Schlumberger is well-positioned to grab huge international pricing power

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by Stephen Ellis (Morningstar Analyst)

Schlumberger's SLB diversified operations did well in a difficult quarter marked by uncertainty overseas and a challenging environment in North America. Both oilfield services revenue and pretax operating income were up 2% sequentially to $10.6 billion and $2.1 billion. Like peer Halliburton HAL, Schlumberger was exposed to a weak pressure pumping market in North America, but revenue only declined 2% sequentially to $3.3 billion, and operating margins just over 200 basis points to 18.6%. This is a better performance than Halliburton's 5% revenue decline and 660-basis-point margin compression over the same time frame; we think the outperformance is due to Schlumberger's smaller pressure pumping operations, but also the fact that Schlumberger didn't purchase overly large quantities of guar at the top of the market. The international market continued to do fairly well this quarter, with Schlumberger noting improved pricing and tight capacity for seismic, wireline, drilling and measurement, and well testing. However, there continues to be significant uncertainty surrounding the global economy as Chinese growth slows. At this point, the balance of oil supply and demand remains tight, with OPEC spare capacity at five-year lows and continued production challenges in non-OPEC countries. However, we caution that as the global economies continue to struggle and GDP and oil demand growth remain stagnant, the tight balance could change, pushing down oil prices, services demand, and Schlumberger's financial results.
Schlumberger is one of the top firms in the oil services industry. In our view, the company is well-positioned to benefit from the industry's current weakness and future rebound, given its financial strength, geographical and product diversification, well-regarded research labs, and unique technology acquisition strategy. We believe the company's focus on building out a product set by making small software-oriented acquisitions to provide deeper insights into solving oil field issues will result in an edge over smaller peers when conditions improve. This strategy is geared toward winning large integrated project-management contracts with national oil companies (where Schlumberger excels), which offer ample opportunities to sell additional services from its wide-ranging portfolio.
Schlumberger's comprehensive services portfolio offers pressure pumping services, seismic services, and integrated project-management efforts. The company's services are typically used to extract oil and gas from wells, an effort that has grown more complicated with the increased complexity and depth of the oil and gas reservoirs under development. We think Schlumberger's one-stop approach earns it customer loyalty, which results in premium prices for its services. Further, we think the company's large product portfolio lets it package many of its products into a single attractive offering, making it very difficult for more narrowly focused competitors to win work. Accordingly, the firm generally has the leading market share in all its product lines. This factor, combined with its R&D strength and technology approach, leads us to assign a wide economic moat to the company.
We believe Schlumberger's market share gains are driven by its substantial R&D investments, which are supported by a clever acquisition strategy. Oil and gas companies will rapidly adopt new products if they can see the value proposition. Schlumberger has had numerous R&D successes during the last few years, including its seismic Q-technology, which has grown into a billion-dollar business. The firm's latest success appears to be its HiWAY fracturing technique, which enables higher well productivity while using less water and proppant. The technology has been successfully deployed in both North America, where it made up 15% of Schlumberger's stages in late 2011, and internationally, with Rosneft ROSN using it in West Siberia. The R&D successes mean Schlumberger can consistently commercialize its research efforts for rich payoffs, which we think peers find harder to accomplish. Further, the company's acquisition strategy feeds its R&D advantages. We believe the firm thinks more like a technology firm and acquires soft assets (such as software), whereas its peers think like consumer goods companies and acquire hard assets (like a Latin American oil services firm). We think these types of technology deals, such as openhole logging services provider ThruBit in late 2011, keep the firm ahead of competitors and positioned for long-term growth around the world.
Still, as Schlumberger competes in many global markets, we believe it faces some risks. Political risk is always a concern when governments can destroy firms for political gain (as we've seen in Russia) or nationalize assets (as we've seen in Venezuela and Argentina). Also, an inability to commercialize key technology could cost the firm project wins and reduce the impact of its heavy investment in its globalized workforce. Finally, we believe that recent cash-for-oil deals with Brazil and Russia could mean a larger Chinese oil services presence in the countries in the future. In our view, one of China's goals behind the deals is to secure larger roles for its oil services arms overseas, which will ultimately mean more competition for Schlumberger.
Valuation

We are keeping our fair value estimate at $75 per share. While lower guar prices should benefit Schlumberger in the latter half of 2012, we remain concerned about the impact of lower oil demand from Europe and China and the resulting pressure on global oil prices, which would lead to pressure on oil services spending budgets. Our fair value estimate implies a forward 2013 P/E multiple of 20 times and a forward 2013 EV/EBITDA multiple of 10.2 times.
We expect lower profitability in North America in 2012, thanks to the negative effects of continued gas-to-oil rig switching. Rig demand is also dropping, which means more potential oversupply issues for the services industry. International markets such as Brazil, Iraq, and Russia all offer growth opportunities for the next few years. Overall, we see Schlumberger's revenue growth at 11% in 2012 (which is affected by the Wilson sale), mostly thanks to strength overseas. Over the long term, we believe many of Schlumberger's markets can grow 8% annually (on average) as the increasing complexity of the oil and gas reservoirs requires more services to fully develop. We expect the firm's long-term operating margin in North America to be around 22%. In the international markets, we believe margins will be 23%, as the markets gradually improve and Schlumberger reaps higher prices. We expect the company's capital expenditures in 2012 and 2013 to be $4.2 billion and $4.3 billion (which includes M&A activity) as it continues to build out its international presence.
Risk

As with all oil services companies, Schlumberger could face difficult times if oil and gas prices had a significant and sustained fall. Its reliance on technology and acquisitions to drive revenue could backfire if a competitor developed better technology or if an acquisition failed to perform up to expectations. The company's extensive infrastructure in Russia could prove to be a liability if the government decides to treat service companies like it has treated operators such as Yukos.
Management & Stewardship

New CEO Paal Kibsgaard leads one of the deepest and strongest management teams in the oil services industry. Longtime CEO Andrew Gould remained as chairman of the board until April 2012. We think the firm's disclosures in its financial statements and on its website are very good and provide much insight into the business and industry. During Gould's tenure, capital allocation was superb, and the firm made many useful technology-related acquisitions to maintain its R&D edge over its peers. We have yet to see evidence of Kibsgaard's ability to allocate capital, but we expect respectable returns. The company's return on invested capital has consistently been well ahead of its cost of capital over the years, and we don't expect that dynamic to change in the near future. We view the Smith acquisition as a significant strategic win in terms of improving Schlumberger's integrated product offerings, but Halliburton has already established its leadership in this area. Overall, the management team has generally strengthened Schlumberger's competitive position over time and has delivered excellent results for shareholders.
Gould stepped down from the CEO role on Aug. 1, 2011, after many years of top-tier leadership. His role at the company has been changing during the last few years, and we believe his most recent efforts have been focused on managing the integration of Smith. The deal for Smith in early 2010 and Gould's retirement now was planned so that Kibsgaard can focus on execution rather than integrating the two companies. Kibsgaard joined Schlumberger in 1997 as a reservoir engineer in Saudi Arabia and quickly progressed through a variety of global management positions in the company, including vice president of engineering, manufacturing, and sustaining. By laying the groundwork well in advance, Gould set Schlumberger up for a very smooth CEO transition, in our view.
Overview

Financial Health:
As Schlumberger historically has generated strong free cash flow, its financial health remains quite healthy. At the end of 2012, we estimate Schlumberger's debt/capital ratio will stand at 24%, its 2012 EBITDA will be about 40 times its interest expense, and its total debt/EBITDA ratio will stand at 1.0 times. We believe Schlumberger is appropriately leveraged, given the cyclical nature of the oil services industry. Unlike peers, Schlumberger has avoided large debt-driven deals during the last few years, and the resulting balance sheet strength should let it acquire some opportunistic bargains.
Profile: 
Schlumberger is one of the largest oil services companies, with more than 113,000 employees across 85 countries. It offers a near-complete array of oil services--from seismic surveys to artificial lifting--to oil majors, exploration and production companies, and national oil companies. In 2011, it generated $39.5 billion in revenue and $4.8 billion in net income.