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In a bearish market environment where all three key benchmarks are in the negative single to double-digit territory so far this year, Schlumberger Limited (NYSE:SLB) is one of the best stocks to buy and hold for lofty returns both in the form of price appreciation and dividends. Shares of SLB have appreciated more than 20% year to date, and the company announced a 40% dividend increase for 2022. I strongly believe that the shares and cash returns of the leading oilfield services company will continue to rise due to three key catalysts including robust upstream spending, pricing power, and cash flow growth. To evaluate SLB's returns, let's examine these catalysts.
1. Aggressive Upstream Spending
As oil and gas prices are expected to remain double their normal levels in the next few years due to a growing gap between supply and demand, the industry is responding to supply constraints by increasing short-cycle investments in exploration and production. The upstream investments are likely to rebound in the second quarter and amplify more strongly in the second half of the year, led by North America, the Middle East, and other key international offshore basins. In 2022 alone, international upstream spending is likely to increase at a mid-teen rate while investments in North America could surge above 20%.
The impact of aggressive spending has already started strengthening Schlumberger's financial numbers. Its first quarter revenues surged 14% year over year to $5.96 billion, thanks to a 31% growth in North American revenue and a 10% increase from international markets. The well construction segment, the largest revenue-generating segment for Schlumberger, posted 24% year over year revenue growth in the March quarter. As stated above, the investment upcycle will accelerate in the second quarter and further intensify in the second half of the year, Schlumberger is poised to generate double-digit revenue growth in 2022.
2. Schlumberger’s Pricing Power
Since oil and gas prices are at a multi-year high and producers are seeking to maximize opportunities, concerns have been growing about a shortage of oilfield services. Continuing equipment shortages and extensive bottlenecks mean oilfield services players have significant pricing power. Schlumberger’s extensive global footprints along with a portfolio of advanced products and technologies such as fit-for-basin technologies, transition technologies, and emissions solutions enhance its pricing power.
In fact, pricing power has already started reflected in earnings reports of oilfield services companies. Schlumberger's pretax segment operating margins increased by 229 basis points (bps) in the first quarter of 2022 while its adjusted EBITDA margins of 21% increased by 94 basis points. Schlumberger expects its adjusted EBITDA margins to end the year at least 200 basis points higher than in the fourth quarter of 2021. Higher margins mean higher earnings and cash flows for the company.
Moreover, the acceleration in upstream production activities during the second half will further expand the scope and magnitude of net pricing impacts in long-cycle development projects.
3. Cash Flows
The company's cash generation potential has improved significantly over the past year, and it is expected to accelerate even more in the coming quarters. The improvement is not only attributed to increasing revenue and profits. The improvement is primarily due to SLB's efforts in the last two years relating to the high grading of its portfolio. It expects to generate a double-digit return on capital employed in the short to medium term.
This means that cash generation improvement is backed by a real change in capital return structure instead of revenue and profits swings. This is also reflected in its free cash flow performance in 2021 when the company generated $0.3 billion more in free cash flows than in 2019 despite a 30% drop in revenue. The company now expects to generate double-digit free cash flow margin growth for 2022 compared to the past year. The 40% dividend increase also indicates management’s confidence in the future cash generation.
How High Can Schlumberger Shares Go?
Schlumberger’s stock price is currently trading around $37, up 21% year to date, and soared 46% in the past twelve months. Market analysts also look bullish about the extension of Schlumberger’s share price upside momentum. For instance, Piper Sandler upgraded Schlumberger's ratings to Overweight from Neutral with a $55 price target.
“The shortages of rigs and other supplies today are "emblematic of the broader industry scar tissue and atrophy that have resulted from being brutally over-downsized for several years ahead of the present energy supply crunch," Piper's Ian Macpherson wrote.
In my opinion, the company’s stock is likely to follow robust broader energy market trends while substantial growth in its top and bottom line will add to investors' sentiments. To find the potential upside and its fair value, I used a discounted cash flow model. I assumed that its levered free cash flow would grow at 15% in the next five years, which is in line with the company’s projection. The company's weighted average cost of capital is 8%, while I used a 5-year average government bond yield of 3.75% to estimate future growth. The model is composed of two stages. In stage 1, I discounted the 5-year cash flow forecast to reach the present value while stage 2 deals with the present value of terminal value to determine equity price.
Stage 1:
Figures in billion | |||||
Year | 2022 | 2023 | 2024 | 2025 | 2026 |
levered free cash flow | $2.00 | $2.3 | $2.64 | $3.04 | $3.5 |
WACC | 8% | 8% | 8% | 8% | 8% |
Present Value | $1.85 | $2.13 | $2.45 | $2.82 | $3.24 |
Present Value of 5-Year Cash Flow = $12.5 billion
Stage 2:
Terminal Value = FCF2026 * (1+g)/(r-g)
Terminal Value = $3.5 billion * (1+3.75%)/(7%-3.75%)
Terminal Value = $85.5 million
Net Present Value of Terminal Value = TV / (1 + r)5
Net Present Value of Terminal Value = 85.5 billion/ (1 + 7%)5
Net Present Value of Terminal Value = $58 billion
Common Outstanding Shares = 1.2 billion
Equity Value = $48
SLB stock looks more than 20% undervalued trading around $37 compared to the fair equity value of $48.
Risk Factors
Schlumberger's performance is directly linked to exploration and production spending. In 2022, upstream spending is expected to remain strong due to supply shortages, which is favorable for oilfield services companies. The company's strategy of rolling back its Russian operations would also negatively impact its revenue by 5%. The company, however, is optimistic that its revenue from other parts of the world will offset that loss.
In Conclusion
In the current volatile and unpredictable market conditions, Schlumberger looks like one of the best stocks to buy and hold due to its strong market fundamentals. Its shares are likely to extend the upside momentum due to expectations for robust upstream spending and pricing power both in the short and long term. Robust cash flows would also enable it to offer healthy cash returns to shareholders.
