important part in elevating margins at the 18% level, which Dick talked about in reservoir description. You mix in some of these Greenfield projects like Exxon Liaz-2 and some of the others that we’ve mentioned over time, you get a very healthy recovery in reservoir description revenue growth, incremental margins and operating margin growth over the next two years, let’s say 2017 and 2018. We don’t see many hiccups along the way in that because there are number of these projects that are already in the queue for Core Lab.

Okay, great. Thanks. And then just one follow-up for me. You mentioned the HERO new frac…

That’ the HERO PerFRAC.

Yes, correct, sorry. As we think about that and it’s a new project, it’s kind of still early days. Do you have sense for the absorption rate of that? I mean, I guess, are we still kind of in early days and is that really going to just sort of replace a lot of the existing tools you’re using or PerFRACs over the next sort of 12 to 18 months? I’m just trying to get and see how much more runway that product has?

Greg, this is Monty. The HERO PerFRAC system is one we introduced in the second quarter really of last year, and has gained acceptance and of course that means revenue, throughout the year. December was our biggest month, that’s probably going to be superseded here in January as more people see the benefits of it. It is, we believe, the best way and should be used by everybody. If you’re going to frac well, there is no sense fracing a well and only getting 65% or less percent efficiency from the perforating system before you frac the well. So, it’s a system that is helping us gain market share as well as certainly replacing older technology for everybody, including older technology that we were selling. So, it’s system that we see continuing to grow as fracing continues, and we’ll see that a lot in growth in 2017 and onward.

Yes. Greg, we are working right now on a project where on a pad, one well by this operator was perforated using conventional perforating systems and the neighboring well was used totally a PerFRAC system. It will be a nice proof of statement paper that will come out with. And we think that that will increase the acceptance of the industry and further market penetration of this technology.

Okay. So, it sounds like this is maybe the second or third inning still of the HERO PerFRAC.

Correct.

Our next question comes from James West of Evercore ISI. Please go ahead. Please go ahead.

Hi, guys. This is actually Samantha Hoh filling in for James. Dave, just quickly, I noticed that -- I was a little surprised that you left the global decline curve rate unchanged at 3.3%. Is there a risk to that number maybe following over the next year, it sounds like you’re seeing in terms of [indiscernible] production and all that stuff?

Yes. Samantha, it does, when you have significant changes in a way that worldwide production acts at times like that, it’s difficult to find tune what that curve might be. But I think you make a good observation that any risk to that curve is going to be expanded. With some of the cuts that were made around -- the easiest way to do a decline curve is to know that the world, the globe is producing at full capacity. And you could easily then, -- anybody could easily calculate what that rate would be. But, when you have nominated production cuts like we’ve seen across the board from the OPEC countries and then some other cooperating countries like Russia cutting 300,000 barrels per day into 2017, it’s difficult to fine tune that. We’re going to work on that and try on our first quarter call to update the net decline curve in the U.S. and internationally. We are betting people, we would suggest that, we’ll take the bets and we’ll bet the over on the international decline curve rate going from 3.3 [ph] probably higher.

That’s great, Dave. Thank you for that. And then, I just had one other question, really great to see how excited you guys are for just the bottoming of deepwater internationally in the first half. Monty, I was just particularly curious about your comments regarding reservoir management and national study sales increasing dramatically over the last quarter. Is this the sign that maybe you guys are starting to see a bottom for offshore exploration that maybe there is going to be a trend to come in the next couple of years in that area?

I think what I said Samantha is we try to say is that the interest in these projects is growing a lot, people are interested and looking back at bigger projects that more cost, higher technology needs, and that’s good for us. So, we’re thinking that the international offshore or even international deepwater is picking up interest, and that will probably lead -- people don’t invest in these projects without following through with some work. So, we think there is going to be a pickup in that. Timing is hard to say, but in the not too distant future.

Yes. Samantha, there has been plenty of oil found in deepwater, some of which has not been developed. We think the purchase of these studies is the add for the development of that. Company like Conoco has said that they will no longer explore for new deepwater deposits. However, the ones that they’ve already discovered, they will go ahead and develop it. We believe that those projects will continue along. That being said, although exploration is not a bit part of Core Lab, less than 10% of our business, we’regoing to have to have has somebody going out and finding some new oil, because last year new discoveries totaled only 3.7 billion barrels and you’ve got the globe using over 55 billion barrels. Sooner or later, you have to do that bang pretty quickly.

And then just actually one last one from me is just on the Gulf of Mexico. Dave, I caught your comments that production was not as much as you guys had anticipated. And I was just curious about this new JIP that you guys are launching. Is that targeting more of those like Brownfields? I mean, just can you tell me a little bit more about this new JIP?

The differences -- we had a JIP on deepwater. You could refer to this actually as deeper water. This is a move out further into the Gulf into new areas that are of interest, some activity there, but there is increase of activities in that area as we move further out into the Gulf. And that’s what this study is about. How do you operate in the deeper water to produce and increase your EUR from those reservoirs that are bit different -- every reservoir is different from the last one, but they’re different as you move further out into the Gulf of Mexico, and that’s what that study is about.

Yes. Samantha, these will be the ultra deepwater fields in the southern Perdido fold belt, which is usually refer to has the lower tertiary territory. So, these are merely international line with some of the discoveries that Mexico has made and are looking to the IOCs worldwide to develop that. So, this will entail some additional information over the -- what we look at is the southern Perdido fold belt and from a Mexican side, the northern Perdido fold belt. So, it will be extension of the deepwater, as Monty said, into ultra deepwater. So, we are getting some real good interest on that; more on that in Q1, but we think that project does get fired up in Q1.

That sounds really exciting. Thanks so much, guys.

Okay, Samantha.

Our next question comes from Rob MacKenzie of Iberia Capital. Please go ahead.

Thanks, guys. Dave, I wanted to come back to the Pioneer, HRL, the technology and see if you can give us a little feel for -- I know you’re talking about couple of clients you think it applies to but how when does that commercialization you think start and how many clients in the aggregate, how big can that be here?

Well, essentially, Rob, it is commercialized. We were out there two weeks ago, signing agreements. They actually went through the description of a core that had literally thousands of different environmental phases [ph] in it. And out of all the phases that were identified by this computer learning, there were only three in question. So, it is right now a commercially viable service that will offer not only in the Permian Basin, but expanding that worldwide. What it does is it reduces big data in a big hurry for the operator. So, we think that saves him time, money and he makes smarter decisions. So, right now that is ready to start generating revenue. The size of it, don’t know, hard to quantify, but we think like some of our other technology, it is certainly cutting edge and will take time for client acceptance. but from what we’ve seen so far, we are very pleased with the application of that technology. And not only for unconventional reservoirs, we think this has huge application offshore where we’re looking at maybe thousands of feed of Core that can be analyzed and described within, if not minutes, hours as opposed to days. And with spread rights back in 2014 at 1.1 million a day, you can see the considerable savings for our clients all in by allowing us to perform that service.

How about savings for you guys in terms of perhaps being able to scale revenues while hiring if anything very few incremental technical staff?

Yes. And actually, when you look at that this has got to be -- the machine has to be taught by the expert. So, we -- our geological staff that we have here has been involved in that. In the future, we may have to hire less incremental geologists, but the staff that we have right now will be full time busy machine learning this from expert guidance. And the thing that we had mentioned was our worldwide rock catalog where we really have thousands of phases around the globe. It will take us to machine learn over a period of several quarters, if not a year to machine learn from our expert geologist on how those phases faces should be interpreted.

Okay, great. Coming back to title EOR, clearly making some great progress in the lab there, that’s going to be material, over time. With some of the development costs of those testing apparatus, what impacted description margin this quarter?

No, that really wasn’t part of it, Rob. It was really more the mix, as we’ve seen the shift in the business to go more North America from international. And when you think about today, the size of the projects in North America, they’re just smaller. Their reservoirs are not as complex, so the level of technology that we employ is lower. And so, the reason for margin degradation has really been at shift towards North America. The things that we’re trying to do to shift that to go back to higher margins are exactly what you just talked about, the EOR and the machine learning technology that Dave just talked about. Both of those should help us in North America to improve margin.

Okay. And then, on the title EOR, is it still experimental or what is the prospect for that becoming material to earnings for Core Lab in the next two, four, six, eight quarters?

Yes. We are generating revenue from that right now, Rob, but it is in the experimental stage. For instance, a lot of the operators originally wanted to cycle time of the lean gas one time. We now have a project where we’re cycling it seven times, looking at what we’re able to absorb from that gas over each cycle. So, these tend to be longer term projects. So, I would say, commercialization probably is still a bit away, but we’ll continue to grind on these projects in laboratory. I think a real revenue center probably in 2018, but right now we are generating high margin reservoirs from that as we’ve had to build and construct that equipment, it’s not available any other place on the planet.

Our next question comes from Thijs Berkelder of ABN-AMRO. Please go ahead.

Reservoir descriptions [ph] that we see with the U.S. recovery especially, can you maybe explain in Q4, what drives U.S. revenues versus international decline?

Yes. If you look at, it was driven by our production enhancement unit that had really U.S. land revenue up 13%. And so that was a lead over -- and all of production enhancement up 15%. So, when we look at reservoir description, international was only up 3%. So, you can see the activity levels in North America was behind the carry for that and the lower levels of international activity, which we still outperform on a relative basis, was only up 3% versus North America being up 15% for production enhancement.

Okay. Looking at the sequential improvement in the U.S. and the huge jump in activity in the U.S., why sequentially, looking at Q1, are we not seeing a similar growth continuation then?

We will indeed see that, but will be manifested in production enhancement because we see revenue, or we see EBIT margins there going into the low double digits and generating incremental margins that can reach up to 60%. On the downside, we’ll probably still see flat to down revenues coming from the international theater, and that will be manifested in reservoir description.

And Thijs, as you see that historically, if you go back multiple years, Q1 is always lower than the preceding Q4 in reservoir description, and that’s just because of the international complexion that business. You think about the IOCs and more particularly NOCs’ budgeting cycle is a little bit slower than the independents in the U.S. They get their budgets wrapped up in the first part of the year and then they go about spending it as the year progresses. So, you see a natural sequential increase in activity, once they get those budgets taking care of. You feel in a little seasonality from weather in the Northern Europe and in Russia, and you will see virtually every year, reservoir description for us is lower in Q1 and Q4, but not much, not more than 5%, but it does impact us because we keep our structure in place, because we are going to need those people to execute as the year progresses. So, it normally means, the margins compress slightly in Q1 versus the prior Q4. It’s nothing unusual and we are saying it’s going to happen again. The positive is the improvement in production enhancement, Dave talked about, will enable our revenues to be flat in Q1. So, what we are very pleased about is our Q4 revenues were up about $5 million higher than we expected. The good news is we are not going to lose any of that to the traditional bleed that you normally see going into Q1. So, we are very pleased about that revenue level staying where it’s at as we transit from Q4 to Q1.

Then more factual cash flow question. CFFO, so, cash flow from operating activities in Q4 was only $23 million, I think the lowest level in 10 years’ time. If I add a net result, stock-based, depreciation and working capital, I get to 23 -- or $33 million or $35 million. What explains the $10 million cash out in the operating activities? And the similar question I have on the financing activities. If I look at balance sheet there, my calculation, look at dividend cash out, I also have a GAAP cash out of $7 million?

Hi, Thijs, this is Chris. I’m not sure I fully understand what you’ve done, but I think it would probably better if you called me after our call, and we can make sure we were on the same page and then I could probably answer your question better.

Yes. No, that’s fine because let’s say in your Q4 outlook you said you where looking at the refining the share buyback schedule, the cash flow in Q4 is not sufficient to finance that?

Yes. That’s a good point. One of the broader issues that we had in Q4 is a pleasant thing. Our revenues actually went up, so our receivables went up, so our investments in working capital went up which caused our free cash to go down. But remember our receivables went up because revenues went up, product [ph] creditor collection issue, in fact as Chris said, our DSOs improved. So, that broadly speaking is a reason why our free cash was a little bit soft in this quarter, because revenues were up. But, please [technical difficulty] details of that.

Okay. And last question, can you remind me on the debt to covenant on that debt to EBITDA, because you are now back at 1.8 times, I think?

So, the covenant is 2.5, but it is -- there are adjustments that you add back.

Right. It’s adjusted EBITDA, and I do not think we’re anywhere close to 1.8. So, there is a lot of room, there is still a lot of room with the most restrictive covenant that we have which is the one Dick mentioned.

Can I go back to the last K, and it shows what those add backs are.

Okay.

So, it’s stock-based -- there are like three or four things, and in the K it numerates those, so you can see clearly. And we show what it would be if it was just debt-to-EBITDA, but we also show what the test method is using those add backs. So, you can see in both ways.

Okay. Very good. Thank you.

Okay. Kerry, we’ll take one more question.

All right. Our last question will come from Sean Meakim of J.P. Morgan. Please go ahead.

So, Dave, we’ve seen a surge in the rig count into the holiday season in the fourth quarter and it’s continued here early in the year. From your perspective, I was just curious, how much you think the continued shift towards pad drilling higher, higher wells per pad, all that’s elongating the lag between drilling and completions activity. And then, how does that eventually translates into something like completions tailwind for North America?

Yes. Sean, I think you make a very good point there. If you look at the number of drilling rigs added compared to the number of completions, completions were up 2%. And of course that’s what makes a revenue event for Core Lab. Certainly, pad drilling, if we look at a pad that’s going to drill give wells, that’s going to be let’s say somewhere around 60 days to drill all five of those wells at a very efficient drilling process, you’re probably going to look at some delay in the completion of that entire pad by somewhere between 90 and 120 days. So, you’re exactly right, we’re building up, we’re slowing building up a backlog of wells that have been drilled and uncompleted. And actually if you look at the number of DUC wells that are out there, at the end of the quarter, it was nearing an all time high. These aren’t fail DUCs, these are DUCs that have been drilled in pad drilling that are waiting on completions that are going to start to occur probably in Q1, certainly in Q2.

Got it. Okay. Thank you. And then, just one last thing on the margins, we talked about that target of 60% incrementals. How do we think about the levers that are required to get you to that level in the early recover here?

Yes. We’ve got a fixed cost system; we have added some employees to production enhancement, but that certainly will be overwhelmed by the amount of revenue that we are going to add. And we believe that in Q1, you will see incrementals approaching that 60%.

Got it. Okay, great. Thank you.

Okay, Sean. So in summary, Core’s operations continue to be positioned for the Company to -- for the upticks in activity levels in the first quarter of 2017, but we know significant challenge is away. However, we have never been better operationally or technologically positioned to help our clients maintain and expand their existing production base. We remain uniquely focused and are the most technologically advanced reservoir optimization company in the oilfield services sector. This positions Core well for the challenges ahead. The Company remains committed to industry-leading levels of free cash generation, returns on invested capital with capital being returned to our shareholder via dividends and future opportunistic share repurchases. So, in closing our 86th quarterly earnings release, we thank all of our shareholders and the analysts that follow Core. And as already noted by Monty Davis, the executive management and Board of Core Laboratories give special thanks to our worldwide employees that have made all these results possible. We are proud to be associated with their continuing achievements. So, thanks for spending your morning 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 your lines. Have a great day.