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Back to Part XXII - Tobacco Dividends That Smoke The Market

By Mark Bern, CPA CFA

If you are joining the series for the first time, you may find it informative to refer to the first article in the series, "The Dividend Investors' Guide to Successful Investing," where I provide more details about my process for selecting companies for my master list and details about why I use the metrics that I do.

The oilfield equipment and services industry looks like it is beginning to see some nice revenue gains this year to me. This is a very cyclical industry and it is best to buy early in the cycle because the troughs can be pretty dramatic. Fortunately, I believe that the current cycle is just getting a good start and has a long way to go. Offshore drillers are busy and building additional rigs, most of which are already contracted for, to meet growing demand. From an article about Seadrill (SDRL):

"Based on these developments and analysis of the rig market, Seadrill has concluded that it is highly likely that lack of sufficient rig availability in the deep-water market will become a key bottleneck until significant new drilling capacity is added."

Another article from The Wall Street Transcripts Online:

"Mr. Weiss: What's going on offshore is, I think the deep-water is a really exciting place. I think there's lots of potential in deep-water. We're finding new basins there."

My point is that there is a lot of offshore drilling that will be done in the coming years; more rigs and more services will be needed to provide continued growth for the industry. On the other side of the industry there is also a significant potential for increased land-based drilling activities, not just in North America, but globally because of the advances in technology that have unlocked previously known but uneconomical deposits such as oil and gas shale formations. The U.S. and Canada do not own a monopoly on these resources with more than half of expected land-based drilling rigs to be deployed overseas. A report from Douglas Westwood Energy Business Advisors quote illustrates this:

"The onshore drilling rig market is set to expand to more than 9,100 units over the next four years, driven by increasing volume and complexity of well requirements. The new World Land Drilling Rig Market Report 2011-2015 published by award -winning energy business advisors Douglas-Westwood, suggests an increasingly important role for frontier markets globally with an estimated 57% of active rig demand coming from regions outside North America by 2015. Substantial increases in production will see strong growth of drilling activity in China, India and Iraq, for example; while investment in enhanced oil recovery techniques in Saudi Arabia and Kuwait are expected to boost productivity in some of the world's largest maturing fields."

Another article that quotes the updated version of the above report at drillingcontractor.org points to land-based drilling rig demand expanding to 7,300 active rigs by 2015 with 52 percent located outside of North America. According to wtrg.com, the total number of active rotary drilling rigs in the world as of July 2012 was 3,516 and that includes offshore. The U.S. had 1,931 active rigs drilling as of August 10, 2012; of that number 1,881 were on land. Canada had 299 active drill rigs which brings the total number of rigs in North America to 2,230. If a similar percentage of the active rigs in Canada are on land (291), then the total number of active land-based rigs drilling in North America would be about 2,172.

Now, even if we assumed that all the remaining active rigs globally were on land (which we know is false, but I could not find a reliable break down), then the total active rigs drilling on land outside of North America today would be about 1,286 and the global total would be about 3,458. To get to 7,300 active rigs drilling of land by 2015 we would need an increase of 3,842 active rigs; more than double today's number. To put things into perspective, in the early 1980s, the world active rig count peaked at over 6,000. Oil prices peaked at under $40 per barrel back then. Today the average price for a barrel of oil is likely to remain above $80. Even an increase in the active rig count back to 6,000 would create hefty profits for the oilfield equipment and services industry.

I believe that technology improvements have only begun and that the costs to locate and extract oil will continue to be reduced. I also believe that technology will continue to make it possible to recover more of the crude resources from mature fields. Those advances will come from and be applied by the companies that make up this industry. I don't expect huge gluts in oil driving oil prices down to make exploring and production cost prohibitive. I believe that the major oil producing companies are too smart to allow that to happen as they, along with OPEC, control the majority of oil production and supply in the world. Control of supply can be translated into effective control of the price and control of the price can loosely be translated into controlling profits. I don't hate oil companies. I own shares in more than one. I don't believe that we are on the verge of running out of oil or that oil production has peaked. I also believe that the management in charge of the major oil companies will not create a glut in oil supply that would be harmful to the bottom line of their respective companies. Yes, a peak in oil production is coming someday, but that day has been postponed for several more years by technological breakthroughs. And future breakthroughs are likely to forestall peak oil even longer, in my opinion. But a glut in supply would create havoc for those in charge of supply. Therefore, my intuitive guess is that a glut, not making sense to those who control supply, is highly unlikely.

To provide some support to my opinion that the industry in on the rise, please consider an article about Schlumberger (SLB) that provides strong evidence that the drilling cycle is on the rise. Another author published an article with a less optimistic view for readers who would like a second opinion.

And SLB is the first company from this industry on my list. As a matter of fact, it is the only company from this industry to make the list. I will go through several of the close calls later in this article. The company has increased its dividend in all but one of the last eight years. It is the world's leading oilfield services company with products and services that cover the entire life cycle of exploration to production for oil and gas resources. SLB has an international bias with most of its operations located outside the U.S. The transition from drilling for dry natural gas to liquids that is occurring in the U.S. is having less impact on SLB than on some of its competitors. SLB caters more to the deep water projects where margins are better, and since I expect that drilling activity in the Gulf of Mexico to ramp up over the next few years I also expect SLB to benefit.

The seismic exploration services division of SLB is currently the fastest growing part of the company. When this happens, it usually leads to growth in other segments for the future. I expect the current drilling cycle to be an extended one lasting out into 2016 or longer. The company's share price has not completely recovered from the slump of 2009-2010, but that is a more normal occurrence for this industry. Shares are only 7.4 percent below the recent peak, but the long-term potential remains excellent. Let's look at the metrics.

Metric

SLB

Industry Average

Grade

Dividend Yield

1.6%

2.7%

Fail

Debt-to-Capital Ratio

21.0%

20.8%

Pass

Payout Ratio

28.0%

18.0%

Fail

5-Yr Average Annual Dividend Increase

11.8%

N/A

Pass

Free Cash Flow

$0.69

N/A

Pass

Net Profit Margin

12.1%

10.8%

Pass

5-Yr Average Annual Growth in EPS

6.1%

-1.1%

Pass

Return on Total Capital

12.5%

12.5%

Pass

5-Yr Average Annual Growth in Revenue

12.7%

13.4%

Neutral

S&P Credit Rating

A+

N/A

Pass

Two fails, one neutral ranking and seven passes create nothing critical that sticks out to me. The two fails are related to the dividend. Unfortunately, the dividend is below where I would like and the payout is above the industry average but still manageable. The critical point is that the pace in dividend increases may be slower than the pace of future growth in EPS. Over the next five-year period, I expect EPS to growth at a compound rate of about 15 percent per year. I also believe that there should be some expansion in the P/E ratio over the next five years. My five-year price target for SLB is $129, which works out to an average annual total return of about 19 percent.

The closest miss belongs to Carbo Ceramics (CRR). The company makes and sells ceramic proppant and provides software and consulting services to shale oil and gas industry participants. Proppant is ceramic and resin-coated sand designed for hydraulic fracturing. While drilling in shale is just getting started on a global scale, CRR is facing tough competition from Chinese companies that are undercutting the price and squeezing CRR's margins. CRR also has inefficiency in its distribution system that needs to be addressed. I don't expect adequate progress in this area until more of the U.S. shale regions are more fully under development. That would require a change in access to federal lands.

I do expect CRR to gain more traction as the number of rigs drilling in shale increases. Right now the industry is going through a transition period moving from dry natural gas drilling fields to regions with more liquids (both oil and liquid forms of natural gas). But until the rig count expands significantly, I expect CRR margins and earnings to remain under pressure from competition. The long term could be murky if the Chinese decide to try to take global control of the proppant industry. Let's look at the metrics:

Metric

CRR

Industry Average

Grade

Dividend Yield

1.6%

2.7%

Fail

Debt-to-Capital Ratio

0.0%

20.8%

Pass

Payout Ratio

16.0%

18.0%

Pass

5-Yr Average Annual Dividend Increase

15.0%

N/A

Pass

Free Cash Flow

$2.20

N/A

Pass

Net Profit Margin

20.8%

10.8%

Pass

5-Yr Average Annual Growth in EPS

20.4%

-1.1%

Pass

Return on Total Capital

20.7%

12.5%

Pass

5-Yr Average Annual Growth in Revenue

12.8%

13.4%

Neutral

S&P Credit Rating

NR

N/A

Neutral

One fail and two neutral rankings along with seven passes is the best showing in the industry. Strictly by the numbers the company makes the list. But this is where the qualitative analysis comes into play. The Chinese factor scares me enough to put CRR on the probation list to watch for how management responds over the next year or two. The share price has a lot of potential appreciation (probably more than any other company in this industry after the recent price decline), as does the dividend, if management can successfully meet the Chinese challenge. The key metric that I will be watching is the net margin.

In the most recent quarter, revenue per share for CRR rose by 18.7 percent (year-over-year) while EPS grew by only 6.6 percent over the same period. I want to see EPS growth much closer to growth in revenue per share. Then I can consider putting this high-octane company back on the list.

Another company that did not make my list is Halliburton (HAL), another giant in the industry of providing services to energy companies with operations in about 80 countries around the globe. HAL is divided into two divisions: completion and production (which accounted for about 61 percent of 2011 sales and 73 percent of operating income) and drilling and evaluation (39 percent, 27 percent). The completion and production division offers well cementing, well stimulation, intervention and completion services while the drilling and evaluation division does models, measures and well construction optimization. North America accounted for about 42 percent of sales in 2011. The primary reason I did not select HAL for my list is that the dividends have been flat. I like rising dividends and HAL management has not shown the interest in returning value directly to shareholders through dividends. Let's look at the metrics.

Metric

HAL

Industry Average

Grade

Dividend Yield

1.1%

2.7%

Fail

Debt-to-Capital Ratio

27.0%

20.8%

Neutral

Payout Ratio

11.0%

18.0%

Pass

5-Yr Average Annual Dividend Increase

3.7%

N/A

Neutral

Free Cash Flow

$0.86

N/A

Pass

Net Profit Margin

12.1%

10.8%

Pass

5-Yr Average Annual Growth in EPS

7.7%

-1.1%

Pass

Return on Total Capital

17.5%

12.5%

Pass

5-Yr Average Annual Growth in Revenue

13.2%

13.4%

Neutral

S&P Credit Rating

A

N/A

Pass

One fails, three neutrals and six pass rankings is not terrible. The fail for having a low dividend yield is exacerbated by the neutral rating for the dividend growth rate. Company management has demonstrated that it does not intend to increase the dividend or the payout ratio. The reason that I listed HAL, even though it is not on my list, is because I believe that the company's stock has been beaten down and represents a good opportunity for those investors looking for more growth potential and not as interested in the dividend. My five-year price target for HAL is $72 which represents an average annual total return of about 22 percent.

Diamond Offshore (DO) is a unique case. The company contracts to drill offshore oil and gas wells worldwide. It operates a fleet of mobile offshore drilling rigs. In 2011, Petrobras (PBR) accounted for 35 percent of revenues. DO is likely to do well, but while I do admire its dividend policy, it does not meet my requirements. The basic dividend is a flat $0.125 per quarter ($0.50 per year) with the remainder made up of a dividend that adjusts based upon the profitability of the company. The adjustable portion is what does not meet my requirements, as it can go down as easily as up in any given year. This may be a very suitable system for some investors, but I like to have a greater level of assurance for my future dividend income stream.

Metric

DO

Industry Average

Grade

Dividend Yield

5.1%

2.7%

Pass

Debt-to-Capital Ratio

25.0%

20.8%

Neutral

Payout Ratio

51.0%

18.0%

Fail

5-Yr Average Annual Dividend Increase

11.8%

N/A

Pass

Free Cash Flow

-$0.44

N/A

Fail

Net Profit Margin

29.0%

10.8%

Pass

5-Yr Average Annual Growth in EPS

6.2%

-1.1%

Pass

Return on Total Capital

17.2%

12.5%

Pass

5-Yr Average Annual Growth in Revenue

8.5%

13.4%

Fail

S&P Credit Rating

A-

N/A

Pass

Three fails, one neutral and only six passes is not good enough to make the list, even with a great dividend. The payout ratio is too high to expect it to be maintained if the company wants to keep up with competition by upgrading existing rigs and building more, in my opinion. The free cash flow is also a show stopper for me. This one is for braver investors than me.

Many of the companies in this industry do not offer a dividend and therefore are under consideration since I only follow dividend-paying companies. Companies like Tidewater (TDW) and Baker-Hughes (BHI) pay flat dividends. I require dividends to increase consistently over time. A number of companies' share prices are too volatile having fallen by 75 percent or more during the Great Recession. I prefer companies that fall less than the overall market and rebound better. National Oilwell Varco (NOV), Helmerich & Payne (HP), Oceaneering International (OII), Ensco (ESV), and DO fall into this category. Companies that exhibit too much volatility in dividends or EPS also get passed over. DO, ESV and RPC (RES) fall into this category. Finally, when the dividend is much below one percent and the payout ratio is consistently low, I do not consider management commitment to returning value to shareholders through dividends strong enough. HP and NOV were eliminated for this reason as well.

That concludes my assessment of the oilfield equipment and services industry. I hope you have found it interesting and informative. If you would like to read my assessments on other industries, a complete list of all articles in this series is available with the articles listed both chronologically by date of publication and by industry in my blog titled, "The Dividend Investors' Guide to Successful Investing Index Concentrator." As always I welcome comments and will attempt to answer any questions. The exchange of information is always welcome and it is how we all become better-informed investors.

Source: The Dividend Investors' Guide: Part XXIII - Oilfield Equipment And Services Demand Rising