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Edited Transcript of CLB earnings conference call or presentation 25-Jul-19 12:30pm GMT

Q2 2019 Core Laboratories NV Earnings Call

AMSTERDAM Jul 31, 2019 (Thomson StreetEvents) -- Edited Transcript of Core Laboratories NV earnings conference call or presentation Thursday, July 25, 2019 at 12:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Christopher Scott Hill

Core Laboratories N.V. - Senior VP & CFO

* David M. Demshur

Core Laboratories N.V. - CEO & Chairman of Supervisory Board

* Gwendolyn Y. Schreffler

Core Laboratories N.V. - SVP of Corporate Development & IR

* Lawrence V. Bruno

Core Laboratories N.V. - COO, President & Supervisory Director

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Conference Call Participants

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* Byron Keith Pope

Tudor, Pickering, Holt & Co. Securities, Inc., Research Division - MD of Oil Service Research

* Chase Mulvehill

BofA Merrill Lynch, Research Division - Research Analyst

* Connor Joseph Lynagh

Morgan Stanley, Research Division - Equity Analyst

* Ian MacPherson

Simmons & Company International, Research Division - MD & Senior Research Analyst of Oil Service

* Scott Andrew Gruber

Citigroup Inc, Research Division - Director and Senior Analyst

* Sean Christopher Meakim

JP Morgan Chase & Co, Research Division - Senior Equity Research Analyst

* Stephen David Gengaro

Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Analyst

* Vaibhav D. Vaishnav

Scotia Howard Weil, Research Division - Analyst

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the Core Laboratories Q2 2019 Earnings Conference Call and Webcast. (Operator Instructions) Please note that this event is being recorded.

I would now like to turn the conference over to David Demshur. Please go ahead.

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David M. Demshur, Core Laboratories N.V. - CEO & Chairman of Supervisory Board [2]

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Thank you, Chris.

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' Second Quarter 2019 Earnings Conference Call. This morning, I'm joined by Chris Hill, Core's CFO; Gwen Schreffler, Core's Head of IR; and Larry Bruno, Core's President and COO.

The call will be divided into 5 segments. Gwen will start by making remarks regarding forward-looking statements. And then we will review some of the current macro environment, updating industry trends pertaining to Core Lab's expected future performance. And then some current thoughts on worldwide crude oil supply trends. We will then review Core's 3 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 Gwen discussing Core's third quarter 2019 outlook and a general industry outlook as it pertains to Core's prospects. Then Larry will go over Core's 2 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.

And then we will open the phones for a Q&A session.

I'll turn it over to Gwen for remarks regarding forward-looking statements. Gwen?

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Gwendolyn Y. Schreffler, Core Laboratories N.V. - SVP of Corporate Development & IR [3]

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Thank you, David. Before we start the conference this morning, I'll mention that some of the statements that we make during this call may include projections, estimates and other forward-looking information. This would include any discussion of the company's business outlook. These types of forward-looking statements are subject to a number of risks and uncertainties relating to the oil and gas industry, business conditions, international markets, international political climate, and other factors, including those discussed in our 34 Act filings, 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 statement. 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 most recent annual report on Form 10-K as well as other reports and registration statements filed by us with the SEC and the AFM.

Our comments include non-GAAP financial measures. Reconciliation to the most directly comparable GAAP financial measures is included in the press release announcing our second quarter results. Those non-GAAP measures can also be found on our website.

With that said, I'll pass the discussion back to Dave.

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David M. Demshur, Core Laboratories N.V. - CEO & Chairman of Supervisory Board [4]

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Thanks, Gwen. Now some industry trends and then on to our 3 financial tenets.

Core is encouraged that operating companies are furthering their commitments to operating within their own free cash flow and emphasizing returns on invested capital as demanded by today's investors. This trend benefits Core, whose clients tend to be technologically sophisticated and are heavy users of technology over commodity-driven solutions.

During the second quarter, Core continued to host several conference calls, industry sessions and industry groups and analysts to discuss optimal well spacing, rightsizing, upsizing, well positioning and parent-child well relationships. Proper upsizing and well spacing are 2 of the most discussed topics within Core's clients today. Also, improving perforating efficiencies and effectiveness rank a close second. Larry Bruno will have a detailed discussion of Core's recent commissioning of the industry's most advanced Reservoir Optimized Completions Laboratory or ROC Lab. To that end, the industry will continue to add perf clusters per stage, yielding less but more complex stages while lateral lengths are nearing their maximum length owing to frictional forces. Perf clusters are now increasing to as many as 15 to 20 per stage, reducing the cost and time for well completion and stimulation programs owing to the lower stage count. The reasons for more perf clusters and fewer stages are our clients are changing the way reservoir rock is being stimulated to produce the maximum amount of stimulated reservoir volume within close proximity to the wellbore. Long frac channels are to be avoided as they are the source of well interference. It is possible to rebelize more Stimulated Reservoir Volume in the near-wellbore region and avoid costly well interference problems using more perf clusters. We see this trend continuing.

Adding a new and growing -- addressing a new and growing market, the recent acquisition of Guardian Global Technologies continues to be a technological windfall for Core Laboratories. We have received positive client feedback, market acceptance and market share on our industry-leading preassembled energetic systems via the company's GoGun. Core's current biggest challenge is scaling up to meet gun demand as automated systems are currently being added. Core recently had to turn down a single order for over 13,000 guns, an order valued at $7 million. The most critical components of any preassembled energetic system remain the perforating charges and their interaction with the reservoir rock. Core's industry-leading ballistics team continues to innovate the best perforating systems, including Core's most recently introduced refrac system that significantly improves the results and economics of refrac-ed wells. Note, watch the refrac-ed well space over the next several quarters and next several years.

The last and most important trend for Core is that client activities have continued to increase for international and deepwater long-cycle projects that will be needed to meet future production demand. The foreshadow of this increase in activity has been evident in the 20 FIDs approved in 2017, another 30 in 2018 and 30 more queued up here in 2019. Revenue from these longer-cycle projects has mainly been absent from Core's Reservoir Description revenue streams dating back to 2015. The increased international activity did bolster Reservoir Description revenue in the second quarter of 2019, more than offsetting lower activity in North America. Remember, the decline curve still always wins and never sleeps.

Now some comments on worldwide crude supply. An indication of the effects of the decline curve comes from the fact that non-U. S. and non-OPEC production totals have fallen for their seventh consecutive year, more than offsetting production gains in Russia. Also notable, Russian gains over the last several years have been slowing. Moreover, Eagle Ford -- the Eagle Ford play is in permanent decline as Bakken production will near its projected peak over the next year or so. We remain bullish on crude oil.

Now to review the 3 financial tenets by -- which Core has used to build shareholder value over the 24-year history of being a publicly traded company.

During the second quarter of 2019, Core generated over $10 million in free cash flow, marking the 71st consecutive quarter of generating positive free cash. Core has no plans on cutting our dividend as we view its importance to our investor base, especially our European investor base, as being sacrosanct. With the emergence of international markets pushing Core Lab revenue and operating margins, Core is confident that the company's asset-light model will allow Core's future cash flow to more than cover our dividend. And to add further to bolster free cash, the company has embarked on a North American cost-cutting plan. We are continuing to streamline businesses via increased automation and continues to review operating structures to right size cost for current market conditions. In addition, as was the case in the second quarter, the company will continue to review divestment opportunities of noncore, nonstrategic, low-margin businesses.

Also in the second quarter, Core once again produced the oilfield industry-leading return on invested capital for the 39th consecutive quarter with an ROIC of 21.3%. We appreciate all the analysts pointing that out in the notes that they've recently put out. Also during the second quarter of 2019, Core returned approximately $25 million back to our shareholders via our quarterly dividend. Core will continue to return capital back to its shareholder via quarterly dividends and share repurchases as free cash flow levels increase.

I'll turn it back to Chris for a detailed financial overview. Chris?

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Christopher Scott Hill, Core Laboratories N.V. - Senior VP & CFO [5]

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Thanks, David. 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 20%. So accordingly, our discussion today excludes any foreign exchange gain or loss for current and prior periods. Additionally, we have excluded the gain of $1.2 million on the divestiture of a nonstrategic business and a $3 million charge associated with the company's efforts to streamline our operating structures and business reporting lines as part of a company-wide cost reduction program.

Now looking at the income statement. Revenue from continuing operations was $169 million in the second quarter, comparable to last quarter but below the same quarter last year. Of this revenue, service revenue was $117.9 million for the quarter, down 2% sequentially. This quarter's activity was impacted by lower-than-projected service revenue in North America and with the reduction of almost $2 million in revenue associated with the divestiture of a nonstrategic business in Asia Pacific. However, the impact from these items was partially offset by increased activity from international and offshore projects, which is anticipated to continue improving into the second half of 2019.

Product sales, which are more tied to North American activity, were $51.2 million for the quarter, nicely up 5% from last quarter. The growth in product sales for the quarter was led by our U.S. energetic product sales, which grew 18% this quarter.

Moving on, the cost of services for the quarter are 73% of service revenue, down from 75% in the previous quarter due to improved operational efficiencies. Cost of sales in the second quarter was 75% of revenue, down slightly from 76% in the previous quarter due to improved absorption of fixed costs.

G&A ex items for the quarter was approximately $10 million, which is down slightly from last quarter. For 2019, we now expect G&A ex items to be between $42 million and $44 million for the year. Depreciation and amortization for the quarter was $5.8 million, which is comparable to the last several quarters. In 2019, we would expect depreciation expense to remain at similar levels and our capital expenditures to also be in line with our operation.

EBIT ex items for the quarter was $29.6 million and continues to represent best-in-class EBIT margins of 17.5%. GAAP EBIT for the quarter was $28 million.

Income tax expense for the quarter was $5.2 million using an effective tax rate of 20%. GAAP income tax expense for the second quarter was slightly lower at $4.8 million. We continue to project our effective tax rate to be approximately 20%. Additionally, as discussed in prior earnings calls, the effective tax rate will continue to be somewhat sensitive to the geographic mix of earnings across the globe and the impact of items discrete to each quarter.

Income from continuing operations ex items for the quarter was $20.7 million, up $1 million or a little over 5% from $19.7 million last quarter. GAAP income from continuing operations was $19.5 million for the second quarter.

Earnings per diluted share from continuing operations ex items was $0.46 for the quarter and also up almost 5% from last quarter. GAAP EPS from continuing operations for the second quarter was $0.43.

Now we'll move on to significant aspects of the balance sheet. Receivables stood at $134.9 million, up a little for the quarter and up $5.7 million from year-end. However, our DSOs have remained consistent at 67 days for the quarter.

Inventory stood at $49.3 million, up about $3.6 million from year-end but down about $800,000 from last quarter as we continue to work through some bulk purchases of raw materials that were purchased in Q1. Inventory turns were 3.2 for the second quarter, and we anticipate inventory turns will improve for the second half of 2019.

And now on to the liability side of the balance sheet. Our long-term debt at quarter-end was $292 million (sic) [$290 million], down $5 million from last quarter-end. The company completed the sale of the business that was held as a discontinued operation and a nonstrategic business in Asia Pacific region for net proceeds of approximately $19.6 million. The surplus proceeds from the sale of these businesses were used to reduce our debt under our revolving credit facility. Our debt is comprised of our senior notes at $150 million as well as $142 million under our bank revolving credit facility.

Looking at cash flow. In the second quarter, cash flow from operating activities was $17.1 million. And after paying for $7 million in CapEx, our free cash flow in Q2 was $10.1 million, which is the 71st consecutive quarter Core Lab has generated positive free cash flow. Our free cash flow for the second quarter was impacted by an increase in working capital and increased capital investment associated with technological innovations and automation programs. These capital investments add additional operational efficiencies and can expand our capability and service offerings for new technologies like the integrated GoGun system and our ROC Lab. For 2019, the company anticipates that its CapEx will be between $22 million to $24 million.

As Dave previously mentioned, the emergence of the international market is important for Core Lab and will continue to fuel the expansion of our operating margins and future cash flow. We remain confident that our incremental margins will continue to be strong, operating margins will continue to improve and the future generation of free cash flow will grow to more than cover our dividend. Our free cash flow conversion ratio, which is free cash flow divided by income from continuing operation using a normalized 20% effective tax rate, continues to be one of the highest in the industry at just over 100% for the first half of 2019. 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.

I will now turn it over to Gwen for an update on our guidance and outlook.

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Gwendolyn Y. Schreffler, Core Laboratories N.V. - SVP of Corporate Development & IR [6]

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Thank you, Chris.

During the first half of 2019, the global crude oil market stabilized with the continuation of OPEC production cuts and a modest decline in global crude oil inventories supporting a balance between supply and demand. The most recent International Energy Agency report estimates demand growth of -- for 2019 will be 1.1 million barrels per day, slightly down from the first quarter of 2019. Also during the second quarter, the international offshore rig count increased by 26% year-over-year, and the overall international rig count increased by 14.5% year-over-year. While market concerns exist regarding the balance of future crude oil supply and demand, crude oil production additions are limited on a global basis. The decline curve is prevailing in the mature crude oil fields internationally, heading towards a supply gap over time. These crude oil fundamentals drive for clients international activity levels which are expected to continue to improve in the third quarter of 2019. The balancing of the crude oil supply and demand supports the crude oil price, which underpins the final investment decisions and emerging international crude oil field reinvestment. These international investments are critical as the decline in production from mature fields continues and new field development is required for supply replacement. Consequently, Core expects the Reservoir Description segment to benefit from increased client spending in the international crude oil market.

The average third quarter 2019 U.S. rig count is projected to be down. While operators continue to focus on generating free cash flow and returns on investment, optimizing well completions remains a significant lever in growing field investment returns while managing their capital budgets. As a result, Core projects U.S. onshore completion activity to be flat sequentially. Core would expect U.S. energetic sales to exceed the rate of completion activity, as they did in the second quarter of 2019. Therefore, we expect consolidated third quarter 2019 revenue of approximately $171 million to $175 million and operating income of approximately $30.6 million to $32.6 million, yielding operating margins of 18% with incremental margins ex items exceeding 50%. The company's EPS for the third quarter of 2019 using an effective tax rate of 20% is projected to be $0.48 to $0.52.

Core Lab's third quarter 2019 guidance is based on projections for the underlying operations and excludes gains and losses in foreign exchange.

To summarize, the following assumptions were used to provide third quarter 2019 company guidance. The international recovery is expected to continue, benefiting the international revenue generated by Reservoir Description. Third quarter 2019 U.S. rig count is projected to be down. However, Core projects U.S. onshore completion activity to be flat sequentially. And we would expect U.S. energetic sales to exceed the rate of completion activities, as they did in the second quarter of 2019. And lastly, the potential North American market challenges that may affect both business segments.

With that said, I'll turn the call over to Larry.

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Lawrence V. Bruno, Core Laboratories N.V. - COO, President & Supervisory Director [7]

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Thanks, Gwen. First, I'd like to thank our global team of employees for providing innovative solutions, integrity and superior service to our clients. The team's collective dedication to servicing our clients is the foundation of Core Lab's success.

Turning first to Reservoir Description. During Core's 2019 Q1 conference call on April 25, Core announced that it was engaged in the analysis of over 700 feet of conventional core from the Talos Energy Zama-2 well located in Block 7 of the Sureste Basin in the Gulf of Mexico. In the second quarter of 2019, Core Laboratories, under the continued direction of Talos Energy, provided similar services on conventional core from a second well in this offshore Mexico project, the Zama-3 delineation well. Over 700 feet of conventional core was captured from the Zama-3 well with 99% recovery, breaking Talos' own record for the longest conventional core from a single well in the history of offshore Mexico. Previously established workflows, including proprietary core preservation and stabilization techniques developed by Core Lab for a wide range of sandstone reservoirs in the U.S. portion of the Gulf of Mexico, were again successfully applied. Upon arrival in the laboratory, the Zama-3 conventional core was immediately scanned using Core's proprietary noninvasive, dual-energy CAT scanning and high-resolution special gamma ray detectors. These surface logging technologies provide Talos Energy with lithologic data and a wide range of critical parameters for pay assessment well in advance of time-honored laboratory analytical methods. Advanced laboratory analysis is ongoing. Talos will use the datasets provided by Core Laboratories on the Zama-2 and Zama-3 wells to calibrate models that will ultimately provide reliable calculations of recoverable resources on what Timothy Duncan, Talos' President and CEO, has described as a globally recognized asset. Core Lab continues to be pleased to be part of this unprecedented exploration achievement and looks forward to completing the detailed geoscience and engineering studies.

Also during the second quarter of 2019, Core completed a fully integrated study of Brazil's North Eastern Offshore Basin. This multi-company interpretive study incorporates stratigraphy, geochemistry, reservoir geology and seal rock analysis across several Atlantic Margin Basins offshore Brazil. This study provides the participating companies access to a rock-based subsurface dataset to evaluate new opportunities, including deepwater, Late Cretaceous turbidites that are attracting considerable attention from operators.

In addition, in Q2, Core continued to make progress on its 2 multi-company EOR projects in the Eagle Ford and in the Permian Basin. Core's clients are using the detailed reservoir fluid analysis and laboratory-based engineered gas injection tests' results to evaluate opportunities for field-scale deployment. Some of Core's clients are already in the field-scale testing, and additional companies are looking at the opportunity through proprietary work with Core Lab.

Moving now to Production Enhancement. During the second quarter of 2019, Core's Production Enhancement segment commissioned its new, cutting-edge Reservoir automated -- Optimized Completions, or ROC Lab in Godley, Texas. The ROC Lab is designed to determine the best energetic solutions for a specific rock type so as to maximize productivity of an operator's reservoir. The ROC Lab features an industry-leading test vessel capable of matching the temperatures and pressures encountered in the most challenging oil and gas reservoirs on the planet. The perforation test vessel is paired with a Core Lab proprietary flow system that uses highly specialized, internally developed and manufactured pumps and flow controllers. Combined, these technologies create a proprietary flow loop capable of dynamically displacing oil, brine and gas through the rock samples that have been perforated with preselected energetics. Core relied on its many decades of experience in conducting multiphase fluid flow tests through porous medium to optimize this technological investment. In addition, the ROC Lab has a high-resolution, industrial-grade 3D CD -- CT scanner. This on-site scanner gives clients the ability to look inside the test samples, see depth of penetration, determine tunnel volume and geometry and assess completion damage to the information, all with industry-leading imagery resolution.

The ROC Lab is a collaborative development between the ballistics engineering experts in Production Enhancement and the scientists in Core's Reservoir Description rock, fluid and laboratory instrumentation segments. This collaboration, for which Core Lab is uniquely positioned, presents clients with the opportunity to obtain measured data on the interrelationships among rocks, pore fluids and various energetic options, all at reservoir stress conditions. Combined with Core's proprietary geological analysis techniques, Core's clients can now select energetics that will optimize performance for specific stratigraphic targets.

Core's Ballistic Delivery System and its Addressable Fire Switch are key differentiators of Core's preassembled GoGun Adaptive Perforating System.

During the second quarter of 2019, client adoption of these technologies continued to grow as they convert from legacy devices to Core's advanced delivery system and downhole communication offerings.

Also in the second quarter, Core saw a substantial increase in demand for its proprietary refrac perforating technology. Refrac works as part of a mechanical isolation approach to recompletions in existing wells. Mechanical isolation involves placing and cementing a smaller-diameter casing inside the existing well casing, completely closing off communication between the reservoir and the original wellbore. This approach avoids the reliability issues that can be encountered when diverter technologies are attempted for recompletions. The challenge with mechanical isolation is to reestablish effective communication through 2 layers of casing string while generating consistent perforation hole size. Without uniform hole size, the recompletion attempt would produce uneven stimulation effects. Core's refrac perforating solution, the first offering of its kind, provides optimal and consistent hole sizes through both strings of tubulars. This allows for new zones in a lateral to be effectively pumped and stimulated, breathing life into older, understimulated wells. Advances such as Core Lab's proprietary refrac technology are key to successfully expanding recompletion opportunities across mature, unconventional plays.

Core continues to assist its clients in understanding parent-child relationships between frac wells. Core's fracture diagnostic services utilize technology to determine optimum well spacing and proppant usage while minimizing well interference. During the second quarter of 2019, Core designed a large-scale field program with a Permian Basin operator to profile production and communication across 19 total wells on multiple pads. Critical to evaluating such a large, complex program were Core's extensive portfolio of proprietary FLOWPROFILER EDS hydrocarbon tracers, which were deployed in both 100-mesh and 40/70-mesh sizes, as well as the expertise of Core's engineers to design diagnostic programs around the operator-specific objectives. Core was able to identify which portions of the frac treatment were overlapping with offset fracture networks as well as the impact on well performance. Work is ongoing on this project.

That concludes our operational review. We appreciate your participation. And Chris will now open the call for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question is from Chase Mulvehill of Bank of America Merrill Lynch.

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Chase Mulvehill, BofA Merrill Lynch, Research Division - Research Analyst [2]

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I guess first question, if we can kind of just talk about the 3Q outlook in particular on the Production Enhancement. It sounds like that you all think that completions will be flat and energetics will outperform that. So if we think about revenues for Production Enhancement in 3Q, should we be thinking about those revenues being up or kind of flattish?

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Gwendolyn Y. Schreffler, Core Laboratories N.V. - SVP of Corporate Development & IR [3]

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I think those are going to -- Chase, this is Gwen. I think those are going to be somewhat flattish. And on the energetics, we would owe that to penetration with existing customers as well as adoption with new customers in the new technology. So that's having a flat completion activity sequentially and then more energetic sales.

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Chase Mulvehill, BofA Merrill Lynch, Research Division - Research Analyst [4]

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Okay. And on the energetics and the GoGun in particular, could you kind of quantify, if you could, maybe the penetration that you've gotten so far, maybe kind of what kind of market shares that you think you have on the preassembled guns? And really, what differentiates your GoGun versus everyone else's?

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Lawrence V. Bruno, Core Laboratories N.V. - COO, President & Supervisory Director [5]

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So yes, Chase, it's still very early innings of the introduction of the GoGun into the market. And I think -- so it's -- we're still in a ramp-up phase on that. I think the important point is the differentiator is ultimately the energetics. We can deliver and other companies can deliver a convenient package to the wellsite in terms of the preassembled gun. But ultimately, it's the efficiency and effectiveness of the energetics that is the determining factor. And that's what drives people to Core Lab's offerings.

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Chase Mulvehill, BofA Merrill Lynch, Research Division - Research Analyst [6]

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Okay. Right. That's helpful. The quick follow-up here on Reservoir Description. Obviously a good quarter. Nice rebound in margins. Could you maybe just talk about the back half of the year and the FIDs that seems -- possibly be kind of coming through in the back half of the year? So what kind of year-over-year growth? So when do we hit that 10% mark on year-over-year growth for Reservoir Description? And what about that 20% EBIT margins? Do you think that's possible by the end of the year for Reservoir Description?

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Lawrence V. Bruno, Core Laboratories N.V. - COO, President & Supervisory Director [7]

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Not quite ready to give full year guidance here, but our view right now is that we'll see improving margins in the third quarter and further penetration of this rebound in the international market.

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David M. Demshur, Core Laboratories N.V. - CEO & Chairman of Supervisory Board [8]

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Yes. We ought to be cautioned, though, Chase, because we do generate some Reservoir Description revenue in North America, so that's going to offset some of the international impact. Right now, we do see international growth at 8% where some of that was offset by some decrease in North America. So I think that's the watchword. If you can hold North America flat in Reservoir Description, I think we get to the 10%, certainly high single digits maybe as early as next quarter. And on margins, Chase, I think we're looking at 18% next quarter. So we could be knocking on that door fourth quarter.

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Operator [9]

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The next question is from Byron Pope of Tudor, Pickering, Holt.

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Byron Keith Pope, Tudor, Pickering, Holt & Co. Securities, Inc., Research Division - MD of Oil Service Research [10]

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For -- within Production Enhancement, so clearly the energetics demand continues to trend in the right direction. I was just wondering if you could give some color on the discretionary services where there were some headwinds in Q2. I'm just trying to understand that dynamic as you think about the back half of the year. Because again, I realize the energetics demand will continue to trend in the right direction.

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Gwendolyn Y. Schreffler, Core Laboratories N.V. - SVP of Corporate Development & IR [11]

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So -- Byron, so on the services part, that is a fairly discretionary service. So that is diagnostic services that represents about 1/3 of the Production Enhancement segment. So we did see somewhat of a decline in the North America part of that business.

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Byron Keith Pope, Tudor, Pickering, Holt & Co. Securities, Inc., Research Division - MD of Oil Service Research [12]

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Okay. That's helpful.

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Lawrence V. Bruno, Core Laboratories N.V. - COO, President & Supervisory Director [13]

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Byron, I'll answer that, that there is some very nice opportunities for our completion diagnostics in offshore field development programs. And so as those improve both offshore U.S. and internationally, we see that providing some support for completion diagnostics going forward.

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Byron Keith Pope, Tudor, Pickering, Holt & Co. Securities, Inc., Research Division - MD of Oil Service Research [14]

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Okay. That's helpful. And then that's a good segue to my next question. Just thinking about international across both business segments, I realize it's more skewed towards Reservoir Description. But if I recall correctly, that your -- Middle East region is your -- more this international region. And can you just frame the growth prospects that you see there over the next 12 months?

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Lawrence V. Bruno, Core Laboratories N.V. - COO, President & Supervisory Director [15]

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Yes. I think the Middle East is -- as I think I mentioned in the last quarter and still hasn't changed views on, I still see the Middle East as a sort of on the forefront of our -- of the international recovery. We've seen some nice things developing -- continuing and developing in South America for us, offshore primarily. And so maybe, I still think that Brazil opportunities for us are largely a 2020 event. But for the back half of this year, I think the Middle East, as -- is leading. We've got a very nice project going on in Australia as well. I'd say Asia Pac, not quite as mature, the recovery, as the Middle East. And South America, ongoing work, continuing in a very nice clip and some new opportunities emerging for us into 2020.

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David M. Demshur, Core Laboratories N.V. - CEO & Chairman of Supervisory Board [16]

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Yes. Byron, just to add to that, looking at -- we would rank growth prospects: Middle East, still #1; and Latin South America, #2 at this point; and Asia Pac, third.

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Operator [17]

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The next question is from Sean Meakim of JPMorgan.

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Sean Christopher Meakim, JP Morgan Chase & Co, Research Division - Senior Equity Research Analyst [18]

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I was hoping we could unpack the mix in Production Enhancement in the second quarter or maybe have, I guess, a little more of a read into your guidance for the third quarter. So was the -- so I guess if U.S. energetics were up 18%, could you give us a sense of what percentage growth or what percentage of products would constitute energetics and what the growth rate was for products overall? So just given that that's 2/3 of the segment, services are 1/3 and it's the third that drove the decline, just trying to get a sense of the magnitude.

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Christopher Scott Hill, Core Laboratories N.V. - Senior VP & CFO [19]

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So we typically don't give the sales by product lines, but energetic business is a significant part of the product sales. We also sell some instrumentation. So if you're just looking at total product sales, there's also instrumentation in there from our Reservoir Description group as well.

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Lawrence V. Bruno, Core Laboratories N.V. - COO, President & Supervisory Director [20]

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But energetics are the bulwark of our product sales.

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Christopher Scott Hill, Core Laboratories N.V. - Senior VP & CFO [21]

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Products sales. And especially more so in Production Enhancement.

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Sean Christopher Meakim, JP Morgan Chase & Co, Research Division - Senior Equity Research Analyst [22]

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Right. And about 2/3 of the business is in the U.S. and 1/3, roughly, is international and offshore. So I'm still trying to figure out. I get you don't often give a lot of the detail, but you gave some of the detail. And so I'm just trying to understand, if the bulk of the products business was up 18%, how much of a drop-off we had to see in the services and diagnostics to get to that down 4% quarter-over-quarter? It seems like it's hard to bridge the -- to bridge one data point to the other. So I was just trying to conceptually understand that better because I don't -- we've never heard of that much volatility in the services previously.

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Christopher Scott Hill, Core Laboratories N.V. - Senior VP & CFO [23]

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Got you.

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Gwendolyn Y. Schreffler, Core Laboratories N.V. - SVP of Corporate Development & IR [24]

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Yes, Sean, that equated to about $4 million during the quarter down in services.

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Sean Christopher Meakim, JP Morgan Chase & Co, Research Division - Senior Equity Research Analyst [25]

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Okay. And I'm happy to talk more offline, but I'm just trying to understand that, the bridge to one data point and the other. So maybe just another question on Reservoir Description. I mean Dave already kind of gave a little bit of where I'm trying to go in terms of what the exit rate could look like. So it sounds like you're confident that you could be knocking on that 20% door. And directionally, I think it makes sense. Are there any other factors driving the step-up in profitability in the second quarter besides mix? Is it just job mix? Is there any shifts in the company that may be coming through?

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David M. Demshur, Core Laboratories N.V. - CEO & Chairman of Supervisory Board [26]

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Yes. It's international and offshore. And of course, challenged by North America. So Sean, we've seen these trends take place in recoveries in 2010 through 2014. We think this -- we're seeing the beginning of those stages actually currently happening right now.

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Gwendolyn Y. Schreffler, Core Laboratories N.V. - SVP of Corporate Development & IR [27]

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And Sean, just as a reminder, the step-up is directly tied to more activity, and that's coming through a fixed cost structure. So it's the reason you see the nice incrementals and the nice EBIT margin.

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David M. Demshur, Core Laboratories N.V. - CEO & Chairman of Supervisory Board [28]

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Right. So some of these FIDs that were announced back in 2017 and 2018 are finally coming to fruition for us, generating revenue from those.

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Sean Christopher Meakim, JP Morgan Chase & Co, Research Division - Senior Equity Research Analyst [29]

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Right. So it'd be the higher-margin projects and then you get the fixed cost operating leverage on top, and that's why you see the big step-up?

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David M. Demshur, Core Laboratories N.V. - CEO & Chairman of Supervisory Board [30]

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Correct.

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Operator [31]

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The next question is from Ian MacPherson of Simmons.

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Ian MacPherson, Simmons & Company International, Research Division - MD & Senior Research Analyst of Oil Service [32]

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My question's on the operational side had been pretty well covered. I wanted to ask Chris or whomever on the free cash flow side just because operating cash flow has fallen short of dividend coverage in the first half, I think, by about 40%. And I know that you have a target to bridge that, but I wanted to see what that looks like in the second half, what your expectations are for dividend coverage from operating cash flow and what leverage you have to pull to get there.

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Christopher Scott Hill, Core Laboratories N.V. - Senior VP & CFO [33]

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Sure. So I think it's important to remember that the fundamentals of what have sort of generated free cash flow for Core Lab historically are still all there. It was down slightly this quarter, and I highlighted some of the factors that impacted that. But as we go into the second half of the year, we continued to talk about and believe that free cash flow is going to improve, and it's driven by this international activity and the growth from our Reservoir Description group and the expansion of those margins. So we do -- I'm going to reiterate what I said in my notes that -- or my speaking notes that we are confident that as we get deeper into this international recovery, that's going to be reflected in our free cash flow generation. So -- but we're pulling the levers that we would normally pull. I think we'd like to see inventory turns improve a little bit. But like we talked about, we're expanding our product lines there, so there's a little bit of build in inventory with some new product offerings. But then also, we did have some bulk purchases there. So as we work through that, you'll see some improvements there as well.

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Ian MacPherson, Simmons & Company International, Research Division - MD & Senior Research Analyst of Oil Service [34]

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Okay. So as I understand it, it's essentially the low capital intensity associated with the expected uplift in RD earnings in the second half?

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Christopher Scott Hill, Core Laboratories N.V. - Senior VP & CFO [35]

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Yes, exactly.

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Lawrence V. Bruno, Core Laboratories N.V. - COO, President & Supervisory Director [36]

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No additional bond required? And so that's -- a fixed cost structure is a real theme here that we'll be deploying at Core Lab.

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Ian MacPherson, Simmons & Company International, Research Division - MD & Senior Research Analyst of Oil Service [37]

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Got it. And then for the follow-up, any -- will there be any lingering or continuing restructuring charges beyond the $3 million that you took in Q2 that we should see again?

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Christopher Scott Hill, Core Laboratories N.V. - Senior VP & CFO [38]

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We don't see any -- yes. As Larry said, we don't have any planned at this time.

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Ian MacPherson, Simmons & Company International, Research Division - MD & Senior Research Analyst of Oil Service [39]

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And anything material remaining on the -- you mentioned the potential for more noncore divestitures. Anything as significant as what you sold last quarter, totaling $20 million.

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David M. Demshur, Core Laboratories N.V. - CEO & Chairman of Supervisory Board [40]

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Ian -- Yes, Ian, we're always going to review. We've got 70 locations in 50 countries, so we'll look through there on one of the divestitures last year. We continually run our laboratory operation in Singapore for the last 50 years. So when we put that lab in, in 1969, Singapore was the center of Asia Pacific. But adding laboratories in Australia, Indonesia, Kuala Lumpur made that central location no longer viable and had become a low-margin operation. So we'll continue to look at things like that. We don't have any businesses that we're holding for sale. The promo was kind of a one-off. So as we stand, we'll look for just individual opportunities of maybe laboratories that aren't positioned in the right place.

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Operator [41]

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The next question is from Scott Gruber of Citigroup.

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Scott Andrew Gruber, Citigroup Inc, Research Division - Director and Senior Analyst [42]

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Just coming back to the domestic frac market. I realize visibility is low. But early indications from the frac companies is that completion activity is going to be trending down in 3Q. What signs are you seeing in the marketplace that provide confidence that the market would be more flattish in 3Q versus down?

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Gwendolyn Y. Schreffler, Core Laboratories N.V. - SVP of Corporate Development & IR [43]

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It's the intensity of the energetic utilization and the completion that we see, Scott. So we saw that in Q2. We would expect that to continue into Q3 as well.

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Scott Andrew Gruber, Citigroup Inc, Research Division - Director and Senior Analyst [44]

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Yes. So the flattish comment is more on energetic sales versus overall wells fracked?

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David M. Demshur, Core Laboratories N.V. - CEO & Chairman of Supervisory Board [45]

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Yes. And so in my commentary, I talked about the increasing complexity of the completion, especially associated with the energetics. Right now, we're seeing as many as 20 clusters per stage. This feeds revenue into Production Enhancement, and there's no reason why that should not continue to increase. So from our standpoint, total number of wells might be -- completed might be down a bit. But from our revenue opportunity, flattish.

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Scott Andrew Gruber, Citigroup Inc, Research Division - Director and Senior Analyst [46]

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Makes sense. I certainly hear about it from the E&Ps. And just on the refrac technology. It sounds interesting. And Dave, you highlighted we should be watching the penetration rate here. Can you size, though, the revenue opportunity for Core over the next 12 or 18 months?

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David M. Demshur, Core Laboratories N.V. - CEO & Chairman of Supervisory Board [47]

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Unknown at this point. This is a brand-new product that we've just introduced. We've had some opportunities to use that in some of the older unconventional plays. We are now targeting certainly plays like the Eagle Ford, which is in decline. We will be targeting over the next couple of quarters the Haynesville, which is a natural gas producer but will go into decline, and also the Bakken, which we project is nearing production peak here over the next year or 1.5 years.

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Lawrence V. Bruno, Core Laboratories N.V. - COO, President & Supervisory Director [48]

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We think the adoption opportunity is very large for us. Just think about where we were completion-wise several years ago. Not uncommon for wells to have 3 to 5 stages, 3 to 8 stages. There was a lot of unstimulated rock between those stages. So that's the market that we're looking at. We're working very closely with a couple of operators that have had some very encouraging results. We're in the process of beating the drum on that with other clients to look over their under-stimulated wells. And so we think the market penetration can be very nice. It's been improving at a pretty good clip for us. But still early to put any hard metrics on where we see it going in the near term.

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Operator [49]

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The next question is from Connor Lynagh of Morgan Stanley.

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Connor Joseph Lynagh, Morgan Stanley, Research Division - Equity Analyst [50]

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I wanted to go back to Reservoir Description here. I was wondering if you could help us think about is your revenue run rate or your earnings run rate right now -- I mean, it seems like there's not a lot of FID impact. So should we think about sort of the $400 million annual run rate as a good baseline? And then beyond that, can you think about how we should layer in the impact of these FIDs we're seeing this year in terms of longer-term revenue growth?

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Lawrence V. Bruno, Core Laboratories N.V. - COO, President & Supervisory Director [51]

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Yes, Connor, during the -- it's called the darker days of the downturn, reservoir Description was running at about a $100 million per quarter run rate, which largely reflected OpEx spending from clients. So what you've seen in the lift-off from that, getting us now into the $105 million, $106 million and moving in the right direction here, is more of that capital spending coming into the revenue stream.

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David M. Demshur, Core Laboratories N.V. - CEO & Chairman of Supervisory Board [52]

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So if you look at 2014, you had revenues running in the $130 million a quarter. We would expect that once you start to pile up these FIDs over 4 or 5 years, we could again approach those levels in 2021, 2022.

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Gwendolyn Y. Schreffler, Core Laboratories N.V. - SVP of Corporate Development & IR [53]

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And that also shows that, Connor, our operating income being up sequentially 30% and 23% year-over-year, so you see expanding -- or you see incrementals and then the expanding EBIT margins.

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Connor Joseph Lynagh, Morgan Stanley, Research Division - Equity Analyst [54]

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Yes. Makes sense. So maybe just to follow up there on the margin side. Is there any reason to think that the margin at which you're bidding work for these incremental FIDs is different than it had been historically in the 2014 time horizon?

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Gwendolyn Y. Schreffler, Core Laboratories N.V. - SVP of Corporate Development & IR [55]

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No, Connor.

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David M. Demshur, Core Laboratories N.V. - CEO & Chairman of Supervisory Board [56]

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No. The margins in 2014, which was kind of the peak, reach the high 20s, 28%. We like our product offerings better. We like our cost structure better. So no reason that, that can happen.

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Operator [57]

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(Operator Instructions) Our next question is from Emily Boltryk of Scotia Howard Weil.

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Vaibhav D. Vaishnav, Scotia Howard Weil, Research Division - Analyst [58]

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This is Vebs in place of Emily. Sorry to disappoint you.

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David M. Demshur, Core Laboratories N.V. - CEO & Chairman of Supervisory Board [59]

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No.

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Lawrence V. Bruno, Core Laboratories N.V. - COO, President & Supervisory Director [60]

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A worthy pinch-hitter there.

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Vaibhav D. Vaishnav, Scotia Howard Weil, Research Division - Analyst [61]

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So I guess I just wanted to ask you more about the cost-cutting efforts that you took. How should we think about future cost savings, the potential timing or what you would realize back? And then maybe taking a stab at what do you think U.S. activity could be next year.

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Lawrence V. Bruno, Core Laboratories N.V. - COO, President & Supervisory Director [62]

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Yes. In terms of the cost cutting, we're working to streamline businesses, improve operational structures. We've been on a long-term path toward laboratory and manufacturing automation. Now that's a big driver of our cost savings. And so it's -- we've got some things that we've started on that. More that we'll be implementing in the near term. But it's a -- think of it as a progression of -- or an evolution of building a more efficient structure.

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David M. Demshur, Core Laboratories N.V. - CEO & Chairman of Supervisory Board [63]

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Yes. We're going to target, Vebs, somewhere between 3% and 4%. If we can get to that level, we'll be quite pleased.

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Vaibhav D. Vaishnav, Scotia Howard Weil, Research Division - Analyst [64]

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Okay, okay. So I guess implied with what you're saying is if -- even if U.S. grows modestly, you are now properly -- your business structure is properly sized for that kind of activity? Is that a fair takeaway?

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David M. Demshur, Core Laboratories N.V. - CEO & Chairman of Supervisory Board [65]

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Correct. Well, not yet. Over the next couple of quarters, it will be there. And also with adding some automation, we can get to those levels.

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Vaibhav D. Vaishnav, Scotia Howard Weil, Research Division - Analyst [66]

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Got you. Got you. And just one modeling question, if I may. So my -- I think on Production Enhancement, it's, I guess, about 40% international. And given that the revenues declined by 4%, my back of the envelope suggested the U.S. share of the revenues for Production Enhancement declined like about 10%. Am I in the ballpark? Can you help me over there?

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David M. Demshur, Core Laboratories N.V. - CEO & Chairman of Supervisory Board [67]

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Yes. We're good with that.

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Operator [68]

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Next question is from Stephen Gengaro of Stifel.

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Stephen David Gengaro, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Analyst [69]

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Two things, if you don't mind. One, just thinking about RD and sort of the international leverage there. A lot of your peers are talking about kind of high single-digits growth this year, maybe 10%-ish in 2020. Do you think that's reasonable for the RD business as you go forward here?

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David M. Demshur, Core Laboratories N.V. - CEO & Chairman of Supervisory Board [70]

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Yes. We're at 8% right now, so we definitely can get there.

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Lawrence V. Bruno, Core Laboratories N.V. - COO, President & Supervisory Director [71]

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Yes. RD international revenue is up about 8% for us year-over-year. And we see that building, yes.

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Christopher Scott Hill, Core Laboratories N.V. - Senior VP & CFO [72]

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80% or so of that segment, their revenues are sourced from that market. So think about that when you're trying to model or determine what kind of growth would be in Reservoir Description.

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David M. Demshur, Core Laboratories N.V. - CEO & Chairman of Supervisory Board [73]

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Yes. And you can see it nicely offsets a decrease in North America because we even had margin expansion from that international growth.

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Stephen David Gengaro, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Analyst [74]

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So international was up 8%. The total business was up, what, around 3%. So that suggested that 20% piece was down dramatically.

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David M. Demshur, Core Laboratories N.V. - CEO & Chairman of Supervisory Board [75]

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Correct. You can do the math.

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Stephen David Gengaro, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Analyst [76]

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Okay. Okay. That makes sense. And then as you -- you talked about sort of the intensity on the energetic side. Would you be willing to hazard a guess, if you had sort of a flat environment, what percentage growth, sort of what that sort of intensity measure looks like over the next 6 to 18 months?

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David M. Demshur, Core Laboratories N.V. - CEO & Chairman of Supervisory Board [77]

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I'd put it in the teens.

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Stephen David Gengaro, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Analyst [78]

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In the teens?

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David M. Demshur, Core Laboratories N.V. - CEO & Chairman of Supervisory Board [79]

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In the teens.

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Stephen David Gengaro, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Analyst [80]

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Wow. Okay. Great.

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Gwendolyn Y. Schreffler, Core Laboratories N.V. - SVP of Corporate Development & IR [81]

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Stephen, an example of that is if you've got completions that were up 8% sequentially, our U.S. energetic sales were up 18% sequentially.

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Lawrence V. Bruno, Core Laboratories N.V. - COO, President & Supervisory Director [82]

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So 10%.

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Gwendolyn Y. Schreffler, Core Laboratories N.V. - SVP of Corporate Development & IR [83]

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So there's 10% right there.

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Stephen David Gengaro, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Analyst [84]

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Okay. That's helpful. The -- and then when you think about your -- the number you gave, up 18% energetic sales, what does that number encompass? Is that everything? Is that just -- that's not just GoGun sales, obviously. That's all of your energetic product sales?

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Gwendolyn Y. Schreffler, Core Laboratories N.V. - SVP of Corporate Development & IR [85]

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That is correct.

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David M. Demshur, Core Laboratories N.V. - CEO & Chairman of Supervisory Board [86]

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Perforating charges.

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Stephen David Gengaro, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Analyst [87]

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Charges and delivery systems?

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David M. Demshur, Core Laboratories N.V. - CEO & Chairman of Supervisory Board [88]

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Yes.

Chris, we're going to go ahead and wrap while we don't any more questions.

So in summary, Core's operations continue to position the company for activity levels in the third quarter of 2019, and 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, 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 and returns on invested capital with capital being returned to our shareholder via dividends and future opportunistic share repurchases as free cash flow levels expand.

So in closing our 96th quarterly earnings release, we'd like to thank all of our shareholders, the analysts who follow Core. And as already noted by Larry Bruno the executive management and Board of Core Laboratories give a special thanks to our worldwide employee base that made these results possible. We are proud to be associated with their continuing achievements.

So thanks for spending time with us this morning, and we look forward to our next update. Goodbye for now.

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Operator [89]

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Thank you very much, sir. Ladies and gentlemen, that concludes this conference call, and you may now disconnect your lines.