Schlumberger: Energised for growth

Schlumberger (pronounced “Shlum-Bur-Zhay”) is the world's largest oilfield services company. In 2013 it generated revenues of $US45.4 billion and net profit of $US6.3 billion. Employing over 127,000 people worldwide it has a market capitalisation of $US142.4 billion.

Schlumberger (SLB US) is a solid long-term play on a growing global market for energy exploration and production. What is not widely appreciated about this company is it is first and foremost a technology company, and that's why I like it. It is also an excellent “steward” of capital and an exceptional growth oriented company in spite of its size. While SLB has outperformed the US market this year, recent geopolitical events in Iraq and Russia and slightly average results in the last quarter have pressured the shares and now present savvy investors with a buying opportunity and the potential for a 25-30% return.

First, a bit of company background. SLB has a large number of business segments and, as they say, “a lot of moving parts” The main business groups are:

Reservoir Characterisation Group consists of the principal technologies involved in finding and defining hydrocarbon resources. These include WesternGeco, Wireline, Testing Services, Schlumberger Information Solutions and PetroTechnical Services. WesternGeco is the geophysical services company, providing worldwide reservoir imaging, monitoring and development services. WesternGeco offers the industry's multi-client data library. Wireline provides the information necessary to evaluate subsurface formation rocks and fluids to plan and monitor well construction, and to monitor and evaluate well production. Wireline offers both open-hole and cased-hole services, including wireline perforating.

Testing Services provides exploration and production pressure and flow-rate measurement services both at the surface and downhole. The technology also provides tubing-conveyed perforating services. Schlumberger Information Solutions provides software, consulting, information management and information technology (IT) infrastructure services that support core oil and gas industry operational processes. Schlumberger Information Solutions provides software, consulting, information management and IT infrastructure services that support core oil and gas industry operational processes. PetroTechnical Services supplies interpretation and integration of all exploration and production data types, as well as expert consulting services for reservoir characterisation, field development planning production enhancement and multi-disciplinary reservoir and production solutions.

The Drilling Group consists of the principal technologies involved in the drilling and positioning of oil and gas wells and consists of Bits & Advanced Technologies, M-I SWACO, Geoservices, Drilling & Measurements, PathFinder, Drilling Tools & Remedial Services, Dynamic Pressure Management and Integrated Project Management well construction projects. Bits & Advanced Technologies designs, manufactures and markets roller cone and fixed cutter drill bits for all environments. The drill bits include designs for market segments where faster penetration rates. The technologies leverage modelling and simulation software for the design of application-specific bits and cutting structures.

Production Group

Production Group consists of the principal technologies involved in the lifetime production of oil and gas reservoirs and includes Well Services, Completions, Artificial Lift, Well Intervention, Subsea, Water Services, Carbon Services and Schlumberger Production Management field production projects. Well Services provides services used during oil and gas well drilling and completion as well as those used to maintain optimal production throughout the life of a well. The services include pressure pumping, well cementing and stimulation operations as well as intervention activities.

Completions supplies well completion services and equipment that include packers, safety valves, sand control technology as well as a range of intelligent well completions technology and equipment. Artificial Lift provides production equipment and optimisation services using electrical submersible pumps and gas lift equipment, as well as surface horizontal pumping systems. Well Intervention develops coiled tubing equipment and services and provides slickline services for downhole mechanical well intervention, reservoir monitoring and downhole data acquisition. Subsea offers solutions that are designed to improve reservoir recovery optimise production and maximise production uptime of subsea assets.

When you see the business segment titles (“Reservoir Characterisation, Drilling Group, Production Group”) it hardly paints a picture of a sophisticated technology provider. In fact you have visions of oil covered workers in hard hats on a drilling platform. However when you drill down and see exactly what each unit provides to the energy industry another picture emerges all together.

SLB has historically been an early adopter of technologies that assist their clients in finding, operating, extracting, and producing energy assets. In fact, the company invented “wireline” technology and well logging in the 1920s when the brothers Schlumberger (from the Alsace region of Germany, now France) placed a battery powered electrical cable in a well hole in order to “log” it or get a picture of the geology. In more recent times the company has consistently overspent its peers in R&D and it has paid off. Over the past six years however, the company has spent even more heavily and devoted substantial resources to this area to try and speed up the rate of innovation and shorten time to market. As a result SLB is extremely well placed to develop and commercialise developing technologies which will provide future growth. That's one part of the investment thesis.

For example, SLB recruits from and collaborates with many of the leading Universities globally. A project with Cambridge is developing an MRI system to analyse core plugs in a brine flood. SLB has expanded its M&A activity (some 15 acquisitions since 2011) especially in supporting early stage companies that have complementary technologies such as Foro Energy which is developing the use of lasers for downhole and subsea applications. The company is also active in technology collaboration with major customers such Saudi Aramco, Chevron, and Total.

The best commercial example of this is the “INTERSECT” program in which SLB and its partners created a next generation simulator employing new numerical and parallel computing science approaches that can interpret the world's most difficult and challenging fields worldwide (33% of the total now). External collaborations with other non-energy companies are paying off as well. Working with chip maker Nvidia, SLB has developed high-performance processing technologies specifically for the oil and gas industry. For example, SLB has recently offered a service called “Broadband Sequence Fracturing” which raises the well flow rate by improving proppant suspension in the reservoir and then allows it to be sealed economically. This product is particularly appropriate for the shale players in North America.

Other promising technologies include the “ThruBit platform, which is essentially an approach in extracting the tool from the centre of the drill bit leaving the measuring device behind. Less than 5% of unconventional wells are logged this way, leaving a large potential market to be addressed. Other tools such as the Saturn 3D probe and the Litho Scanner are expected to gain traction in the next 1-3 years. In seismic, the new “IsoMetrix” technology is expected to take share as well.

At the end of the day, SLB's command of technology-based solutions means lower well costs for customers and higher margins for the company. Many of these new products are software based and dependent on the power of new computing technology. If SLB's software division (Schlumberger Information Solutions) was broken out it would rank among the world's 50 largest software companies globally. Over 30% of SLB's R&D is spent on software, and it is paying off since the company is extremely well placed to participate in the new “disruptive” technologies such as real-time analytics, big data, automation, robotics, and the “Internet of Things.” SLB believes that by 2017 new products will represent over 25% of revenue.

Russia and Iraq - Headline Risk Only

The US has imposed sanctions on the major Russian oil producers including Rosneft, one of SLB's major clients. In a recent earnings release SLB's CEO made a point of saying that their Russian business was tracking well and he expected a strong finish to the year driven by an increase in activity after a harsh winter. On August 12, the company quantified what the sanctions on moving people and equipment in and out of Russia would mean for third quarter earnings, stating that there could be a drag of roughly 0.03 US cents a share on consensus estimates of $US1.51/share, but there would be no interruption for its Russian clients. Even in its forced isolation Russia needs oil and gas. Russia represents but 5% of the company's total revenue. In Iraq, the company has admitted that the situation has deteriorated significantly in the southern area of the country and may well impact financial performance there, but that could be offset by activity in the northern part of the country where business remained strong. Again, a very small part of SLB's overall profits.

The Mexican Opportunity and Latin America

Latin America will continue to be a bright spot for the company. Mexico has passed new laws to open up the energy sector, breaking a 70-year monopoly held by government owned Pemex. SLB has been doing some business there but as a subcontractor. Under the new laws it's likely that SLB and its peers Halliburton and Baker Hughes will be allowed to put in a “mega tender” for large and far more lucrative contracts, particularly in deep water and unconventional oil and gas areas that are currently acutely underdeveloped. Remember the geology of Mexico, both in the Gulf of Mexico and on land is similar to Texas and other high production regions in the US. This new business could be a game changer for the oil service industry given its size and scope, although lack of infrastructure may delay any immediate impact to the bottom line. In Brazil, SLB will participate in a new round of oil and gas licences and increased deep water activity by Petrobras. Activity in Argentina, Ecuador and Venezuela will continue to be strong, and the company has just inked a new agreement with PDVSA (the Venezuelan state oil company).

Management

CEO Paul Kibsgaard has been in the job since 2011, succeeding Andrew Gould who retired at age 65. Kibsgaard is relatively young at age 46 and is a 17-year veteran of the company. His previous role was COO and he was chosen for the top job on the basis of his belief that technology should be even more integrated into the company's processes and products going forward and that SLB should continue to emulate other successful companies in the aerospace and automotive industries in product development and manufacturing. The company is structured with very experienced senior executives responsible for each major region or business reporting to the executive management committee. Schlumberger has principal offices in Paris, Houston, London and the Hague, from which the executive management team directs all Schlumberger operations worldwide.

Financials and Guidance

At its annual investor conference in June of this year, the company gave very specific guidance for the next three years (somewhat surprising for a large US company – try getting these projections from Google, Apple, or Microsoft. Good luck!). SLB sees earnings per share growing at 17-20% per annum on a 7-8% revenue growth. Underlying those assumptions are an average oil price of $US100.00, global GDP growth of 3-4% and per annum and oil demand in the 1.5% area. The CEO also flagged a 25% improvement in productivity and a 10% decline in operating costs. The company also intends to convert 75% of earnings to free cash flow and a significant portion of that will be returned to shareholders via share buybacks and dividend increases. After the conference most analysts who follow the company raised estimates and target prices: 39 analysts follow the company and 37 have a buy rating.

Sometimes, if the consensus is that strong, it can be a warning sign but not in this case given the quality and history of the company. The average target price is $US134.To be honest, it would be hard to deviate too far from the explicit guidance that the company has put forth (unless you are a maximum bear on the oil price) hence my estimates have a 7% CAGR in revenues and a 16.5% earnings growth over the next three years. I wouldn't be surprised if the company betters a number of those metrics.

Over the near term fundamentals for the service industry are firmly underpinned by ongoing strong activity in North America, particularly in shale focused horizontal drilling, which has a much higher service intensity than conventional practices. The horizontal rig count is up 24% year over year. I expect SLB's North American land business (restructured in 2010) to participate strongly here given the high demand and specific new products. In the offshore (international) markets, companies and analysts are a bit more cautious, citing slightly lower spending by big oil companies as they concentrate more on improving returns and cash flow. Still capital spending is expected to grow at 6%-7% for 2014, and for the NOCs it will be business as usual. Gulf of Mexico activity is expected to remain strong, with well permits up 60% in March.

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Schlumberger is trading at the lower end of its 10-year range by most valuation measures: EV/Ebitda, and EV/Sales.

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On a forward PE basis SLB is trading on the cheap end of its past 10 years' history. A multiple in excess of 22x has been the norm.

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As you can see, the company has a history of consistent growth in revenues and operating earnings.

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Conclusion and Recommendation

Schlumberger is a “Buy” at current levels. For investors who are going “global” it's a “must have” holding. You are buying an exceptional company that gives investors a truly global exposure to the ongoing exploration and production of oil and gas (including North American shale). You are also buying a genuine growth company that is substantially undervalued relative to its history and has a history and intent of returning cash to shareholders.

At less than 16x 2015 eps the stock is NOT factoring in the next 3 years of projected growth. I see the company approximating its historical normalised P.E. of at least 20X 2015 earnings of US6.75 for a target price of US135.00.

Risks

The oil price is expected to be steady around current levels or higher underpinned by improving global GDP growth, a tightening supply demand environment, and little resolution of geo political stresses in the Middle East. However, a significant retracement in the price of crude COULD slow or derail capital expenditure plans of the oil majors and the National Oil Companies (NOCs).The shares of energy companies and especially the service providers are always affected by the direction of the oil price.

SLB's main competitors – Halliburton and Baker Hughes, while they don't offer the plethora of services that Schlumberger does – will compete strongly on price in a number of energy service segments internationally and in North America. Some analysts believe they have “closed the gap” between themselves and SLB, although they don't have the technologies that SLB has developed.

To see Schlumberger's Forecasts and Financial Summary, click here.