Opportunities in Natural Gas: Baker Hughes, Halliburton, Schlumberger

The Energy sector has outperformed the S&P 500 for several years. An earlier article examined the key issues driving opportunities in natural gas in the U.S. Natural gas is the cleanest burning fuel and is now trading at a lower cost relative to oil. Demand for natural gas should continue to expand, driven by substitution for coal to generate electricity and for heating. Natural gas is also being used by government and corporate fleets, as it is a lower cost and cleaner fuel.

To take advantage of the potential in natural gas, many investors are buying the exploration and development companies. However, the oil and gas field service firms also offer significant investment opportunities. Much like the companies that provided the picks, shovels and other implements to the early gold rush miners, these firms provide the equipment, fluids and services to help the exploration and production companies to find and extract oil and gas.

Three of the biggest firms are Baker Hughes (BHI), Halliburton (HAL) and Schlumberger (SLB). However, which ones offer the best opportunity to investors?

I like to look for companies that possess what several noted investors have called “growth at a reasonable price.” First, I look for companies that are trading at a good value. Then I look to see if they have good growth potential. In addition, it is useful to examine free cash flow and how it relates to the companies sales and enterprise value.

Halliburton Company (HAL)

Halliburton is an oil and gas services company with worldwide operations. They have extensive exposure to the North American natural gas exploration markets. As a result, the company will benefit from the growing demand for natural gas.

The table below presents some of the Value and Growth factors for the company’s 2007 results. In particular, HAL is doing an excellent job generating earnings as indicated by its Return on net tangible Capital and Earnings Yield. As a company that must continue to reinvest its cash into the business to grow, they are generating solid cash flow as measured by the Free Cash flow Margin and Free Cash flow Yield.

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Halliburton experienced a decrease in the price for their services in North America during the second half of 2007 primarily due to the falling price of natural gas. Now that the price of natural gas is trending up, the price for their goods and services is recovering as indicated by their first quarter 2008 results. They also are benefiting from a growing focus on the Middle East and Asia, space dominated by rival Schlumberger.

So far Halliburton is up 25.5% this year, vs. the 6.6% rise in the Philadelphia Oil Service Index ($OSX).

In 2006, Halliburton divested their KBR subsidiary, the company that got so much bad press for their contracting work for the Department of Defense in Iraq. Likely, this issue is still weighing on some investors minds, keeping them from considering a very good company.

Baker Hughes (BHI)

Baker Hughes provides oil and natural gas industry products and services for drilling, formation evaluation, completion and production. BHI operates throughout the world.

Baker Hughes offers a good value as indicated by their Return on net tangible Capital and their Earnings Yield. However, they do not generate as much as free cash flow from their operations as shown by their Free Cash Flow Margin and their Free Cash Flow Yield.

The company sports a slightly higher Price to Earnings ratio and a much higher Enterprise Value to Free Cash Flow ratio, another way to look at the value of the company relative to its free cash flow. Of interest, its most recent and projected revenue growth is lower than Halliburton.

Like Halliburton, Baker Hughes experienced pricing pressures in the last half of 2007. As they reported in their first quarter 2008 results, the current high price of oil and the higher price of natural gas are helping them to increase their prices, adding to their margins. BHI has significant exposure to the North Sea and Russia where weather negatively affected their results.

Baker Hughes is selling at a slight premium when compared to Halliburton without the higher growth potential. BHI is essentially flat for this year, vs. the 6.6% rise in the Philadelphia Oil Service Index ($OSX).

Schlumberger Limited (SLB)

Schlumberger is an oilfield services provider to exploration and production companies around the world. Like the other oil field service firms, SLB experienced pricing pressure due to fewer rigs in North America in the latter half of 2007, when the price of natural gas declined.

Schlumberger is a good value opportunity as indicated by their Return on intangible Capital, which is the highest of the three firms reviewed. However, their Earnings Yield is the lowest, indicating the market places a higher value on Schlumberger.

SLB’s P/E Ratio is the highest of the three firms; another indication the market expects the company to grow faster than the other firms. Their quarterly revenue growth rate helps to sustain this belief.

Schlumberger is considered by many analysts to be the best oil and gas field services firms, which is one of the reasons they have a higher valuation. Given their growth expectations, this is probably justified. Just remember you are buying a firm that is already valued higher than its peers are. SLB is up 6.3% this year, vs. the 6.6% rise in the Philadelphia Oil Service Index ($OSX).

The Bottom Line

Each of the three firms should benefit from the continued demand for energy throughout the world. There should be a pick up in their revenues and earnings throughout 2008 as exploration and development expenditures grow. Investors interested in these companies should listen to the recent earnings conference calls to gain a better understanding of the potential for each of these companies.

Of the three companies, I believe Halliburton is the best value for an investor’s money. Moreover, HAL has extensive exposure to the rebound in natural gas drilling in North America, which should help them. They should enjoy a nice up side, with lower down side risk. Look to buy on dips in the price, rather than chase the recent run up.

Disclosure: none

Comments

[The FItzman]

couldn't agree more. energy services are probably the single best investment theme, and will continue to be so as long as PEAK OIL is ignored by the united states. we need a real energy policy:

seekingalpha.com/artic...

the S&P 500 will continue to swoon, and energy will outperform. this will continue for years & years. individual stocks such as the 3 you mentioned are great. also to be considered, for diversification, would be something like Fidelity Select Energy Service. however, this should be in 401ks only because they distribute gains like mad.

[VintonCounty]

Return on capital must not be defined in GAAP, because many definitions of both the numerator and denominator are used. This data on returns on capital are of little use, because it's undefined.

Earnings yield is the inverse of P/E, but not here. So what is it?

SLB has the advantage of a low income tax rate and the disadvantage of a small earnings yield.