Buying The Cream Of The Oil Driller Crop

| About: Schlumberger Limited (SLB)


This looks like a fraught time for many oil drillers.

However, Schlumberger is differentiating itself and is a core energy holding.

Operations are strong and so is analyst sponsorship.

The stock may deserve even more of a premium valuation, and combined with higher earnings, investors may push the stock price to an all-time high.

Background: Getting oil and gas out of the ground in the modern, complex ways borders on being a technologically miraculous achievement. As an investor who is as happy investing in micro-cap stocks as mega-caps, my goal is to identify the best equities from a reward versus risk standpoint. In this case, while there are cheaper drillers on a variety of metrics, the old standby Schlumberger Limited (NYSE:SLB) looks to me now like a top pick on any time frame you might name, except perhaps on an ultra short-term basis.

There is a specific reason why this article is being written at this time. That is because the CEO of SLB has very recently spoken at a conference in the U.S. and is being reported as having spoken bullishly. Per a Reuters article from Monday:

Schlumberger expects Q1 earnings to jump from last year

NEW ORLEANS, March 24 (Reuters) - Schlumberger Ltd, the world's largest oilfield services company, said on Monday it expects first-quarter earnings to be much higher than in the same period last year, as it takes market share from rivals and cuts costs.

Much of the growth will come from state-owned and independent energy companies that are spending to develop shale and other resources around the world, rather than multinational energy companies, most of whom are cutting spending, Schlumberger Chief Executive Paal Kibsgaard said at an energy conference in New Orleans.

"We still expect strong, year-over-year growth in earnings per share compared to the first quarter of 2013, which further supports our positive view for the year," Kibsgaard said.

Introduction: Schlumberger has always been known as a technology-focused company operating in oilfield services. The company has a multi-decade track record of success. Its stock price was, adjusted for splits, 71 cents on March 24, 1970. Since then, it has appreciated 11.8% per year, versus 7.6% for the S&P 500, and about 9.3% for oil. It has not been known for being generous with dividends, so perhaps its annual total return has been around 13%, an extraordinary track record. Schlumberger was one of the famed 'Nifty Fifty' stocks. It has grown internally and by acquisition to be widely recognized as the world's leading oilfield services company. Sales are projected to exceed $50B this year, up from just under $40B in 2011, which was the first full year after its large acquisition of the U.S.-based Smith International.

At the trough of a previous oilfield services cycle in 2004, sales were $11.5B, equaling $9.75/share. Sales per share are now projected to be about $39/share. Earnings estimates for SLB have been eroding mildly, as they have for many of its competitors, and at last count were $5.71 and $6.74 for 2014 and 2015 (all relevant data are per share). The company is in the enviable position of being strongly free cash flow positive. Value Line estimates are that cash flow will be $8.70 this year. Subtracting $2.95 for capital spending and $0.30 for interest repayment suggests about $5.45 (per share) in FCF. With the stock price at $95, that suggests about a 5% FCF yield.

Dividends are estimated at about 1.8% of the stock price, and about 1.5% of the share base is projected to be retired this year. That leaves extra FCF for acquisitions or debt repayment.

Long-term interest is covered at a lordly 23X by earnings, and the company is the acknowledged technology leader in global oilfield services. The company therefore has several degrees of freedom to allocate resources geographically and technologically where it thinks best.

SLB can be thought of as a tech stock that has been a (or, the) leader in its industry for so long that it's an icon such as Coca-Cola (NYSE:KO) is, and neither company is easily letting up its grip on being #1. Schlumberger is so well regarded in many circles that the often-cautious analysts at Value Line think that both earnings and P/E have a great deal of upside in a 3-5 year time frame (see below for further discussion). Considering that the stock is still trading below a level it first reached in 2007, even though sales and earnings are solidly in record territory, I believe this is a sensible view. The chart confirms this:

Technical factors: Here is SLB's chart going back to the early 1980s. It is a classic cyclical "bottom left to top right" chart:

Chart forSchlumberger Limited (<a href=

Of course, the starting point of this chart in the early 1980s coincides with the downturn springing from the wild and crazy oilfield bull market that peaked in 1980, then crashed. SLB remains one of the most vigorous survivors and long-term winners from that shakeout.

Value Line projects that by about 2018, EPS will be around $8, cash flow (not FCF) around $12, and the P/E will be 20. Thus, it projects a $160 share price, with dividends as a bonus. This is, of course, not guaranteed, but Value Line lists SLB's median P/E as 22X.

Value Line is not alone.

Other independent shops agree that SLB is too cheap given its leadership position. Thomson Reuters' quantitative relative rating system rates SLB as a 9/10, placing it within the top 15% of all stocks it rates. Using a proprietary valuation system, S&P Capital IQ estimates SLB's intrinsic value as $114, representing a very high degree of estimated undervaluation versus its universe of stocks ('5+' ranking on a 1-5 scale). S&P also gives SLB an "Investability Quotient Percentile" rating of 96th percentile, consistent with the stock being a deep blue chip.

These opinions and forecasts make sense to me. Finding oil has gotten more difficult and intrinsically more expensive, and that trend strengthens Schlumberger's relative value to oil producers.

Why turn bullish now? I was long SLB before the Reuters report, and found the cash to double my holdings today after reviewing the situation. As those who follow the industry know, SLB gains a significant amount of profits from offshore, and the offshore drillers have been having earnings estimate cuts right and left. Plus, the harsh winter and other factors have made North America a bit of a tough region for many drillers this year. However, Schlumberger only gets about 30% of its sale and profits from North America, and is the least exposed to that region of any important global oilfield services company.

Upon the Reuters report, the stock jumped Monday and moved up sharply today as well. I take this perhaps as an ultra-short term negative, but beyond that, the CEO appears to have signaled to investors that there will be no negative surprises when the company reports Q1 earnings. Whether the full report and any forward-looking statements will have been fully discounted by the current stock price is, however, as always not knowable. Nonetheless, Schlumberger has no special need to pump its stock at this particular moment; and given reasonable prior analyses that the stock is relatively cheap compared with other high quality equities, it's not difficult to foresee a more sustained rally than the 2-day move that SLB has seen so far.

Risks: SLB is a volatile stock in a volatile industry; crude oil prices can go almost anywhere. Beyond that crucial risk and general stock market risks, a sustained global move away from hydrocarbons as energy sources will be adverse to Schlumberger's business prospects. A large acquisition on the scale of the Smith deal but that turns out poorly would be materially harmful to shareholders. A global crackdown against multinationals that forced them to pay higher cash taxes is another risk. Many other risks must be considered as real possibilities.

Summary: The leading oilfield services company may have just reaffirmed or even enhanced guidance for the quarter that is about to end, and suggested that business conditions going forward may be better than feared. At this difficult time for offshore oil drillers, with excess capacity apparent, this appears to have sparked a rally to 12-month high stock prices in SLB shares. Given that Schlumberger is already in the situation that it has reported record earnings with a stock price that continues to be within its 2007 price range, and given that several independent stock rating services peg SLB as being cheap relative to other high quality stocks and to the stock market as a whole, many types of individual investors may be interested in looking carefully at SLB to see if they wish to purchase shares in the days and weeks ahead.

Disclosure: I am long SLB. 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.

Disclaimer: This article is not investment advice. I am not an investment adviser.