How To Trade Schlumberger Based On Current Fundamentals And Valuations

| About: Schlumberger Limited (SLB)

Shares of Schlumberger (NYSE:SLB) have returned 11.2% over the past 3 months. At $79.07, the stock is trading near its 52-week high of $80.78 achieved just recently and offers a 1.6% dividend yield. After the recent price appreciation, is a buy rating still warranted by the company fundamentals and the stock price level? In this article, I will elaborate on the stock valuation analysis which may assist you in formulating an appropriate investment decision.

Sell-side analysts on average predict Schlumberger's revenue, EBITDA, and EPS to grow at solid CAGRs of 10.7%, 13.9%, and 18.0%, respectively, over the current and next years (see comparable chart below). Those consensus estimates generally outperform the averages of 8.3%, 12.5%, and 19.4%, respectively, for a group consisting of Schlumberger's primary competitors. The company's EBITDA margin is forecasted to expand by 1.6% over the same horizon, slightly below the peer average at 2.0%.

On the profit side, Schlumberger has demonstrated superior performance as most of the firm's margin and capital return metrics are considerably above the par. The company's leverage level is fairly comparable to the group as reflected by its in-line debt to capitalization and debt to EBITDA ratios. In terms of liquidity, Schlumberger is the only firm in the list that generates a positive free cash flow margin. The company's current ratio is below the peer average, but its quick ratio is slightly better, still reflecting a modestly healthy corporate balance sheet.

To summarize the financial comparisons, Schlumberger's significant presence in the oil and gas services sector, slightly better growth potential, as well as its superior performance in profitability and cash flow generation should reasonably justify a solid premium valuation for the stock over the peer-average level. The current stock valuations at 16.5x forward EPS and 0.9x PEG together represent an average premium of 16.4% (see chart above), suggesting that the stock is trading within the fair value range on a relative basis, but likely near the low given the company's robust financial fundamentals.

From another perspective, Schlumberger's trailing P/E multiple of 19.2x is currently at 12.7% discount to its 3-year historical average at 22.0x (see chart below).

I believe the discounted multiple represents an attractive valuation level provided that:

1) Schlumberger's capital return measures including ROA, ROE, and ROIC have all experienced a fairly steady improvement over the past 3 years (see chart below);

2) The company was also able to maintain steady profitability margins over the same period (see chart below);

3) Despite the higher leverage, Schlumberger was able to sustain a healthy interest coverage ratio at above 30.0x level (see chart below); and

4) The currently lower revenue, EBITDA, and EPS growth rates appear to be the primary cause for the lower valuation level; however, the market's consensus estimates indicate a recovering trajectory over the current and next years, and the average estimates for the period are quite close to their 3-year historical average level (see chart below).

Alternatively, Schlumberger's forward P/E multiple of 16.5x is now trading at 14.3% premium over the same multiple of the S&P 500 Index, which stands at 14.4x (see chart below). This valuation comparison appears to indicate a reasonable valuation level given that:

1) Schlumberger shares have been trading at an average premium of 14.9% over the market for the past 12 months; 2) the company's long-term estimated earnings growth rate of 17.9% is substantially above the average estimate of 8.2% for the S&P 500 companies; 3) Schlumberger has a solid market position in the global oil and gas services industry and it is also one of the most profitable companies in the sector; and 4) the stock also offers a 1.6% dividend yield, one of the highest in the O&G sector.

Schlumberger recently announced its upbeat Q4 2012 earnings results. The positive surprises were largely driven by solid service performance in both North America and Latin America regions. Sell-side analysts are generally bullish on the stock. Of the 37 stock ratings, there are 13 strong buys, 10 buys, and 14 holds. Stephen Gengaro, a research analyst at Sterne Agee, wrote in a recent research note (sourced from Thomson One, Equity Research):

"We are maintaining our 2013-14 EPS estimates of $4.80 and $5.90, respectively. While we believe there is potential upside to 2013 EPS, we remain modestly concerned about the slope of international margin improvement based on continued geopolitical risks and a competitive pricing environment. That said, SLB remains very well positioned to generate strong earnings growth and robust free cash flow over the next several years with its excellent package of technologically advanced products and services and solid track record of execution. Furthermore, SLB's exposure to rising deepwater activity through both its core services and seismic capabilities positions it well to continue generating industry-leading international margins. The company's 4Q12 results highlight both its deepwater expertise and the continued risks to somewhat choppy international margin progression."

Bottom line, in light of Schlumberger's solid growth prospects, strong financial performance, as well as the stock's reasonable valuation level, the shares should deserve a buy rating. However, to enhance the margin of safety, I would recommend establishing a long position by selling out-of-money put options to either collect upfront premium or take a potential opportunity to acquire the shares at a lower price level.

All of the charts are created by the author and all financial data shown in the article and the charts are sourced from Capital IQ unless otherwise specified.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SLB over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.