In an earlier article here, I argued that Halliburton (HAL) was meaningfully more undervalued than its competitor, Schlumberger (SLB). Since the piece was published, the market partially corrected the value gap as Halliburton appreciated by 7.5%, while Schlumberger depreciated by 1.8%. However, I continue to find that Schlumberger is not the value play that sell-side analysts make it out to be.
From a multiples perspective, Halliburton is the cheapest of its most competitive peers. It trades at a respective 11.4x and 8.2x past and forward earnings. Baker Hughes trades at a respective 12.1x and 8.8x past and forward earnings while Schlumberger trades at a respective 21x and 13.8x past and forward earnings. I believe that much of the reason for Halliburton's discount stems from the Macondo debacle with BP p.l.c (BP), which, in my view, has been overblown by investors - we will get to this in a second.
A review of Halliburton's top-class services is in order. At the the third quarter earnings call, Halliburton's CEO, Dave Lenar, noted how otherwise solid performance in North America was challenged by cost pressures:
Let me talk about North America in a little more detail. Strong activity in the Bakken, Eagle Ford and Permian Basin drove the sequential growth for the quarter, along with the seasonal recovery from the Canadian spring breakup. Sequential incremental operating margin for the third quarter was 32%, which was lower than the elevated level we saw in the second quarter. The second quarter was favorably impacted by the typical spring seasonal rebound, as well as very high level of Gulf of Mexico incrementals. Incremental operating margins in the third quarter were negatively influenced by cost increases for materials, logistics and labor. Incremental margins were also negatively impacted by weather stoppages in the Marcellus due to flooding in Pennsylvania and by water shortages in the Mid-Continent, due to drought restrictions. We anticipate continued inflation on various cost items like labor, freight, chemicals and profits, which we plan to offset through targeted pricing improvements.
As Morningstar has rightfully noted, Halliburton offers industry-leading comprehensive solution that is of greater cost-effectiveness and quality to clients. Management has the deep industry knowledge that will be demanded as oil becomes more scarce. I foresee an oil grab over the next five years that will dramatically be driven by emerging market demand. Regulatory headwinds may help set back this event, but, in my view, it is inevitable. Operating margins are normalizing around 18% abroad, with greater competition and capital expenditures this number is trending towards $3.3B in 2012. Further complexity within the industry from environmental limitations will have the company set to grow at a CAGR of around 14%.
In regards to the Maconodo spill, I see this providing a major opportunity for high risk/reward returns. There are two ways that Halliburton could proceed - both of which I find will be better than what the market irrationally anticipates. First, it could reach a settlement with BP, which is now suing for Halliburton to pay all of the $21B costs related to the spill ($40B is on the side). This is an egregious amount given that Cameron (CAM) settled at $250M - 68% of which is expected to be covered by insurance. A second option is that Halliburton could move forward and hope that its contractual indemnification holds up in court. Whatever action Halliburton chooses to take, the end result will be greater certainty for the market and subsequent multiples expansion.
Consensus estimates for Halliburton's EPS forecast are that it will grow by 62.1% to $3.34 in 2011 and then by 23.7% and 16.5% more in the following two years. Assuming a multiple of 13x and a conservative 2012 EPS of $4.02, the rough intrinsic value of the stock is $52.26, implying 52.3% upside. Even if the multiple were to plummet to 9x and 2012 EPS turns out to be 9.2% below consensus, the stock would barely fall. Accordingly, Halliburton merits its "strong buy" rating on the Street.
Schlumberger, on the other hand, has struggled to perform. During the third quarter, the company had solid progress with growth in North America on land and offshore. Pricing trends and rig count sequentially improved, as deepwater and exploration activity faced better-than-expected underlying demand. With that said, earnings were still a miss and margins may be reaching a peak at this point. The outlook, particularly in Latin America and Asia, has grown markedly worse.
Consensus estimates for Schlumberger's EPS forecast are that it will grow by 27.6% to $3.65 in 2011 and then by 33.7% and 23.4% more in the following two years. Assuming a multiple of 17.5x - a significant premium to Halliburton - and a conservative 2012 EPS of $4.76, the rough intrinsic value of the stock is $83.30, implying 21.8% upside.