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We are of the opinion that Halliburton (NYSE:HAL) has priced in the negative impact because of an increase in the cost of a key raw material, guar, lower inventory levels, and potential damages from a legal investigation related to the Mocando oil spill. We have a positive outlook on the stock due to its cheap valuation and potential upside in profitability going forward, due to the shift from gas to liquids-and-oil-shale production in the U.S., which requires higher levels of service intensity and offers higher profitability to oil service companies.

Additionally, an uptick in Upstream Oil and Natural Gas spending is expected due to an increase in demand and high oil prices in the future, provided that growth resumes in China and the U.S., and the debt crisis in Europe is resolved.

Industry

Trends in oil and natural gas prices affect the level of exploration, development, and production activity of drilling companies and the demand for the services and products offered by oil service companies. Therefore, high oil and gas prices translate into increased drilling activities, which increase the demand for the products and services offered by the Oil Service Industry.

Upstream spending is considered the best indicator of service revenue, as higher upstream spending means higher demand for the services and products provided by oil service companies.

Catalysts

A turnaround in the economic slowdown witnessed in China and in the U.S. could be a trigger for oil prices, which have decreased by almost 20% in the last three months. A resolution of the debt crisis currently engulfing the European Union would have a similar impact on oil prices, which in turn would increase the upstream spending by oil drilling companies.

Outlook

According to the latest HIS Inc. upstream spending report, It is expected that the total upstream operating and capital expenditures are set to reach a combined record of $1.23 trillion for 2012 and expected to rise to $1.64 trillion in 2016, and this will drive the revenue and profitability of the company going forward.

Expected regional growth

· Increased drilling activities in Saudi Arabia and Iraq are expected to increase CAPEX by nearly 80 percent from 2011 to 2016 in the Middle East.

· Upstream spending in Africa is to be driven by expected growth in offshore activity of 62 percent from 2011 to 2016. This increased activity is linked to both ongoing and upcoming developments in East Africa as well as the Western Gulf of Guinea.

· CAPEX in Europe is expected to rise from $45 billion in 2011 to reach $57 billion in 2016, due to recent discoveries in offshore Norway, which are entering the development stage, and as existing regional pipeline projects are completed.

· Development and exploration spending in offshore Brazil will be the largest contributor for total upstream spending to reach about $230 billion in Latin America through 2012-2016.

· Total OPEX is expected to reach $671 billion in 2016, as new fields are brought online and due to rising global costs per unit of oil/gas produced.

Company Overview

HAL is one of the largest providers of services and products to the Energy Industry. It serves the Upstream Oil and Natural Gas Industry all through the lifecycle of the reservoir, from exploration, to well development and drilling and optimizing production life of the field.

The two primary revenue segments are Completion and Production, and Drilling and Evaluation.

Financial Performance

The EPS of $0.89/share for 1Q2012 increased 46% as compared to EPS of $0.61/share reported in 1Q2011.

Following is the reported revenue for the first quarter:

 

 

 

% Share

1Q2012

1Q2012

% change

Completion and Production

62%

4,290

3,172

35%

Drilling and Evaluation

38%

2,578

2,110

22%

Total revenue

 

6,868

5,282

30%

Source: 10Q

Total revenue

Total revenue increased 30% from $5.2 billion in 1Q2011 to $6.8 billion in 1Q2012, which was primarily attributable to increased activity in North America, as the demand for production enhancement and cementing work continued to rise.

Cash flow from operation and CAPEX

The cash flow from operations of $734 million improved by 30% as compared to $565 million for 1Q2011. The CAPEX of $782 million for 1Q2012 increased 11%, as compared to $704 million for 1Q2011.

U.S. Industry

The U.S. contributed about 61% of the revenue for 1Q2012. The decline in natural gas prices compared to 1Q2011 has increased the shift from natural gas shale plays to oil-and-liquids-rich shale plays. Gas rig count has declined 18%, while oil rig count has increased 39%, and this transition has resulted in additional costs, squeezing the margins of HAL in 1Q2012. However, in the long run, the shift from gas to liquids-and-oil shale will require provision of high service; hence HAL's profitability will increase. Deepwater drilling activity in the Gulf of Mexico continues to recover due to an increase in drilling permit approvals by the U.S. government. Management expects increased level of permit approvals in 2012, which will lead to additional deepwater rigs being installed in the Gulf of Mexico.

International Industry

It is anticipated that the industry will witness volume increases since improved macroeconomic trends support positive upstream spending outlook and new rigs are expected to enter the market due to the prevailing international oil and natural gas prices. These trends will lead to increased demand for service equipment. It is expected that international pricing will remain competitive due to over capacity, and that the Oil Service Industry will witness increased unconventional oil and gas projects.

Guar Gum Cost

Halliburton recently announced that it expected a decline of 5.00-5.50% in its North America margin for 2Q2012, making it 20.0-20.5%, which was higher than its previous 2.00-2.50% guidance, primarily due to higher costs for guar.

The rising guar prices are a result of the rapid shift in the increase in unconventional liquid rich drilling. This increase in guar prices is transitory and is expected to ease with India's Guar seed harvest season in the beginning of next year, and due to the upcoming availability of potential guar substitutes.

HAL had previously stated that it had enough guar for the whole of 2012, but now has indicated that it has a four month reserve to be used if it can't procure supplies. Hence, margins are expected to be affected.

Potential liability due to Macondo

The U.S. government has reservations over HAL's performance in providing cementing services on the Macondo well, which led to one of the largest oil spills in history. Despite indemnification clauses in HAL's contract with BP, we highlight the risk of potential liability in terms of the spill cleanup and compensation for commercial losses.

Market consolidation in unconventional resources

Schlumberger is focusing efforts on unconventional assets in North America, increasing the competition for HAL. Meanwhile, HAL's market share is expected to be hurt as Baker Hughes intends to add capital to the unconventional resource business, according to analysts at JP Morgan & Chase.

Stock price performance

The stock price performance has shown a decline of 16% in the previous three months, a decline of 15% YTD and a decline of 37% in the last one year.

Competitors

The major competitors of SLB include Schlumberger Ltd. (NYSE:SLB), National Oilwell Varco Inc. (NYSE:NOV), and Baker Hughes Inc. (NYSE:BHI).

Schlumberger Ltd is trading at a P/E and P/B ratio of 15.3x and 2.7x and offers a dividend yield of 1.7%.

National Oilwell Varco Inc. is trading at a P/E and P/B ratio of 11.2x and 1.5x respectively and offers a dividend yield of 0.7%, which is much lower than its peers. Its EPS has witnessed a growth of 44% in 1Q2012 and its profitability is expected to rise going forward.

Baker Hughes Inc. is trading at a P/E and P/B of 11x and 1.1x respectively and offers a dividend yield of 1.5%. The company's profits are expected to shrink in the future.

Recommendation

We are of the opinion that the financial position of the company is strong at the moment and our expectations are, based on the shift from gas to liquids-and-oil in the U.S., that the profitability of the company will improve, putting it at an advantage since it is a dominant service company in this field.

Trading at a P/E and P/B ratio of 8.69x and 1.88x, and offering a dividend yield of 1.28, we believe that HAL is expected to perform well going forward. We have a positive outlook on the stock, but advise a cautious stance related to the legal proceeding in relation to Mocondo and non-reversal in the uptick of guar prices going forward.

We recommend a Long position in Halliburton Co. and Short OIH Services ETF (NYSEARCA:OIH).

 

 

 

HAL

SLB

NOV

BHI

Industry

P/E

8.69

15.31

11.23

10.88

21.38

P/B

1.88

2.7

1.53

1.07

1.63

PEG

0.42

0.85

0.62

0.53

0.63

P/FCF

53.05

96.88

20.28

-

27.54

Dividend Yield

1.28

1.68

0.73

1.52

2.17

Total Debt/Equity

34.82

31.43

2.77

27.91

37.81

EPS growth 1Q2012

46%

41%

44%

-1%

-

EPS growth expected 2012

10%

9%

14%

-14%

-

3 month performance

-16%

-14%

-19%

-19%

-

YTD performance

-14%

-5%

-6%

-23%

-

52 Week Performance

-37%

-19

-3%

-43%

-

Source: Buy Halliburton: The Worst Is Priced In