We Are Back In Schlumberger, And You Should Be Too

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About: Schlumberger Limited (SLB)
by: Quad 7 Capital
Summary

Our philosophy generally is to buy the right stocks and sectors when there is blood in the streets.

Energy-related names have been hammered, and we believe there is opportunity in oil service stocks at these depressed levels.

Oil will see equilibrium and EIA data suggests this notion, but watch closely supply disruptions and/or changes in demand.

A strong dividend yield while you wait makes the stock even more attractive.

We expect expenses to be slashed in coming quarters as management vigorously fights to maintain profits.

Prepared by Stephanie/Tara of Quad 7 Capital

Let us make no mistake. Energy-related names have been hammered. While we have an ongoing position in a few names, we haven't talked too much about oil service stocks in a while.

Our philosophy generally is to buy the right stocks and sectors when there is blood in the streets. Timing it, however, can be difficult as one does not want to catch 'the falling knife'. There are others who invest and wait for the first 25% rally before getting long to try and catch the next 10-20%. That works sometimes too. But we like to pickup trades when we think the market is mispricing assets. That takes us to some oil service ideas. You have been watching oil prices, haven't you?

They are back in the toilet and have taken Schlumberger (NYSE:SLB) back down with them, trading under $35 a share right now. The market is saying that oil will stay down and SLB will have to cut back to the bare bones like it did 5 years ago. We, however, think that although supply is high, demand is likely to ramp up as summer approaches. We will discuss performance and such in this column but for several months now "the SLOB" as she is casually referred to in the pits has been slammed back down. We believe you can enter the name and prepare for substantial medium-term upside. A little help from oil prices in conjunction with wise expense management is all it will take. Here is the one year-chart:

Source: BAD BEAT Investing Chartist

Schlumberger's stock has slowly fallen as oil has moved lower and lower off highs of last spring. That said, the company had extremely slashed expenses to maintain a profit in the past and we can expect it again. Operationally, the company is healthier than ever, but with oil futures down so much. We believe that the performance of the name and our expectations moving forward for oil to settle and bounce again justify a buy rating on Schlumberger for a medium-term hold. We believe that our members should consider this play as a nice piece of their core portfolio. We think $40 per share is in the near future, representing 14% upside from the time of this analysis, while in the medium-term (a year plus out), investors should be looking at $50-plus exit targets. This is upside of at least 43%.

When oil does eventually rebound back toward lets say $80, it is not outside the scope of reason for this stock to double. We simply do not see oil remaining depressed for years and years. To be clear, we will need help from oil prices of course, but we like buying here.

The play

Target entry: $33-$35

Target exit short term: $40

Target exit medium-term: $50

Note from author's: Possible double when oil gets its legs--Well timed very long dated call options could result in exponential gains; in this case it is best to wait for some positive momentum in oil

Discussion

Oil prices are key. Schlumberger remains our favorite choice for an oil service stock overall. As you will recall the name had been battered until 2017, when the oil market started turning. Strong profits were made over the course of 18 months, but now the fall has taken the stock back to lows and oil prices are still hurting. If we let it come down a bit more strong prices can be had. But make no mistake, the action is oil driven

Source: Oilprice.com

As you can see the one month chart is ugly. Go back and look at the last month of SLB in the chart above. Look familiar. Now here is the one-year oil price:

Source: Oilprice.com

Another familiar pattern right? Ultimately we believe equilibrium is in the mid $60 range and that is our target for oil. We could test the $40 handles before a rebound starts, which is why we are encouraging a buy below $35. A few more dollars down in oil should push SLB below $35.

Can oil rebound?

The answer is not yes it can, but rather yes it will. We just do not know when. It could turn sharply. It could take months. But we definitely see strong support in the high $40 range for oil, because below this the market forces are simply out of whack and are not sustainable. So we think that is the time to buy. Anyone saying "oil will drop another $20, or will rebound another $20, within a few months" is full of it. No one knows. Sometimes the data is bad and oil rises. Sometimes it is great and falls. Right now the data does support a lower price; for now. But we suspect demand will rise but we also caution you to watch production and supply.

Oil data

We believe the best source of oil supply, demand, and projections is the U.S Energy Information Administration. According to the latest weekly petroleum status report:

U.S. crude oil refinery inputs averaged 16.9 million barrels per day during the week ending May 31, 2019, which was 171,000 barrels per day more than the previous week’s average. Refineries operated at 91.8% of their operable capacity last week. Gasoline production increased last week, averaging 10.0 million barrels per day. Distillate fuel production increased last week, averaging 5.4 million barrels per day. U.S. crude oil imports averaged 7.9 million barrels per day last week, up by 1,065,000 barrels per day from the previous week.

Over the past four weeks, crude oil imports averaged about 7.3 million barrels per day, 7.5% less than the same four-week period last year. Total motor gasoline imports (including both finished gasoline and gasoline blending components) last week averaged 1,095,000 barrels per day, and distillate fuel imports averaged 112,000 barrels per day. U.S. commercial crude oil inventories (excluding those in the Strategic Petroleum Reserve) increased by 6.8 million barrels from the previous week.

At 483.3 million barrels, U.S. crude oil inventories are about 6% above the five year average for this time of year. The West Texas Intermediate crude oil price was $53.49 per barrel on May 31, 2019, $4.91 below last week’s price and $12.32 less than a year ago.

According to the latest data release of the short-term energy outlook:

Brent crude oil spot prices averaged $71 per barrel in April, up $5/b from March 2019 and just below the price in April of last year. EIA forecasts Brent spot prices will average $70/b in 2019 and $67/b in 2020, Compared with an average of $71/b in 2018. This is EIA data. EIA’s higher Brent crude oil price forecast reflects tighter expected global oil market balances in mid-2019 and increasing supply disruption risks globally.

EIA forecasts that crude oil production in the Organization of the Petroleum Exporting Countries (OPEC) will average 30.3 million barrels per day (b/d) in 2019, down by 1.7 million b/d from 2018. In 2020, EIA expects OPEC crude oil production to fall by 0.4 million b/d to an average of 29.8 million b/d. Production in Venezuela and Iran account for most of the OPEC output declines in 2019 and in 2020, but EIA expects these declines to be partially offset by production increases from other OPEC members.

EIA forecasts global oil inventories will decline by 0.2 million b/d in 2019 and then increase by 0.1 million b/d in 2020. Global demand outpaces supply in 2019 in EIA’s forecast. Global oil demand rises by 1.5 million b/d in 2020 in the forecast, up from expected growth of 1.4 million b/d in 2019.

For the 2019 summer driving season, which runs from April through September, EIA forecasts that U.S. regular gasoline retail prices will average $2.92 per gallon, up from an average of $2.85/gal last summer. The higher forecast gasoline prices primarily reflect EIA’s expectation of higher gasoline refining margins this summer, despite slightly lower crude oil prices.

Combined these data suggest that while supply is still high, demand is growing. Any disruptions at all in supply will be wildly bullish. Conversely, should supply remain high and demand weaken, we could see a push toward $40 oil.

Performance

Obviously with the recent decline we expect the present operating quarter to be weak when reported. However, oil prices haven't really been 'strong' of late, though did have legs in Q1. Let us revisit how the Slob is doing.

Overall, Schlumberger stock remains at highly depressed valuations of operating cash flow or free cash flow. Debt remains manageable. The dividend is covered by free cash flow.

Revenues up in Q1 versus last year, thanks to a Q1 rally in oil

Before the move in oil prices in Q1, we excepted disaster. However, the company really delivered and was helped in part by oil that rallied through March. We expected revenues to be down year-over-year but were pleasantly surprised. Revenues did in fact grow in the most recent quarter to $7.88 billion:

Source: SEC filings, graphics by BAD BEAT Investing

As you can see, this represents a demonstrated return to annual top line growth compared to the last few years of Q1 results. However, we fully expect Q2 will be down high single digits in year-over-year revenues thanks to the last month of pricing. That is ok because the company is handling expenses.

In Q1 the company brought in an additional $50 million over our projections. Revenues were up 0.64% as a result. Can this continue? We think Q2 and Q3 may see some pain, but stocks price 6 months in advance and so we need expect oil to rally through summer and the stock to follow suit for a strong Q3-Q4. It comes down to when oil prices can rally, but frankly we expect revenues to around $8 billion in Q2.

If oil prices held at present levels, the company will see revenues and earnings nailed. Despite the rally in prices that last few days, we think the continued risk is to the upside and now that expenses have been slashed in the last three years, we expect solid margins and earnings to improve compared to if expense levels were where they were years ago, more reasons to be long the name at these depressed levels.

Expenses rose but we expect solid management moving forward

When oil prices declined from 2014 to 2016, Schlumberger worked to cut expenses to the bone to maintain a profit. It was a reality the company had to endure. It was painful really, but now the company is back and operations are ramping up. That said, with the small rise in revenues from last year, were were surprised to see the degree expenses increased, but we believe that this rise in expenses will not last and it is very likely that the company will cut from here. Costs of revenues rose nearly 1.5%:

Source: Q1 earnings release

When revenues rise we usually expect a rise in costs. That is the cost of doing business, but since revenues were up slightly we were surprised with the increase. That said, when we factor in the cost of revenues with other expenses we see total expenses were $7.2 billion.

Source: SEC filings, graphics by BAD BEAT Investing

The company saw flat research and engineering expenses and administrative expenses. Overall, earnings fell.

As profit fell we expect management to start cutting expenses again

As you saw, the top line surpassed our expectations while expenses were above our expectations too/ Sadly margins were narrowed, and when we consider operating income and taxable expenses, earnings per share were just below our expectations for $0.31 When we adjusted for items, the company saw earnings per share of $0.30. This is strong down from the $0.08 last year.

Source: SEC filings, graphics by BAD BEAT Investing

This hurts and does not help the balance sheet buy cash is solid. We would like to see Schlumberger take advantage of low share prices to heavily buyback stock. The company does have a fairly respectable amount of debt, however, given the company believes in a recovery, now would represent a good chance to buyback shares. Assuming the company can borrow money for close to its fairly respectable dividend, that should still help the company going forward. Schlumberger has a fairly impressive financial position overall still, and should be well positioned as a company for a recovery.

Take home

Looking at the global oil market, the global stock builds in the current quarter and rising demand, we think the oil market is out of balance and we will see a rebound. Since oil prices drive the momentum in this stock, and in the sector as whole, we love buying here under $35 range, and think a sharp rebound is in store as oil prices normalize. Factor in the dividend and ongoing share repurchases, and Schlumberger is a winner.

Disclosure: I am/we are long SLB. 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.