Despite the Oil Price Slump, I Think Schlumberger Remains a Classic Growth Pick in a Slow Growth Global Economy

11/04/2014 5:41 pm EST


Jim Jubak

Founder and Editor,

Though shares of this oil service company could still go lower if oil prices do, MoneyShow's Jim Jubak thinks a recovery to the July high by the fall of 2015 is a reasonable expectation, so he's lowering his target price, as of November 4.

Schlumberger (SLB) reminds me a lot of Cummins (CMI).

And, in a world were growth looks to be hard to find in the short-term and where global growth looks to be slowing in the long-term, that's a very good thing indeed.

In my October 29 post Cummins: A Paragon of "Growthiness" I called Cummins a paragon of growthiness ("Growthiness" is similar to Stephen Colbert's "truthiness" but growthier) because it combined solid growth prospects because of the market that it's in with a management with a record of investing in growth even in the tough times.

I think that combination also defines Schlumberger—although since Schlumberger is an oil service company—it is particularly challenging now to figure out what the growth rate in its market is in the near-term. What isn't in doubt, though, is that, for a company that dominates the high-technology end of the oil field services business, the slump in oil prices and the cuts in research and development budgets at the major international oil companies is an opportunity to grab even more market share. (Schlumberger is a member of both my 12-18 month Jubak's Picks portfolio and my long-term Jubak Picks 50 portfolio. I added it to my Jubak's Picks portfolio in May 2012 and the shares have gained 50.67% as of the close on November 3.)

On October 17, Schlumberger reported third quarter earnings of $1.49 a share. That was slightly ahead of Wall Street projections of $1.46 a share. Revenue of $12.6 billion was slightly below consensus projections of $12.63 billion. Revenue was up 8.5% year over year.

What was most controversial in Schlumberger's report—as it had been in Halliburton's (HAL) report a few days before—was guidance that said the company wasn't seeing any real slowdown in sales despite sanctions against Russia, the violence in Northern Iraq, and the drop in global oil prices. The worry, of course, is that Schlumberger and Halliburton are both being too optimistic about their markets.

One reason to go with Schlumberger and Halliburton on this is that the companies are being far more granular in their discussion of the oil services market than the financial markets are.

For example, in its guidance, Schlumberger noted that the Russian winter had already shut down operations in the northern parts of Russia. (The Arctic drilling season ends in August.)

Or, to take another example, yes, there is a potential for lower oil prices to reduce demand for oil field services in the US shale geologies. Projections are that it will take an oil price of $75 a barrel over a period of at least six months in length to produce those reductions. That may be overly pessimistic, since it ignores the need for oil producers to maintain cash flows by spending on drilling and improved oil field technologies as aging wells show declining production. Estimates are that four out of five wells drilled in US shale geologies now go toward maintaining production levels. Lower oil prices will indeed force hard decisions on capital spending by oil companies, but the traditional across the board cuts in spending are likely to be replaced with efforts that flag efficiency and increased production with the smallest possible increase in costs and that is exactly Schlumberger's selling proposition.

Schlumberger's read, expressed in documents such as its 2014 investor presentation, is that oil producers find themselves in something of a tight spot that will require them to spend more on outside oil field technologies. Even before the recent drop in oil prices, Schlumberger had concluded that the oil exploration and production industry had fallen behind in its ability to address the increasing complexities of finding, developing, and producing oil and gas. Relatively few companies were willing or able to invest in the internal development of the new tools for seismic exploration, for directional drilling, or for real time analysis of production data. As these technologies became necessities in the oil field, it increased the share of exploration and production work that had to be outsourced to companies such as Schlumberger.

The recent drop in oil and natural gas prices is actually likely to accelerate this trend, since all but the very biggest of the international majors—faced with falling revenue—are likely to cut internal research and development programs and instead buy technology and technology services from companies such as Schlumberger.

In this environment, it would be tempting for a company such as Schlumberger to relax and coast on this trend. After all, the company has extremely strong margins now with net asset margins of 19.4% in the third quarter and international margins of 24.6%.

That's a result of some impressive goals the company set three or four years ago. Beginning with the acquisition of Smith International in 2010, the company launched an efficiency drive and reorganization intended to grow margins in the North American market to No. 1 in that market, to grow earnings faster than revenue, and to increase free cash flow in order to increase dividend and buyback levels without increasing debt loads.

To that effort, the company has added what it calls a complete rebuild of its technology engine that has started to pay off in gains in market share. A major focus has been the drilling unit, which bolstered by the Smith International acquisition, has seen drilling revenue triple since 2010. But what I actually find more impressive than the macro number is the 30% growth in revenue per rig, with more products and services at each rig, Schlumberger is seeing rising margins from this unit. According to the 2014 oil field services report from Spears & Associates, Schlumberger is now No. 1 in five out of six drilling markets.

Schlumberger's biggest opportunity, though, is in what it calls the production unit where, according to Spears, the company has a No. 1 position in only two out of seven markets. In this more fragmented market Schlumberger benchmarks itself against Halliburton, the global leader in this segment. From the first quarter of 2011 through the first quarter of 2014, Schlumberger has outgrown Halliburton in revenue (47.4% to 28.2%) while opening a 290 basis point margin gap. As in the growth of the drilling unit, the key to the growth in the production business has been to sell Schlumberger technology that reduces costs for the customer.

Schlumberger shares have taken a tumble with lower oil prices, falling from $118 in July to $96.52 at the close on November 3. The shares could certainly go lower if oil prices do, but I think a recovery to the July high by the fall of 2015 is a reasonable expectation. So, as of November 4, I'm lowering my target price of $118 a share from the former $131.The shares pay a 1.66% dividend.

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