By The Valuentum Team
The second quarter of 2016 was not kind to energy equipment giant Schlumberger (NYSE:SLB). The firm cut 8,000+ jobs in the quarter, which came after material job cuts in the first quarter of the year, as well as the fourth quarter of 2015, in part of its efforts to contain costs in the face of suppressed energy resource pricing. Its total headcount is now ~40% below its highest levels of employment, reached in 2014. Related to the job cuts, the company took a $1.9 billion non-cash impairment charge and a nearly $650 million restructuring charge.
According to CEO Paal Kibsgaard, market conditions continued to deteriorate in the majority of Schlumberger's global business, but the bottom of the cycle appears to have been reached, at least so the party line of consensus goes. This ongoing market pressure, coupled with the massive impairment and restructuring charges forced earnings to swing to an an adjusted loss of ~$2.2 billion in the quarter, compared to profit of ~$1.1 in the year-ago period. Approximately $1.5 billion in revenue contributions from recently acquired Cameron International provided a bit of support the Schlumberger's top line, though it still fell 20% year-over-year. Let's dig more into Schlumberger's investment considerations.
Schlumberger's Investment Considerations
• Schlumberger is the world's leading supplier of technology, integrated project management and information solutions to the international oil and gas exploration and production industry. By market cap, the firm is bigger than the sum of its three main competitors (HAL, BHI, WFT) by a wide margin.
• Schlumberger estimates global exploration and production spending in 2016 will fall by ~25% from 2015 levels, led by a 40%-50% reduction in North America and a ~20% drop-off in spending in the rest of the world.
• Schlumberger recently completed its acquisition of Cameron International for $14.8 billion in cash and stock. The transaction is expected to be accretive to Schlumberger's earnings in the first year after closing, and synergies of $300 million and $600 million are expected in the first and second years. It will create new growth opportunities by forming the industry's first complete drilling and production systems.
• Technology remains at the core of Schlumberger. The firm's research transformation has shifted to a focus on increasing the rate of innovation, shortening the time to market, and improving product performance. High impact technology launches have surged as a result.
• Though Schlumberger has materially reduced its operating capacity, the firm has maintained its core capabilities beyond that of its current operating requirements, which will create operating leverage that will allow the firm to improve both its market share and margins as crude oil markets stabilize.
Schlumberger's dividend appears to be on solid ground. The firm registers a 1.4 Dividend Cushion ratio.
Schlumberger has used the downturn of the oil market to strengthen its relative position in its industry. Its recent $14.8 billion acquisition of Cameron International has formed the industry's first complete drilling and production system. Synergies of $300 million and $600 million are expected in the first and second years, respectively. Though the acquisition may negatively impact its balance sheet in the near term, these synergies will help the firm's already strong free cash flow generation, which is the basis for its solid Dividend Cushion ratio. Management has not given explicit guidance for its payout moving forward, but we would expect continued growth as the crude oil markets recover and free cash flow generation returns to normalized levels.
The dependence on the cyclical oil exploration and production industry will continue to strain Schlumberger's top line as its customers scale back capital spending. Fortunately, the company's relative balance sheet health and strong free cash flow generation should enable Schlumberger to continue to return cash to shareholders through dividends and share buybacks. Competing uses of capital could impact the health of the dividend moving forward, as share repurchases have been a major part of the company's capital return program in recent years. Despite the increased leverage from the acquisition of Cameron, Management is confident it has the company well-positioned to take advantage of the eventual recovery in its markets served.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Schlumberger's 3-year historical return on invested capital (without goodwill) is 30.7%, which is above the estimate of its cost of capital of 9.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Schlumberger's free cash flow margin has averaged about 15.7% during the past 3 years. As such, we think the firm's cash flow
generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Schlumberger, cash flow from operations decreased about 18% from levels registered two years ago, while capital expenditures fell about 39% over the same time period.
We think Schlumberger is worth $64 per share with a fair value range of $51-$77.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 4.2% during the next five years, a pace that is higher than the firm's 3- year historical compound annual growth rate of -5.5%.
Our model reflects a 5-year projected average operating margin of 13.4%, which is below Schlumberger's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 5.2% for the next 15 years and 3% in perpetuity. For Schlumberger, we use a 9.8% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $64 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Schlumberger. We think the firm is attractive below $51 per share (the green line), but quite expensive above $77 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Schlumberger's fair value at this point in time to be about $64 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Schlumberger's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $81 per share in Year 3 represents our existing fair value per share of $64 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.