Schlumberger (NYSE:SLB) has recently reported strong quarterly results and looks well prepared to face the challenging future. Although the Houston, Texas-based Schlumberger's revenues might start improving from the third quarter as oil prices stabilize, the company isn't out of the woods yet. But thanks to the aggressive cost-cutting measures, the world's leading oilfield services company might remain profitable and continue generating free cash flows.
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Schlumberger released robust quarterly results, marked by profits, steady margins from international markets, and strong free cash flows, even though the company operated in what was arguably one of the most challenging quarters ever.
The oil and gas producers around the world in general and in the US in particular dramatically cut back spending and reduced drilling activity after oil prices crashed to historic lows in the second quarter. The average rig count fell by 50% in the US and by 22% in the international markets in Q2-2020 from Q1-2020. In this environment, Schlumberger's revenues dropped by 28% sequentially and 35% from last year to $5.35 billion. The drop was more severe in North America where revenues fell by 48% from Q1-2020 and 58% from Q2-2019 to $1.18 billion in Q2-2020. The international revenues dropped by 19% sequentially and 24% on a year-over-year basis to $4.14 billion. The company also booked $3.7 billion of pretax restructuring and asset impairment charges which pushed the company to a net loss of $2.47 per share. But excluding one-time items, Schlumberger managed to remain profitable, posting a net income of $0.05 per share, down from $0.25 in Q1-2020 and $0.35 in Q2-2019 but substantially better than the analysts' consensus estimate of a loss of $0.01 per share.
Schlumberger's margins also declined, with pre-tax operating margin falling to 7.4% from 10.4% in Q1-2020 and 11.7% in Q2-2019, indicating pricing pressure. But the company revealed that its international business showed resilience, with margins remaining essentially flat in Q2-2020 as compared to Q1-2020. On top of this, Schlumberger also reported $465 million of free cash flows, which was impressive considering the company's cash flow from operations came under pressure due to the downturn and it made $370 million of severance payments.
Schlumberger's better than expected earnings, resilient margins, and free cash flows, indicate that the company's aggressive cost-cutting measures are bearing fruit. I think this sets up Schlumberger well for the rest of the year.
Schlumberger continues to face a challenging future. The Brent oil price is expected to average just $40.50 per barrel in 2020, down from $64.37 in 2019 and $71.19 in 2018, as per the US Energy Information Administration. In this backdrop, the global oil and gas drilling activity will likely remain low as oil and gas producers will reduce spending. Schlumberger's closest rival Halliburton (HAL) expects oil and gas expenditures to fall by 50% in North America and by mid-teens in the international markets in 2020.
The oil prices, however, have improved in recent weeks, with Brent hovering above $40 a barrel since early-June, up from $29 in Q2-2020. These gains have come on the back of the improvement in oil demand and a decrease in supplies. The ease of lockdown and travel restrictions from several countries around the world, including the US and China, as well as a reduction in oil production from OPEC+ countries and other nations, has helped push oil prices higher.
Oil has now risen to a point where many shale drillers like EOG Resources (EOG) have started bringing curtailed production back online. An oil price environment of $40s a barrel is still not high enough to encourage shale oil producers to meaningfully increase spending and drilling activity. The oil producers likely won't deploy new rigs but if prices continue to hold their ground at the current level, then we might start seeing a modest uptick in frac activity and DUC completions. The international markets, on the other hand, are facing a mixed outlook, with some regions, such as the Middle East, Russia, Europe, and Asia, holding up better than others in the face of weak oil prices, as evident from Schlumberger's second-quarter results. Overall, Schlumberger is expecting a slight contraction in international activity in the third quarter, particularly for deepwater and exploration work. But if oil improves further, then I think we'll start seeing some stability by the end of the year.
The good thing is that the global drilling activity is not in a free fall anymore and might bottom out soon. What I particularly like about Schlumberger is that its revenue trajectory is ahead of the market's recovery. The company has forecast flat revenues for Q3-2020 as compared to Q2-2020, with a slight increase in international markets partly offset by a flat-to-low-single-digit decline in North America. But remember, although the improvement in drilling activity is a positive sign, we are coming from a very low base and it will likely take a while before the market conditions climb back to pre-crisis levels. Full recovery might be a long-term process.
Additionally, the macro-environment is facing major headwinds as the pandemic ravages the US, India, and several key energy markets. There's been a surge in coronavirus cases in every region of the world. More than three dozen countries have reported record levels of infections in the past week, as per a Reuters tally, with the number of countries almost doubling from the week before. If the rise in infections ends up hurting oil demand, then it might derail the nascent recovery. In this case, Schlumberger's revenues and earnings might continue to decline.
That being said, I think Schlumberger's second-quarter results should give confidence to investors regarding the company's ability to continue generating profits as well as free cash flows during the downturn. The company is working on a plan to substantially reduce operating costs, restructure the organization, and work on an asset-light business model. The company has targeted removing $1.5 billion of structural costs, on an annualized basis. A majority of the cuts are linked with the company's international business and primarily reflect cash savings, as opposed to non-cash expenses like DD&A charges. The company has already achieved roughly 40% of the cost cuts and expects to realize the remaining savings by the end of the year. These cost cuts will continue to have a positive impact on the company's margins in the coming quarters.
Furthermore, Schlumberger reported $3.7 billion of charges in the second quarter, including $1 billion of severance and $2.7 billion of non-cash charges linked with impairment of an Asset Performance Solutions (APS) business and excess assets. These charges were booked towards the end of the quarter and will help push the company's quarterly DD&A expenses down by $80 million and lease expenses lower by $25 million. This will also play a big role in helping Schlumberger sustain its profits and margins in the future.
Also, note that Schlumberger has substantially cut its annual capital budget by 45% from 2019 to $1.5 billion, mostly due to reduced investments in North America and APS projects. I believe the low levels of CapEx, combined with the cash cost savings, have put Schlumberger in a good position to continue generating free cash flows in the coming quarters.
Overall, I think Schlumberger has come out looking strong from the quarterly results. The company's shares have risen by 21% in the last three months and are currently trading 10x on an EV/EBITDA (forward) multiple, above sector median of 7.6x, as per data from Seeking Alpha Essential. The stock is also trading at 20x earnings estimate for 2022, the year when its profits are expected to rebound. Schlumberger isn't attractively valued at the moment but the company is well prepared to face the downturn and the stock is worth closely following.
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