- Due to writeoffs in Brazil, Schlumberger currently posts understated earnings.
- The company is growing volumes at 6%, which is a recipe for double-digit earnings per share growth.
- The risk is that investors must tolerate price volatility, earnings volatility, and patterns of frozen dividends to realize the superior returns.
When looking for a good investment, one technique that can lead to outperformance is finding a company that temporarily has understated earnings due to one-time impairments. A lot of times, the earnings "will lie" and create a widening gap between the company's reported earnings per share and the economic reality of the cash flow that backs it. Oil-field service company Schlumberger (NYSE:SLB) is one such example.
Because the energy company had to report write-offs on its Brazilian operations, there is a gap between the company's reported earnings and the cash flow that serves as a better measure of Schlumberger's earnings power. In 2013, Schlumberger posted cash flow per share figures of $7.60 per share. But because of write-downs at the Brazilian wells, Schlumberger only reported earnings of $4.67 over the course of 2013.
The appeal of Schlumberger, then, is that it is a company that (1) has understated profits, and (2) is rapidly increasing earnings per share. I wrote recently about how Chevron's capital expenditures are such that the volume growth doesn't materialize until 2017 or 2018; well, in the case of Schlumberger, you're looking at a company which is growing volumes by 6% over the course of 2014 simply because large investments in Europe and Africa are starting to hit the bottom line for shareholders. In fact, this could be the last year that North America constitutes a higher percentage of Schlumberger's profits than its Europe/Africa operations. Schlumberger will make about $2.7 billion in North America, and $2.6 billion in Europe Africa.
High volume growth is key to understanding why Schlumberger has such high analyst projections for earnings; some are calling for $6.00 per share in profits this year and $8.50 per share within five years. Those double-digit growth figures can only result if Schlumberger manages to keep up its volume and revenue growth in a manner consisted with what the Wall Street Journal has been reporting:
"Schlumberger reported that fourth-quarter income rose 22% as oil-field services revenue jumped in the Middle East and Asia…Oil-field services revenue from North America grew 6.6%. The Europe/Commonwealth of Independent States/Africa region's revenue rose 8.6%. Revenue increased 18% from the Middle East and Asia but fell 3.4% in Latin America."
High volume and revenue outside of the United States can largely explain why Schlumberger has done so well this past decade. Over the past ten years, the earnings per share have increased from $1.03 per share to $4.67 per share, and the dividend has increased from $0.38 per share to $1.60 per share to reflect this excellent business performance. A lot of this, though, is driven by the fact that revenues have tripled over this time frame, and increased efficiencies (Schlumberger is a leader in technology development and has regular cost-cutting programs in place) have allowed the company to more than quadruple profits in the past ten years.
The total returns of Schlumberger have reflected the excellent business performance over the past decade, as shareholders have experienced 13.25% annual returns since 2004. A good follow-up question, then, is this: In order to get that superior performance, what are the principal risks that come with the investment?
I think it is important for all investors, but especially those with a long-term or conservative bent, to understand that an investment in Schlumberger comes with risk in any way you define the stock: stock price risk, earnings risk, or dividend risk. Schlumberger is an extraordinarily high-quality company, however, its business model is almost entirely cyclical, meaning you will not be getting growth in a steady linear fashion, but rather, in quick fits and spurts.
This is what the downside looks like: during 2007 and 2008, Schlumberger's stock price regularly broke into the $110 range. In 2008 and 2009, the stock price of Schlumberger fell to the $30s. Even though these declines represented an incredible buying opportunity for the oil-service firm as its stock price became quite undervalued, not every investor is equipped to see $100,000 investments shrink to $25,000. Even after the crisis, the stock price volatility has continued to be substantial; the stock price fell from $95 in 2011 to $59 in 2012. You need to honestly assess whether you can make peace with that kind of volatility before you invest.
The second risk is in terms of earnings; this company is as cyclical as a commodity can be. Profits fell from $4.42 in 2008 to $2.59 in 2009. And these kinds of declines aren't limited to the financial crisis-Schlumberger's profits tend to fall in half every decade or so. From 1998 to 1999, shareholders had to witness profit declines from $1.25 per share to $0.41 per share. You're not going to get a steady march upward with the profits of this stock; when the stock price is sinking, so will the company's profits. This is tolerable if you're able to recognize that Schlumberger will earn profits far in excess of the cost of its capital expenditures over the full course of the business cycle, but that may not be enough consolation for everyone when prices and earnings are plummeting simultaneously.
And lastly, there is the dividend. Because the company's profits aren't consistently growing, neither is the cash dividend to shareholders. From 1997 to 2004, Schlumberger's dividend stayed static at $0.38 per share. The quarterly dividend froze in 2009 and 2010. And the company only returns about 20% of its net profits to shareholders as dividends, setting aside the rest of the profits for capital expenditure projects to fund volume growth. Even though Schlumberger has been raising its dividend the past couple of years, it's not really a dividend growth investment, but rather, it is a company with a high long-term earnings growth rate that just happens to pay a dividend.
If you look at what Schlumberger is doing to grow volumes, it's easy to see why analysts might be right in predicting double-digit earnings per share growth. And when you figure in the modest understatement of earnings, it is easy to see how long-term investors could get a little kick in the form of long-term P/E ratio expansion. There's a lot to like about Schlumberger, as it's one of the few companies slated to offer 12-14% annual returns over the next five to ten years. But those returns do come with strings attached: you have to decide whether it makes sense for you to handle the price volatility, earnings volatility, and patterns of frozen dividends that come along with it.