Oilfield Services Overview: Alpha Absent At Schlumberger

| About: Schlumberger Limited (SLB)


We look at companies and try to see how they are perceived by different stock selection styles adopted by market participants.

We look at companies and try to see how they are perceived by different capital allocation styles adopted by market participants.

We look for good companies at a good price. That is companies, priced at a level which offers an opportunity to capture potential alpha.

Schlumberger as recently priced, does not present a potential alpha opportunity.

I recently ran posts on several stocks in the energy sector that focused on exploration and production companies and the offshore drilling industry. And with this series on oilfield services companies, I am concluding my review of that part of the energy sector that interests me.

In this post, I will present some information on Schlumberger (NYSE:SLB), Halliburton (NYSE:HAL), Weatherford (NYSE:WFT), Baker Hughes (NYSE:BHI), and National Oilwell (NYSE:NOV). And then present the value case for Schlumberger in this post.

These are all sound companies, but do they, in my view, represent good value? My personal energy positions are presently focused on Shell (NYSE:RDS.A) (NYSE:RDS.B), BP (NYSE:BP), and Transocean (NYSE:RIG), and shall stay that way since they satisfy my unique income, growth and beta tolerance targets. Schlumberger and National Oilwell remain on my radar as sometime, if ever, opportunities; but in my view, the two stocks in particular, and the oilfield services industry in general, is not priced to deliver the kind of long-term return a buy and hold style investor should target.

Please keep in mind that this is not a recommendation to sell. These are all good companies and should not be sold unless they become bad companies. The point I am making is that they are not presently priced to buy for buy and hold style investors.

Quantitative analysis of the behavior of market participants

A couple of years ago, I had written some code to facilitate stock selection. It would help if you read about the build-out of that system here, as that will allow you to appreciate the model output later in this post better. Recently, some of the output of the Alpha Omega Mathematica [AOM] model is being published online, and you can see a list of the top and bottom 20, large, mid, and small cap stocks here. You can view additional information for any specific stock here. You may find differences between the data displayed below in this post and the data on the website: this is because I run the model for a coverage universe of all stocks listed in US with a market capitalization of over $100 million, whereas the website uses a different coverage universe.

I am presenting data and the model output for Schlumberger, Halliburton, Weatherford, National Oilwell, and Baker Hughes. And at the end of the post, I have run through how I value Schlumberger.

Let's start with some AOM Over-all Scores. As you can see, the AOM model likes Schlumberger, Halliburton, and Weatherford. It is neutral on Baker Hughes, and does not like National Oilwell at all.

I personally like National Oilwell: this is a company which is a big beneficiary of offshore drilling, which is an area where the long-term fundamentals are attractive. Today, National Oilwell is being punished as a result of the negative sentiment in outlook for the offshore drilling industry.

Schlumberger, Halliburton, Weatherford, and Baker Hughes are impacted by the offshore drilling environment to a lesser degree, because their product mix is well diversified over land and offshore (and within offshore amongst shallow, mid, deep & ultra-deep water). In addition, unlike the offshore drillers, who are impacted primarily by exploration activity, the oilfield services product offerings are better diversified as they are beneficiaries of production activities unrelated to new exploration. The result is less earnings volatility, and less lumpy capital expenditures, which results in less cyclicality in stock prices versus offshore drillers.

In the table below, you can have a look at the data to determine how you feel about each company relative to the others. The data feeding the AOM system comes from Financial Visualizations, which is believed to be a reliable source. Since the data scored by AOM covers over 5,000 U.S. listed stocks, I do not check the input data. The AOM analysis is primarily intended as a screener and as a tool to understand the behavior of market participants. The need to follow up with more complete due diligence is critical.

Source: MaxKapital Archives using data from Financial Visualizations

Schlumberger AOM Overview

People select stocks to a personal style bias and so we have value, growth, momentum, balanced and agnostic (those with no stock selection style bias) styled investors. This table below gives you information to help you determine whether your stock selection style bias is satisfied by the stock in question.

For Schlumberger the stock selection style model suggests that the quality of return and profit is good. It also suggests the stock is well valued, has sound ownership quality, momentum and growth prospects.

Source: MaxKapital Archives

Some investors like to select what they see as the best stock in a sector. Others prefer to select what they see as the best stock in an industry. And there are yet others, who simply want to own what they see as the best stock available, without regard to the sector or industry in which it operates. These are the three main capital allocation styles. This table below helps you determine if the stock in question allows you to satisfy your capital allocation style.

For Schlumberger, the capital allocation style model output suggests that the stock is very attractive to momentum, growth, balanced, and stock selection style agnostic investors, who allocate their capital using a sector allocation strategy. The stock is also attractive to value investors using a sector allocation strategy. It is also attractive to capital allocation style agnostic investors of all types. Investors allocating capital at industry level are also attracted to this stock, except for stock selection style agnostic and momentum investors, who remain neutral.

Source: MaxKapital Archives

Halliburton AOM Overview

Halliburton scores well on momentum, while valuation is viewed as good. Growth and ownership quality scores are neutral, while return and profitability scores are a disappointment.

Source: MaxKapital Archives

For Halliburton, the capital allocation style model output suggests that the stock is attractive for all momentum investors regardless of the capital allocation style they adopt. It is also attractive to balanced investors and stock selection style agnostic investors, who allocated capital using a sector allocation strategy, or a capital allocation style agnostic strategy. Growth investors who allocate capital using a sectors capital allocation style might also find this stock attractive. All others are neutral.

Source: MaxKapital Archives

Weatherford AOM Overview

For Weatherford, the stock selection style model suggests that the stock represents good value, backed by strong momentum. Growth scores are neutral, while ownership quality scores low. The return and profit quality is poor, which is not surprising given the absence of a profit in 2013. This is not too much of a worry: momentum says that the conviction in a return to profitability next year is high.

Source: MaxKapital Archives

For Weatherford, the capital allocation style model output suggests that the stock is attractive to sector allocators and to investors with no capital allocation bias for all types of investors other than value investors. All others are neutral.

Source: MaxKapital Archives

Baker Hughes AOM Overview

For Baker Hughes the stock selection style model suggests that the quality of returns and profits and value metrics are poor. As with Weatherford, this is as a result of a bad trailing twelve months. The perception of growth potential is weak, while ownership quality is neutral. The value scores are positive, and backed by good momentum.

Source: MaxKapital Archives

For Baker Hughes, the capital allocation style model output suggests that investors are largely neutral to this stock. Though the stock is unattractive to value and growth investors allocating capital at sector level.

Source: MaxKapital Archives

National Oilwell AOM Overview

For National Oilwell, the stock selection style model scores it well on value and poorly on momentum: a combination I like, especially when backed by reasonable ownership quality. The growth score is low, as are the return and profitability scores. Ownership quality is neutral.

Source: MaxKapital Archives

For National Oilwell, the capital allocation style model output that the stock is unpopular with in most capital allocation and stock selection style combinations. Value investors with an industry or sector capital allocation bias are neutral, as are growth investors looking to allocate stock at sector level. The rest dislike National Oilwell. A stock universally despised can on occasion be a good contrarian opportunity.

Source: MaxKapital Archives

The Case for Schlumberger:

Why look at Schlumberger now?

Firstly, Schlumberger is a large-cap stock. This gives it a defensive character relative to small and mid-cap stocks, which appeals to me when I perceive the markets are expensive.

Secondly, in January 2014, Schlumberger hiked its dividend 28% to $0.40 per quarter. While the yield at 1.7% is a slight discount to the market yield, Schlumberger's track record on dividend payment and dividend growth makes it attractive to many investors. And this adds defensive characteristics to the stock.

Thirdly, I believe that we are now either in, or fast approaching the late or mature phase stage of the economic expansion. As I mentioned in a recent post, during such periods, the energy sector has displayed a historic tendency toward out-performance. And the sector out-performance is often led by the higher beta oilfield services industry, which is followed by the highest beta offshore drillers industry.

Fourthly, if the energy sector does outperform, this stock's beta of 1.25 might help drive superior total return via the generation of returns driven by beta.

The danger is that Schlumberger as recently priced is very fully valued. The price includes negative potential alpha of 0.75%. This is a small but meaningful number. An absence of alpha, takes away your all important moat or margin of safety.

Analyst price expectations

Recently Schlumberger traded at $92.67. From Yahoo Finance we know that twenty-nine analysts expect an average price target of $110.76 (median $110), with a high target of $136 and a low target of $99. Schlumberger trades below the lowest price target, and so it could be an interesting buy opportunity. We know the price, and we know analyst perception of future price. But does the current price reflect good value?


We might believe that Schlumberger is attractive. But thus far its attractiveness has been viewed relative to other stocks in its sector, industry, or the coverage universe. We do not know whether the stock is priced to deliver a long-term return in line with our expectations.

Mathematically, the worth of Schlumberger is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate].

What is our long-term return expectation for a stock with a beta of 1.25, a long-term risk free rate of 4.50%, and an equity risk premium of 5.75%? This beta of 1.25 differs from the beta on table 1 of this post, because it is based on a five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the market, adjusted for beta's tendency to converge toward one. You can read more about where I get my estimates for long-term market returns and equity risk premium here. It is calculated as Risk Free Rate plus Beta Multiplied by Market Return less Risk Free Rate. Thus for Schlumberger, we should be targeting a long-term return of 11.6875%. Is the stock priced to deliver that return?

Earnings tend to be volatile from year-to-year over the course of the economic cycle. When I speak of sustainable earnings, I mean the level of earnings that can be expected to occur over the course of an economic cycle, which can be grown at estimated growth rates over a long period of time. I believe sustainable earnings can be estimated as the six-year median earnings per share. Thus cyclically adjusted earnings per share of $3.74, is an estimate of sustainable earnings for Schlumberger. However, an alternative estimate might be $4.42, which is one standard deviation over the trailing twelve month earnings over the past five years. And since Schlumberger has been through five years of unusually slow earnings growth, we might even consider 2013 earnings of $5.06 as the most appropriate measure of sustainable earnings: this level is near 2 standard deviations above the five year average. I'll be an optimist and go with $5.06 as an estimate of sustainable earnings.

The adjusted payout potential is that part of sustainable earnings that we can expect the company to return to shareholders via dividends and buybacks, net of dilution. I expect Schlumberger will payout approximately 35% of earnings via dividends. While Schlumberger does habitually return value via buy-backs, the historic trend on shares outstanding suggests that the buy-back program acts more as one which limits the dilutive impact of the gift of value to employees, than a return of capital to owners.

If we use a very long-term growth expectation of 9.59%, Schlumberger is worth $92.67. Schlumberger Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 109.59% * $5.06 * 35% / (11.6875%-9.59%) = $92.67. At this price it is likely that an investor with a return expectation of 11.6875% will be satisfied.

The growth estimate implied by the current market price of 9.59% is high. In my view, Schlumberger can be expected to grow at a slower rate: an 8% growth rate in line with potential real Global GDP growth of 4.2% and global inflation of 3.8% should be achievable over the very long-term. Given the slow earnings growth witnessed over the past few years, and analyst forward growth expectations of 18.50%, I am willing to accept a cyclical growth acceleration going ahead and very long-term composite growth estimate of 8.84%, but no more.

If I am right, the spread between the 9.59% growth priced by markets, and an 8.84% growth expectation, is 0.75%: this represents potential negative long-term alpha. Alpha is the difference between actual returns and the risk adjusted return expectation. Since we have a risk adjusted return expectation of 11.6875% for Schlumberger, a long-term investor targeting a risk adjusted return of 11.6875% will end up earning a return of 10.9365%.

Schlumberger quality is such that a lower than desired long-term return at a point in time is not a reason to sell. On the other hand, the current market price is not attractive for a buy and hold style investor. The opportunity to buy Schlumberger at a good long-term price is a rarity, found closest to bear market bottoms.

Notwithstanding the above comments, Schlumberger may still represent a decent short-horizon opportunity. Analyst estimates for 2014 are at $5.72, rising to $6.75 for 2015. And growth expectation estimates for the coming several years are running high at 18.5%. A squeeze on risk premiums, together with realization of high short-term growth rates, could take the price up to $102 rapidly, and up further to $120 in a year if conviction in growth continues to build. But as of now Schlumberger as priced is not right for my pocket.

The formula above helps to compute a fair value for a stock. It is simple, and you can use it to calculate a value based on your expectations, as opposed to mine. But if you do so, be cautious.

If you alter your risk free rate assumptions, you will need to evaluate how that will impact market return expectations, and the equity risk premium. You will also need to think about how the risk free rates will impact long-term growth. If you alter the adjusted pay-out assumptions, think about how that might impact the growth assumption and the capital structure. For instance, higher growth may signal a need for fresh equity or debt. And if the capital structure changes, so will beta. When you alter growth assumptions, think about how it might change the operational mix, and the impact that might have on the stocks beta, and stock return expectations.

There is a high degree of inter-connectivity between beta, growth, adjusted pay-out ratios, risk free rates, and market and stock return expectations. And reading the inter-connectivity wrong will result in an answer that ranges from absurd to obscene: this model comes with warts. To avoid falling into this trap, here are some ideas which I hope will help.

1. Since valuation is about what you are willing to pay for a stock, perhaps the most important consideration is the growth risk premium: that is Long-term Return Expectation minus Long-term Growth Rate. The question to ask yourself is that if you expect a stock to grow at a certain rate, how much over and above that growth would you want by way of a stock return expectation, to compensate you for the risk that the long-term growth rate might not be in line with your expectations. This spread will be low for a fast growing stock, where there is great confidence in forward growth expectations, and higher for stocks where the confidence in growth is low. In the very long-term, the growth risk premium has tended towards 4.5% for the market.

2. When you look at sustainable earnings for a growth stock, you need to look at where you expect earnings to be a few years down the road. And then discount that number to its present value using your stock return expectations to obtain today's sustainable earnings

3. When you look at long-term growth rates, remember it is not the next years' growth, or the next five years growth you are looking for. You are looking for a composite long-term growth rate expected over the life of the company. This will be made up of foreseeable growth rate for some years, reversion to market growth rates, and finally a terminal growth rate. The terminal growth rate used by many is the risk free rate. I tend to use the very long-term market growth rates, since if the terminal growth rate is below market growth rates, I as an investor have the option to exit and enter the broad market. The life-expectancy of a typical Fortune 500 company is 40 to 50 years: you can read more about this here. So we can consider using a five-year forward rate, and then assume growth shall revert to being in line with market growth expectations for the following 45 years. What this signals is that I am willing to pay a premium for currently foreseeable growth expectations, but after that period, I expect to share fully in the reward of growth over market growth rates. On excel you can calculate a composite growth rate for a company growing at 15% per year for five years, followed by growth at 8% for the following 45 years as 8.68% [=POWER(1/1*115%^5*108%^45,1/50)-1].

4. Test your adjusted payout expectations. Take your growth rate and divide it by 1 minus the pay-out ratio. The result will estimate the return on equity implied in the model for the company. Review the return on equity to see if it is broadly consistent with the return on equity for the industry over the long-term. If it is high, review the return on equity in the context of the leverage employed by the company. A levered company will have a higher return on equity, and so a high return on equity for a company may be perfectly justifiable in some circumstances. However, higher than industry leverage implies higher financial risk and this implies a higher beta, and a higher market return expectation. If you see a low beta with higher than industry leverage, you may want to compute a bottom up beta for the company, instead of one generated using regression analysis.

Disclosure: I am long RIG, RDS.B, BP. 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.