Drilling Into Schlumberger and the Outlook of Energy

Since I began covering the energy industry in-depth some two decades ago, one of the quarterly events I look forward to most is the earnings release from Schlumberger , asserts Elliott Gue, an leading energy sector expert, a contributor to MoneyShow.com and the editor of Energy & Income Advisor. I am again taking a deep dive into its second-quarter results and what that means for the industry. There have now been three different CEOs since I began covering Schlumberger and market conditions for the company have changed dramatically over the years. However, one thing has remained constant -- Schlumberger has an almost unique bird's eye view of the industry with tentacles expanding into just about every oil-producing region of the world from West Texas to central Africa, Russia and Asia. Over the years, management has always been a useful font of information regarding industry trends that's pointed us to several profitable Energy & Income Advisor recommendations. And, just as valuable, Schlumberger's comments helped us to decide it was time to exit names like Seadrill when they were still flying high and before shareholders were wiped out by the oil price collapse starting in 2014. Its second-quarter results show the long-awaited turn in the international business is under way. Overall, Schlumberger's Q2 revenue increased 5% sequentially, led by an 8.5% increase in its international business. International growth outpaced the 6% increase in the active rig count outside of North America and management stated more than half of Schlumberger's international markets posted high single digit revenue growth or better on a year-over-year basis. Schlumberger's international revenues generally shrink from Q4 to Q1 due to seasonal factors such as year-end budget spend and winter weather. In 2017 and 2018 international revenues fell by an average of just under 7% sequentially. This year, however, Q1 revenues only fell 4.7% compared to Q4 2018. International revenues have historically seen a further step-up between Q1 and Q2. The average sequential growth in 2017 and 2018 is 4%. In 2019, however, the sequential change in Schlumberger's international revenues was more than double that average at just shy of 8.5%. Management is looking for total growth of 7% to 8% in 2019 compared to last year. Given revenues already booked in the first half, the top end of that forecast growth range implies that SLB's international revenues will grow about 10.3% in the second half of 2019 relative to the first half, which would also be more than double the average second half step up of 4.4% over the past two years. And the recovery appears broad-based in Q2. Highlights include a 30% jump in offshore exploration revenue -- wireline services used to evaluate reservoirs being explored - in the first half of 2019 relative to the same period one year ago. Also, shallow water offshore revenues surged 14% in the first half. In addition to the raw numbers on revenues and margins, I like to keep tabs on the change in the qualitative tone of commentary in SLB's quarterly calls. Schlumberger's international business has been through a sort of U-shaped bottom. Based on comments from management, it appears the business hit a trough in early to mid-2017 but, for the most part, the recovery was not broad-based and represented little more than a bounce from extraordinarily low levels of activity. It appears that, at least until last summer, much of the optimism was focused on North America, which was the more direct beneficiary of rising oil prices through the first three quarters of 2018. The big upside inflection point for the international business was Q2 2018 though management's comments remained conservative on growth prospects through to early this year. It appears the recovery in international spending continues to gain traction and management sounds more confident in the growth prospects in the second half of this year and into 2020. Revenue growth outside North America is the best it has been since the tail end of the last big energy cycle in 2012-13. On the other hand, there has been no meaningful growth in North American revenues for SLB. In the near term, we don't see much scope for the picture in North America to improve for Schlumberger and the other services firms. In fact, Schlumberger is anticipating a big slowdown in North America in Q4 2019 driven by a combination of normal seasonality and, more importantly, budget exhaustion. In effect, U.S. E&P capital spending was skewed to the first half of 2019, meaning that most of the major producers plan to reduce spending in the second half. Like last year, they'll simply run out of CAPEX budget for 2019 towards the end of the year. The good news for Schlumberger is that it's less exposed to the challenging North American services environment than its major peers. That's because the company derives about two-thirds of its revenues from outside North America where it's already seeing an upturn. As Schlumberger's management team reported in its Q2 call, the company's market share and product mix in international markets give it about four times the upside earnings leverage to the upturn underway as compared to its largest competitor (Halliburton). Longer term, rapid shale development and production growth in the U.S. have created inefficiencies in the industry and the relationship between services firms and producers. Schlumberger has long been known for innovation and it has long pursued a strategy emphasizing smarter production growth and well efficiency over brute force and building pressure pumping horsepower. The question remains if or when its North America focused service innovations will drive sustained better profit margins or more stable growth in this market. Earlier this year, Schlumberger formed a joint venture with industrial giant Rockwell Automation called Sensia. Simply put, the joint venture aims to couple Schlumberger's oilfield expertise with Rockwell's expertise in sensors, data analytics and automation. Sensia aims to automate more of the drilling process to make it both more efficient and less costly (reducing, among other imports, labor costs). Ideally, Sensia and Schlumberger will likely be looking for contracts to partner with major producers on wells. To the extent that they're able to drive efficiency and productivity using Sensia technology, the company would be able to extract higher margins through performance-related pay. And Schlumberger is also a player in industry consolidation, including through the purchase of now-bankrupt Weatherford's pressure pumping assets back in late 2017. In short, Schlumberger is making all of the right moves in North America and ultimately, we think the status quo in this market is unsustainable. That said, Schlumberger is in the midst of a management transition right now with Paal Kibsgaard stepping down as CEO on August 1 (after a roughly 10-year run at the top) to be replaced by the company's current COO, Olivier Le Peuch. Mark Papa, shale legend, former CEO of EOG Resources and current CEO of Centennial Development, will also be taking over as Chairman of the board. New CEO Olivier Le Peuch was, as expected, fairly quiet on long-term strategic moves during their July conference call but indicated he plans to reveal more this fall where he's scheduled to speak at a number of industry conferences. He also did hint that he's keeping the company's options open for OneStim -- essentially Schlumberger's North American fracturing business. It sounds like the company's strategy may be to attempt to drive higher margins through the levers I just outlined and, if that's not enough, Schlumberger might even look to JV with another company to reduce risks and capital spending needs. All told, Schlumberger benefits from its industry-leading exposure to healthier international markets and its differentiated, technology-focused approach to improving North American profit margins. We also see the company's management transition and the new CEO's planned communications on strategy as possible upside catalysts for the stock this fall. Schlumberger's new CEO reaffirmed his commitment to the company's $0.50 per quarter dividend. Based on consensus free cash flow estimates, Schlumberger will not cover the payout this year though funding it should be no problem given the company's recent non-core assets sales. In 2020, however, even assuming ongoing weakness in North America and a slow-but-steady improvement internationally, free cash flow should be comfortably above what's needed to pay its dividend. The current yield stands at more than 5% on the stock. Bottom line: Well positioned and with several upside catalysts this year, Schlumberger is our favorite diversified oil services stock to buy right now.

Drilling Into Schlumberger and the Outlook of Energy

SLB is our favorite diversified oil services stock to buy right now.

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