Last Friday, oil services companies Baker Hughes (BHI) and Schlumberger (SLB) reported earnings that helped drive up the Oil Services Index (OIH) by 1.2%. A strong performance considering the market was weak with the S&P 500 falling more than 1%.
If anything, the price jumps were more based on a relief rally that the industry didn't keep falling off a cliff after a very weak start to the year. Stocks in the sector, including Weatherford International (WFT), had been trading close to two year lows.
The industry in general had been undergoing a boom with demand for more complex and time consuming drilling, completion, and pressure pumping services due to drilling deeper wells in more harsh conditions or requiring more complex techniques due to horizontal drilling versus the previously more common vertical drilling.
The issues with the industry remain very over played as the global prices for oil and natural gas continue to suggest that oil service demand will remain strong. Too many U.S. investors with only a regional concept of the commodity markets fail to realize that Brent crude trades over $102 and natural gas trades above $10 in just about every location in the world. Both price levels suggestive of strong end demand.
Baker Hughes reported earnings results that smashed estimates though a part of the beat consisted of lower taxes. The company only paid a 25% tax rate compared to guidance for the full year in the 33% to 34% level. Now, if only Weatherford could figure out how to report lower than expected taxes. For those not up to speed, Weatherford has spent the last year trying to explain why a move to Switzerland in order to save on taxes in fact led to higher taxes.
The more important numbers for Baker Hughes were that operating profits increased 2% sequentially. This number was actually much better than expected in this operating environment especially considering analysts expected a roughly 10% drop in earnings per share to $0.77 from the $0.86 reported for Q112.
Those numbers are not typically what would induce a nearly 10% rally on the stock, but the oil service sector was trading at lows whereas results held up.
Schlumberger as well reported better than expected earnings and a tick up from Q1112 numbers due to strong international markets while seeing pressures on margins from domestic pricing and higher costs. It in fact reported higher numbers than back in Q311 when the oil services business was still pumping strong.
One of the main costs hurting profits continued to be the extremely high prices for guar used in hydraulic fracturing. This Reuters article highlights how that cost has now dramatically retreated. Ironically, one of the major contributors to the surging prices was the desire of Halliburton (HAL) and other oil service companies to build a huge stockpile while inventories were tight.
With Weatherford being a more international play [See Weatherford: A Good International Oil Services Play], the positive mentions by both Baker Hughes and Schlumberger on the areas such as Europe, Latin American, and the Middle East works directly into the strengths of this company. The company ranks right behind Schlumberger with 54% of revenue from outside the U.S.
Maybe more importantly it has the least exposure to the domestic gas shale play of the big major oil service firms with 80% of North American revenue coming from oil based activity.
As Morgan Stanley pointed out in this note, the real key to a stock gain from Weatherford will be the expected improvements in margins and lower tax rates.
Weatherford International Ltd. returns should improve because of its significant synergies among its core capabilities, normalizing margins, and tax rates, according to Morgan Stanley. The firm keeps its Overweight rating and $23 price target on the stock.
As mentioned in the previous article, international margins peaked at 25% in early 2011 and entered the year at only 6.5%. The tax rates as well are expected to drop below 30% from the 35% rate currently paying. These numbers will be key on the Q212 earnings report on the 25th. Any major progress in these areas will contribute to significantly higher earnings and greatly improve investor confidence.
The risk remains that this company will continue to fail to execute according to plan or at least the plan of analysts. The company has easily missed analyst estimates in the last two quarters after reporting the big tax issue last year.
Weatherford trades at the cheapest valuation of the majors yet it probably has the most upside as it works its way out of the tax problems. Based on the sequential improved results from Baker Hughes and Schlumberger, analysts are likely too pessimistic on it. The company reported $0.25 in Q112 and the forecasts are for a decline to $0.24 for Q2. The likelihood has increased that the company will actually meet the original forecast of $0.27 from 90 days
Of course, readers should go back and read the previous risk section to understand why a logical prediction might not come to fruition.
The below chart highlights the severe downward pressure the stock has faced since the beginning of 2011. Weatherford's stock has suffered twice the loss of the other three major oil service stocks.
Weatherford remains one of the more frustrating stocks in the market. The company correctly focused on a more international footprint and steered clear of the gas shale rush in North America. While beneficial moves, the stock has yet to see the rewards due to continued financial issues.
The stock traded double the current price back in 2011 prior to the tax issue and the industry slowdown and troubles in North Africa. As the global commodities of oil and natural gas reignite, Weatherford provides one of the best large cap stories in the market.
Disclosure: I am long WFT.
Additional disclosure: Please consult your financial advisor before making any investment decisions.