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Weatherford International's (NYSE:WFT) second quarter report contained several positive data points:
- Operating EBITDA for the quarter was positive $58 million.
- The company highlighted a sequential increase in North America operating profit on aggressive cost reductions, in spite of a 26% drop in revenue.
- Most notably, Weatherford provided upbeat guidance. The company expects operating margins in the Middle East/North Africa/Asia Pacific region to increase to the 10%-11% range in the second half of this year, from the break-even level in Q2, while North America margins are expected to improve gradually, reaching a break-even by mid-2017. Latin American is expected to lag.
Given the macro environment and the market's recent primary concern with Weatherford's liquidity situation, expectations for this very difficult quarter have likely been low. With that in mind, Weatherford's report can be interpreted as positive. That said, the company's operating margins continue to compare unfavorably to the peer group. Free cash flow for the quarter was negative.
Furthermore, despite some early signs of recovery in the industry, the timing and shape of the upcycle remain uncertain, in my opinion, while the company's outlook regarding an upturn in activity, operating margins and cash flow appears to be predicated on oil price optimism. In the longer term, a case can be made that Weatherford is at a strategic disadvantage relative to the "big three" global integrated oil service providers and the lag in relative operating and financial performance is likely to persist.
Operating Margins Remain Weak
Positive data points notwithstanding, Weatherford's operating margins remain at the low end of the range for the peer group, where I include Schlumberger (NYSE:SLB), Halliburton (NYSE:HAL) and Baker Hughes (NYSE:BHI). Readers may find it interesting to compare Weatherford's results for the quarter with those reported by Schlumberger and Halliburton, which I reviewed recently.
Weatherford's adjusted operating margin for the quarter was negative 8.3%, a sequential decrease of ~1.7%. To put this figure in perspective, Schlumberger, the margin leader in the peer group, posted operating margin of over 10% during the same period.
In terms of revenue, Weatherford's result for the quarter was 11% lower sequentially, which is in line with peers. Revenue trends by region were also similar to those reported by peers:
- In North America, the company's revenues declined 26% sequentially, driven by lower activity and pricing pressures. However, in line with competitors' recent comments, Weatherford believes that North America activity levels have hit a bottom.
- In Latin America, second quarter revenues were down 18% sequentially, driven by across-the-board declines, particularly in Mexico, Brazil and Colombia. Cost reduction actions were taken late in the quarter and did not salvage the results for the quarter.
- In Europe/Sub-Sahara Africa/Russia, second quarter revenues were down 5% sequentially, driven by customer activity reductions across offshore West Africa, principally in Angola, partly offset by the seasonal recovery in Russia.
- Middle East/North Africa/Asia Pacific was a relative bright spot. Second quarter revenues were up 11% sequentially. However, the increase in revenue was primarily due to the settlement of the Zubair legacy contract in Iraq, partially offset by activity declines across the Asia Pacific operations. Excluding the impact of the Zubair contract, adjusted operating income was essentially at break-even levels, decreasing sequentially due to the lower activity levels during the quarter.
- Land Drilling Rigs segment had second quarter operating margin of negative 15.7% on a 9% sequential decline in revenue.
Cash Flow Burn Continued
Weatherford free cash flow was negative $160 million. The company attributed the result in great part to working capital dynamics and the impact of restructuring charges.
According to the company, NOC customers delayed payments during the quarter and receivables balances did not generate as much cash as expected. In addition, inventory reductions were lower than expected due to the decline in product sales. Weatherford also commented that the quarter's free cash flow reflected an accelerated $27 million payment due to the early retirement of Weatherford's senior notes. Additionally, $50 million of cash severance and restructuring costs were paid to further reduce operating costs going forward. On the other hand, overall cash flow for the quarter was positively impacted by the reduction in capital expenditures to $31 million, down 28% sequentially.
According to the company's comment on the conference call, the working capital and other factors impacted its second quarter free cash flow by ~$250 million. The company's current forecast for free cash flow for the year has been reduced to the range of positive $100 million to $150 million. This implies a strong recovery in free cash flow generation in the second half of the year.
The expectation reflects a seasonal pattern which, based on Weatherford's comments, is normal for the industry. The estimate is also predicated on improved operating results, stronger customer collections, lower inventory levels, much lower severance cash costs, absence of employee annual bonus payments and continued discipline in capital spending.
Weatherford's cash flow guidance implies an expectation of $450-$500 million positive free cash flow to be posted in the second quarter of this year. The guidance appears aggressive, given that both Weatherford and its peers have been pointing to continued pricing pressures in all regions and lack of pricing power due to poor capacity utilizations. While Weatherford's guidance is very encouraging, it is difficult not to ask questions with regard to the realism of the underlying margin assumptions. It is also not obvious whether the company will be successful in accelerating its receivables collections in the second half as projected.
Regardless of the outcome, Weatherford's liquidity situation had significantly improved following the company's second quarter capital market transactions that provided plenty of near-term financial flexibility and liquidity. As long as Weatherford can avoid increasing its net debt, investors are likely to be comfortable with the credit situation and look through the cyclical trough to the recovery in oil prices.
Weatherford remains an important company in the sector and has significant operating leverage in the event a cyclical recovery in oil proves to be strong. Similar to its peers, Weatherford has significant underutilized capacity across all regions and product lines, which should enable the company to increase sales volumes without significant increase in operating costs and with only modest capital investment.
Given that the company's enterprise value has declined to just ~$12 billion, a big portion of bad news appears already discounted in the stock price.
That said, the upside in the stock is strongly dependent on a robust recovery in oil prices, in my opinion. Under a lower-for-longer oil price scenario, on the other hand, the value thesis becomes difficult to defend, given the company's underperformance in operating margins and weaker competitive position relative to larger peers in strategic markets such as the Middle East.
Overall, the stock's risk/reward profile appears less compelling in comparison to the industry's leaders, Schlumberger and Halliburton.
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Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment, tax, legal or any other advisory capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. The author explicitly disclaims any liability that may arise from the use of this material.
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.