Core Laboratories Inc (CLB) 2016 Q4 法說會逐字稿

Welcome to the Core Laboratories fourth-quarter 2016 earnings conference call.

(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, Carrie. Good morning in North America. Good afternoon in Europe. Good evening in Asia-Pacific. I'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 will 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 will 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 markets, international political climate and other factors including those discussed in our 1934 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, see item 1-A 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 will 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 under supplied as indicated by several consecutive months of declining worldwide crude-oil inventories. 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 the continuing rally in oil prices and energy prices in 2017. As Core has continually stated, the Middle East was producing oil at unstable levels. We are sure that some of these cuts were more than welcome by several Middle Eastern producing countries.

All that Core did was listen to the reservoirs and not the rhetoric. Also importantly, US 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 [2015]. At that time, Core calculated a US net decline curve rate of 11% per annum. US 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 made calculations and projections for US 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 million added in 2016. The US 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 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 declines, 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. Incidentally, 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 $121 million equal to 190% of net income, clearly, one of the best in the oil field service industry. Moreover and more importantly, Core converted over $0.20 of every 2016 revenue $1 into free cash flow, again, leading all oil field service companies. Free cash flow matters to Core Lab shareholders.

During the fourth quarter 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.

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 US 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 completions in the US during the fourth quarter, indicating an improvement in our market penetration.

Moving on to cost of services for the quarter, or 72% of service revenue remaining consistent with the last couple quarters. For the full year, cost of services averaged about 70.5% of our service operating and our service operating margins continue to be some of the strongest amongst oil field 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 $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, 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 that 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 the guided tax rate of 6%. 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 US 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 an 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 from $16.7 million last quarter. 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 $1.46 for the full year. As we move on to 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 continued to increase as the quarter progressed or up about $6 million this quarter, but down over $31 million from $145.7 million at prior year end. Our DSO's continued 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. Our inventory levels are expected to remain at similar levels.

Now, on to the liability side of the balance sheet. 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, 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 at $150 million, as well as $68 million under our bank revolving credit facility. Shareholders' equity ended the year at $155.3 million, 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, 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. As I have stated earlier, Core Lab has the ability to increase its investments in support of these strengthening activities.

Looking at cash flow, in the fourth quarter, cash flow from operating activities was $23.2 million. 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 our free cash flow, after paying for our CapEx program was $120.5 million, representing over $0.20 for every $1 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 companies' financial results, particularly, for those shareholders who utilize discounted cash flow models to assess valuations. 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.

Okay, thanks, Chris. All right. For the first quarter, revenue and 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 margin of approximately 35% to 45%, well into the 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 be drilled and subsequently completed, stimulated, cored or have reservoir fluid samples collected before we can realize a revenue event.

We are clearly benefiting from increased US 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 under supplied. This is indicated by 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 extended worldwide inventory declines, which could create a continuing rally in energy prices throughout this year. As customary, we expect traditional typical seasonal sequential industry activity patterns that will cause the first quarter of 2016 to 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 to low double-digits, 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 a 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 rate can vary based on the jurisdiction where income is earned, we believe an effective tax rate of 14%, as stated during last quarter's call and Chris's comments, is more likely in the first quarter of 2017, as a result of the shift in activity to the US. 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. Core expects to continue to make opportunistic repurchases of our shares using that free cash flow in excess of our dividend payment. Okay. With that review of our guidance, let's turn the conversation over to 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 will be out today. For the second year in a row, Core Lab was ranked as the top oil field 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 continue 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 dependent 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 matrix 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 cycle gas compositions and in different stratigraphic horizons. Core's proprietary reservoir condition 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 in the rock matrix 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 test 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 the optimum fluid cycling procedures for subsequent field testing. 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 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 fracking jobs, they have begun to understand the importance of a uniform perforating hole size throughout each frac stage.

Core's HERO PerFRAC system provides an industry-leading, consistent hole size around the well bore, 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 systems 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 will allow the frac engineer to select a 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 the 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 at an 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 the US, products focusing on the Permian Basin outweighed sales from the studies of other plays by almost 2 to 1. The Permian plays continue to drive the high margin, high levels of merger and 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 geo-mechanical profiling, to optimized completion practices and petrographic analysis to streamline reservoir characterization gained acceptance from our clients. Carrie, we will now open the call for questions.

(Operator Instructions)

Ole Slorer, Morgan Stanley.

It looks like we are kind of defining a trough for the Company with production enhancement in full flow and reservoir description kind of consolidating around international trends. You guided down a bit in the first quarter on the reservoir description. I suppose part of that is also maybe seasonal, but could you talk a little bit more about how your incoming coal volume is trending there at the moment? You highlighted that you expected a series of FIDs this year to benefit. 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 die down 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.

So the revenue decline downtick in reservoir description in the first quarter?

That's our seasonal -- typical seasonal pattern, Ole.

Yes, Okay, that was my question to what extent was that seasonal? To what extent is it?

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. Actually, we may have seen that, followed by offshore and Deepwater. If you just look at some of the most recent press releases -- there was one this morning on Exxon Liza, which will be FID'd sometime in 2017, projects like this are good news for Core Lab.

We're doing the full battery of rock analysis there. We're following up with a 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 2 in the Deepwater Gulf of Mexico, we will see other FID's 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. 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 IOC's in Europe just recently, I came away kind of feeling a very sharp contrast with what I'm hearing. At this point front lip-service is from the IOC's in the US where this seems to be a very big focus on shale, while in Europe. My sense is that there's a string of FID's that could be sanctioned, particularly maybe in the Bering Sea. So, how would that affect you? Clearly, positively, but what's your view on that?

Yes, we would certainly agree that you've 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 are going to be more aggressive in FID'ing offshore and Deepwater projects. But I think in the queue back here in the US in some of these projects, I think we're getting strong indications that we will see additional FID's in some of the projects we've mentioned. You can 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 -- we're hearing also from another big operator in the Bakken yesterday, that they are experimenting with a range of different completion types, higher sand volumes seem to be a general theme yet again. What is -- you talked about miscible gasses.

What's going on in this side oil business? Are customers, again, willing to pay up for technology? The past 2 years seems to have been sort of a race to the bottom as far as quality and prices and everything. Are you sensing -- to what extent are you sensing the change now with a slight also change in the customer base in North America? Are there more?

Yes, Ole, I would bifurcate the North American clients into those that are technologically sophisticated clients. In that camp, 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, formally 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 will be able to leverage to some of these other technologically sophisticated clients. (multiple speakers) I think we're bi --

Sorry, Dave. What do you expect the impact on 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. For a number of these projects, for instance, like Apache, in the southern Delaware Basin, certainly, we had to manufacture that equipment because we're using NMR technologies at the frequencies not produced by any other equipment maker. So we went ahead and make that equipment ourselves.

So, the impact it will have in reservoir description will be higher revenues that also contain higher margins. So, a number of these projects that we are 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 profit is a blueprint for higher returns and higher EURs.

However, you run 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. That sand can be either northern white or some regional sands that are available, looking at the use of 100 mesh size and maybe finer grain sizes, depending on which stage of the frac that they are pumping. So, a lot of exciting technologies that will bear fruit here over the next couple of years. At Core Lab, we think we've got the pulse right on this.

That sounds very good, exciting. Just one final one, you mentioned finer grain, are you seeing any signs that there is a return of higher crush resistant product like ceramics? Or is it all sand? You mentioned it going the other way to regional sand. Any signs it's 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. 100 mesh and finer sand is something that the industry will probably trend to. Because can see it here in our laboratories, that's probably the way to go.

Thank you very much. I will hand it back.

Okay, Ole.

Gregory Lewis, Credit Suisse.

Dave, just as we -- just following a little bit up on Ole's questions about FIDs. We're hearing or seeing that it looks like there's going to be, at least in the near term, it's going to be more of a brownfield story, where the greenfield projects may be following in late 2018 or 2019. How does that play into the reservoir description? 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 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 you 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. Some of these brownfield developments we'll 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. We would agree right now, they are 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 Liza-2 and some of the others that we have 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 a number of these projects that are already in the queue for Core Lab.

Okay, great, thanks. Then just one follow-up for me. You mentioned the HERO, new frac, this is one of --

That's the HERO PerFRAC.

Yes, Correct, sorry. As we think about that, it's a new product, it's still early days. Do you have any sense for the absorption rate of that? Are we still in early days? Is that really going to replace a lot of the existing tools you are using or PerFRAC's over the next 12 to 18 months? I'm just trying to get -- 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 a well.

There is no sense fracking a well and only getting 65% or less 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 a system that we see continuing to grow as fracking continues. We will see that a lot in the growth in 2017 and onward.

Yes, Greg, we're working right now on a project -- we're on a pad, one well by this operator was perforated using conventional perforating systems. The neighboring well was used totally a PerFRAC system. It will be a nice proof of statement paper that we'll come out with. We think 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.

Okay. Perfect. Thank you very much for the time.

Thanks, Greg.

James West, Evercore ISI.

This is actually Samantha Hoh filling in for James. Dave, just quickly, I noticed -- 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 falling over the next year based on what you are seeing in terms of [filling out to be] production and all that stuff?

Yes, Samantha, it does -- when you have significant changes in the way that worldwide production acts, it's difficult. At times like that, it's difficult to fine-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 -- the easiest way to do a decline curve is to know that the world -- the globe is producing at full capacity. 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 too 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 US and internationally. We are betting people; we would suggest that we'll take the bets. We'll bet the over on the international decline curve rate going from 3.3%, probably higher.

That's great, Dave. Thank you for that. Then I just had one other question. It's really great to hear how excited you guys are for just the down -- the bottoming of Deepwater and international in the first half. Monty, I was particularly curious about your comments regarding reservoir management, international study sales increasing dramatically over the last quarter. Is this a sign that maybe you guys are starting to see a bottom for offshore exploration? That maybe there's going to be a churn to come in the next couple of years in that area?

I think what it says, Samantha, as we tried to say is that the interest in these projects is growing a lot. People are interested. In looking back at bigger projects that have 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. That will probably lead -- people don't invest in these projects without following through with some work. So, we think there's going to be a pick-up 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 to add to the development of that. A company like Conoco has said that they will no longer explore for neat 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 big part of Core Lab, less than 10% of our business, we're going to have to have somebody going out and finding some new oil. Because last year, new discoveries total only 3.7 billion barrels. You've got the globe using over 55 billion barrels. Sooner or later, you empty that bank pretty quickly.

Then just actually, one last one for me, just on the Gulf of Mexico. Dave, I caught your comment that production was not as much as you guys had anticipated. I was just kind of curious about this new JIP that you are launching. Is that targeting more of those brownfields? Can you tell me a little bit more about this new JIP?

The difference -- we had a JIP on deepwater. You can 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 an increase of activities in that area as we move further out into the Gulf. 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 a bit different? Every reservoir is different from the last one, but they're different as you move further out into the Gulf of Mexico. 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 referred to as the lower tertiary. So, these are near the international line with some of the discoveries that Mexico has made, and are looking to the IOC's 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 the Mexican side, the northern Perdido Fold Belt. So it will be extension of the deepwater, as Marty said, into ultra-deepwater. So, we're 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.

Rob MacKenzie, Iberia Capital.

Dave, I wanted to come back to the Pioneer/HRL, the technology, see if you can give us a little feel for -- I know you talked about, I think, maybe a couple of clients that you think it applies to, but how -- when does that commercialization you think start? 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, signed the agreements. They actually went through the description of a core that had literally thousands of different environmental facies in it. Out of all the facies that were identified by this computer learning, they were only three in question. So it is, right now, a commercially viable service that we'll 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. It will take time for client acceptance.

But from what we've seen so far, we're 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 many thousands of feet of core that can be analyzed and described within, if not minutes, hours as opposed to days. With spread rights back in 2014 at 1,000,001 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 in terms of, perhaps, being able to scale revenues while hiring, if anything, very few incremental technical staff?

Yes, 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.

The thing that we had mentioned was our worldwide rock catalog, where we will really have thousands of facies around the globe. It will take us, to machine learn, over a period of several quarters, if not year to machine learn from our expert geologists on how those facies should be interpreted.

Okay, great. Coming back to tight-oil EOR. Clearly, making some great progress in the lab there. That's going to be material over time. Was some of the development costs of those testing apparatus what impacted description margins 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. When you think about, today, the size of the projects in North America, they are just smaller. The reservoirs are not as complex, so the level of technology that we employ is lower. So, the reason for margin degradation has really been that shift towards North America.

The things we're trying to do to shift that, to pivot that 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. Then on the tight-oil EOR, is it still very experimental? Or what is the prospect for that becoming material to earnings for Core Lab in the next two, four, six, eight quarters?

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 some of the lean gases 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. These tend to be larger term projects, so I would say commercialization probably is still a bit away.

But we will continue to grind on these projects in laboratory. I think a real revenue spinner, probably in 2018. But right now, we are generating high-margin reservoirs from that, because we've had to build and construct that equipment. It's not available any other place on the planet.

Great. Thanks. I'll turn it back.

Okay, Rob.

Thijs Berkelder, ABN AMRO.

Congratulations with the US recovery, especially. Can you maybe explain in Q4, what is rising US revenues versus international decline?

Yes, Thijs, if you look at -- it was driven by our production enhancement unit that had US land revenue up 13%. So that was leaned over -- and all of production enhancement of 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. Lower levels of international activity, which we still perform on a relative basis was only up 3% versus North America being up 15% for production enhancement.

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

We will, indeed see that, but it will be manifested in production enhancement, because 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. That will be manifested in reservoir description.

Thijs, you see that historically. If you go back multiple years, Q1 is always lower than the preceding Q4 in reservoir description. That's just because of the international complexion of that business. You think about the IOC's and more particularly the NOC's budgeting cycle is a little bit slower than the independents in the US. 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 throw 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 than Q4. But not much, not more than 5%, but it does impact us because we keep our cost structure in place because we're 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.

That's nothing unusual and we're saying the same thing's going to happen again. The positive is the improvement in production enhancement that 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're not going to lose any of that to the traditional bleed that you normally see going into Q1. So we're very pleased with that revenue level staying where it's at as we transit from Q4 to Q1.

Okay, clear. Then a 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 up net result, stock based compensation, depreciations and working capital, I get to $23 -- or to $33 million or $35 million.

What explains the $10 million cash out in the operating activities? A similar question I have on the financing activities. If I look at the balance sheet there, my calculation-- look at dividend cash out, I also have a GAAP cash out of $7 million.

Thijs, this is Chris. I'm not sure I totally understand what you have done, but I think it would probably be better if you called me after our call. We can make sure we were on the same page. Then I can probably answer your question better.

Yes. No, that's fine because, as I said, in your Q4 outlook, you said you were looking at reviving the share buyback schedule. But 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 investment in working capital went up, which caused our free cash to go down.

But remember, our receivables went up because revenues went up. It's not a credit or collection issue, if fact, as Chris said, our DSO's improved. So, that broadly speaking, is reasonable why our free cash was a little bit soft in this quarter because revenues were up. But, please, call (multiple speakers) together and you can go through the details of that.

Yes. Okay. Last question, can you remind me on the debt covenant level on the debt to EBITDA? Because you're now back at 1.8 times I think.

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

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

Thijs, go back to the last K and it shows what those add-backs are: so it's stock based compensation --

Okay.

There are like three or four things. In the K, it enumerates those so you can see clearly. 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 it both ways.

Okay. Very good, thank you.

Sean Meakim, JPMorgan.

So, Dave, we've seen this surge in the rig count in through the holiday season in the fourth quarter and it's continued here, early new year. From your perspective, I'm just curious, how much you think the continued shift towards pad drilling, higher wealth per pad, all that's elongating the lag between drilling and completions activity? Then how does that eventually translate into something like a 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%. Of course, that is what makes a revenue event for Core Lab.

Certainly, pad drilling -- if we look at a pad that's going to drill five 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 are 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 slowly building up a backlog of wells that have been drilled and uncompleted. 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 stale 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. 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 recovery 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're going to add. 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 up-ticks in activity levels in the first quarter of 2017. But we know significant challenges await. 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 oil field 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.

As already noted by Monty Davis, the executive management and Board of Core Laboratories gives 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. 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.