Schlumberger (NYSE: SLB)

Key Takeaways:

• Schlumberger’s focus on services related to exploration and new field development has fueled revenue and margin growth.
• Profit margins continued to climb in the international market, as the firm raises prices on smaller contracts and is rewarded for superior execution on projects.
• Results from WesternGeco indicate that the market for marine seismic services is in the early stages of an up-cycle, with prices up at least 10 percent from a year ago.
• With prices down about 20 percent from their peak, hydraulic fracturing remains the sole weak spot in the company’s portfolio of services.

Oil-field services giant Schlumberger grew its second-quarter revenue by 5.3 percent sequentially, led by the reservoir characterization segment, where sales increased by 7.4 percent to $2.8 billion and pretax operating profit margins ticked up 223 basis points to 28.2 percent.

Schlumberger’s reservoir characterization unit includes services and products that help exploration and production companies find new oil and gas fields, delineate their size and evaluate their potential productivity and economics.

The end of easy oil has forced oil and gas companies into the deepwater and other expensive-to-produce plays, increasing demand for Schlumberger’s reservoir-description services. Based on data gathered from the field and analyzed using sophisticated software packages, operators can model how a particular reservoir will behave over time and use this information to develop an appropriate development plan.

Given the service intensity and expense required to develop deepwater fields, producers are eager to pony up for services and products that expedite the exploration and development process and limit costs.

Boasting the most advanced technology of its peers, Schlumberger dominates the industry and stands to benefit as oil and gas companies ramp up capital spending on deepwater exploration and development.   

Among the various service lines and products that fall under the banner of reservoir characterization, Schlumberger’s WesternGeco subsidiary has benefited from a tightening supply-demand balance in the market for offshore seismic data.

WesternGeco and other marine geophysical companies gather this valuable data on vessels that discharge sound and pressure waves into the depths of the ocean. These emissions, which bounce off formations under the seafloor, are received by hydrophones attached to lengthy streamers that are affixed to the vessel’s stern and drag beneath the water’s surface. From this data, powerful software extrapolates an image of these formations. In general, the more streamers attached to a ship, the more data it can collect and the faster it can perform surveys.

How robust is demand for these services? WesternGeco has already booked all of its available capacity to perform seismic surveys in the third quarter and 60 percent of its capacity in the fourth quarter–traditionally a period of seasonal weakness.

During a conference call to discuss second-quarter earnings, management noted that WesternGeco has raised prices on these services by 10 percent from year-ago levels and emphasized that unless global economic conditions change dramatically, this strength should carry into 2013.

The company’s brass also discussed IsoMetrix, an isometric marine seismic technology that Schlumberger plans to introduce later this year. The firm officially unveiled this technology in a June press release, and, judging by reports in a number of industry publications, IsoMetrix has attracted considerable buzz.

One of the largest engineering projects in Schlumberger’s history, IsoMetrix technology collects seismic data with an unparalleled level of granularity. A sophisticated software package uses this information to generate detailed, easier-to-interpret three-dimensional maps of offshore oil and gas fields. Management indicated that a vessel towing 12 of these advanced streamers produces output that’s equivalent in resolution to the results from a ship dragging 144 streamers (a physical impossibility).

Schlumberger plans to equip a single vessel with the technology and put it through additional testing and evaluation. Management expects to introduce IsoMetrix to the market in 2013 and expressed confidence that the technology will command a premium price.

After reservoir characterization, Schlumberger’s drilling group posted the second-best performance during the quarter, growing revenue by 5.7 percent sequentially and pretax operating margins by 107 basis.

This business segment comprises a range of services and products involved in drilling wells and field development, another business line that stands to benefit from increased investment in exploration.

M-I Swaco, which Schlumberger acquired through its takeover of Smith International, specializes in drilling fluids, a heavy concoction that operators pump into the well during the drilling process to counteract reservoir pressures and prevent a blowout.

Designing drilling fluids involves a combination of art and science. Drilling liquids that are too heavy for the application could unnecessarily impede drilling or damage the well, while a concoction that’s too light might result in environmental damage if hydrocarbons gush from the field.

M-I SWACO also performs mud-logging, a service that analyzes recirculated drilling fluids to identify the hydrocarbons dissolved in the mud or examine the shavings of rock that come from the bottom of the well. These findings provide the operator with additional information about the field.

During the conference call, management singled out M-I SWACO’s products and services for their strong quarter and highlighted growing demand for services related to directional drilling, or the sinking of wells that deviate from the vertical bore.

Schlumberger’s management team also noted that superior technology and execution in its reservoir characterization and drilling group has enabled the firm to push through price increases to customers that are increasingly less-willing to settle for inferior or inefficient work. In fact, the company replaced competitors on 39 service jobs during the second quarter, while losing only six gigs to rivals. CEO Paal Kibsgaard discussed this phenomenon at length during the q-and-a segment of Schlumberger’s conference call:

Paal Kibsgaard: I would just say that we continue to replace our competitors on key projects and key rigs. So this whole focus around operational integrity and quality, I would say, has now become quite a significant market share driver. We’ve been quoting this D&M [Drilling and Measurements] replacement ratio number over the past couple of quarters and that number again this quarter was 39-to-6. So we replaced our competitors 39 times; we were replaced six times. So that ratio us maintained, and I would say that the driver behind that is being able to perform within the contracts that you initially win. So the key is to win the contract on reasonable pricing to allow you to invest and perform. That’s really the only way to maintain the contracts in the international market.

Analyst: And you’re doing that with incremental pricing power?

Kibsgaard: Yes, we are not going in to replace our competitors at their pricing or at the average pricing. We need a premium to do that.

Note that Schlumberger isn’t replacing competitors on jobs by offering to do the work for a lower price; rather, customers are willing to pay Schlumberger a higher price because of its superior technology and execution.

This focus on quality rather than price reflects the upsurge in the day-rates charged to lease deepwater rigs. And recent activity in the contract-drilling market suggests that this trend could persist for the foreseeable future.

Aggressive Portfolio holding SeaDrill (NYSE: SDRL) recently secured a fixture for three of its rigs–one unnamed rig that’s in operation and two new drillships slated for delivery in first and second quarters of 2013–that covers a total of 19 rig years and equates to a day-rate of $575,000.

Thus far, the majority of fixtures that have involved day-rates in excess of $600,000 have featured a relatively short duration of one to three years. That a producer has opted to lease three rigs for a period of more than six years at such an elevated day-rate suggests that the supply-demand balance for deepwater drilling rigs will remain tight for the foreseeable future.

In this pricing environment, delays or inefficiencies can severely impact a project’s economics; oil and gas producers are willing to pay up to secure the best-in-class service provider. This dynamic prevailed during the 2004-08 up-cycle and should bolster the industry’s profit margins once again.

Schlumberger’s reservoir production segment was the lone laggard during the second quarter. Although the group increased its revenue by 5.7 percent from the prior three months, pretax operating profit margins slipped 117 basis points.

Much of this weakness stemmed from North America and services related to hydraulic fracturing, largely because producers are shifting drilling activity from primarily gas-producing basins to those that yield oil and natural gas liquids (NGL). There’s even speculation that the recent decline in NGL prices could prompt operators to ramp up activity in shale oil plays at the expense of NGL-rich gas fields such as the Granite Wash. Linn Energy LLC (NSDQ: LINE), for example, has indicated that it will adopt this strategy.

Although this great migration hasn’t caused a drop in activity–the onshore rig count is flat this year–natural-gas deposits are often found at greater depths than liquids-bearing formations. Accordingly, these plays usually require additional horsepower to pump the fluid and proppant into reservoir at such a force that the rock fractures, creating fissures through which the hydrocarbons can flow. Unlocking natural gas from these deep-lying plays requires substantial horsepower.

In short, the industry’s transition from natural gas-focused plays to liquids-rich fields hasn’t diminished demand for drilling–only horsepower for pressure pumping. Schlumberger has weathered this challenge with relative ease, but Halliburton (NYSE: HAL), with its substantial exposure to North America and heavy investments in pressure pumping, continues to struggle with margin compression.

Schlumberger’s management team indicated that prices for pressure pumping have declined almost 20 percent from their peak in both oil and gas basins and suggested that further downside could be in the cards.

Fortunately, the remainder of Schlumberger’s business in North America fared well during the quarter, with prices for wireline services and directional drilling holding steady. The firm’s North American operations also received a welcome boost from a resurgence of activity in the Gulf of Mexico.

Although weak demand for pressure pumping drove the 2 percent sequential decline in Schlumberger’s North American revenue, a recovery in international activity and profit margins offset these headwinds. The company’s revenue outside North America surged 9 percent in the second quarter, and pretax operating profit margins gained 161 basis points as the supply-demand balance tightened.

Schlumberger continues to raise prices on smaller contracts, as the proliferation of these deals usually limits the amount of competition relative to the hotly contested mega-projects. Although winning work on massive projects garners more headlines, Schlumberger generates about 80 percent of its revenue from smaller contracts.

The Verdict

Schlumberger reported strong second-quarter earnings, and management’s comments support our view that the oil-field services industry is in the midst of a cyclical up-cycle that’s being driven by exploration and development in international markets.

Despite thid enouraging news, oil-field services stocks remain out of favor. Shares of Schlumberger–the undisputed industry leader–trade at 2.25 times trailing revenue, roughly the same valuation that the stock fetched at the height of the market implosion in 2008. The stock also trades at about 16.5 times the 2012 Bloomberg consensus earnings estimate, a figure that has increased since the firm reported second-quarter results. At these levels, shares of Schlumberger are a bargain–particularly for investors with a longer time horizon–and rate a buy up to 100.

Read-Through

Our gleanings from Schlumberger’s second-quarter results and commentary have implications for a number of our Portfolio holdings.

Petroleum Geo-Services (Oslo: PGS, OTC: PGSVY)

A pure play on offshore seismic services, Petroleum Geo-Services should continue to benefit increased spending on deepwater exploration and a tightening supply-demand balance for these vessels. At the end of July, the company raised its guidance for full-year earnings before interest, taxation, depreciation and amortization (EBITDA) to between $750 million and $800 million from $700 million.

The firm cited many of the same upside drivers as Schlumberger. The company’s order book for seismic work surged by 19 percent from year-ago levels, to USD689 million, while customers have already booked 90 percent of its high-end capacity that’s available in the fourth quarter. This robust demand for seismic services in a seasonally weak quarter bodes well for 2013. With the company raising prices, EBITDA margins ticked up to 60.8 percent in the second quarter, compared to 50.1 percent a year ago. Buy Petroleum Geo-Services’ American depositary receipt up to 17.50.

SeaDrill (NYSE: SDRL), Ensco (NYSE: ESV) and Pacific Drilling (NSDQ: PACD)

During Schlumberger’s conference call to discuss second-quarter earnings, management discussed how elevated day-rates for deepwater drilling rigs is prompting oil and gas companies to privilege execution and efficiency over price when awarding services contracts.

Aggressive Portfolio holding SeaDrill recently announced that three of its deepwater drillships, two of which are slated for delivery in early 2013, had secured a six-year fixture at a rate of $575,000 per day. The contract driller also inked shorter-term deals that could yield day-rates of more than $600,000. We expect SeaDrill’s modern fleet of high-specification rigs to remain in high demand. SeaDrill rates a buy up to 45 for investors seeking a high current yield and dividend growth.

Growth Portfolio holding Ensco also offers exposure to this growth story. The contract driller has four ultra-deepwater rigs on order, three of which have yet to secure work. With day-rates on the rise and producers seeking to lock up high-quality rigs, we expect these vessels to earn lucrative contracts when they join the fleet. Buy Ensco up to 60.

Our most speculative bet on the contract-drilling industry, Pacific Drilling has four deepwater drillships in operation, two slated for delivery in 2013 and one rig due to join the fleet in mid-2014.

In late July, Pacific Drilling announced that the Pacific Sharav, which the shipyard will deliver in the fourth quarter of 2013, has secured a five-year contract with Chevron Corp (NYSE: CVX) to operate in the Gulf of Mexico at a day-rate of almost $590,000. Given the company’s relatively small fleet, this fixture will move the earnings needle considerably.

The announcement of fixtures for the Pacific Khamsin and the Pacific Meltem, both of which are under construction, could be a major upside catalyst for the stock. Buy Pacific Drilling under 11.

Cameron International (NYSE: CAM)

Cameron International manufactures a wide variety of equipment used by the oil and gas industry, but the firm is best-known for its subsea equipment and blow-out preventers.  

The company also stands to benefit from the increase in deepwater spending and blew away expectations by booking $572 million in new subsea orders in the second quarter, including purchase requests for 10 new blow-out preventers. Buy Cameron International up to 62.

Weatherford International (NYSE: WFT) posted solid second-quarter results, but ongoing tax accounting issues forced the company to delay its quarterly filing and restate results for the third time in two years. The oil-field services firm also took a $100 million charge related to the potential settlement of alleged violations of the Foreign Corrupt Practices Act (FCPA).

These nonoperational issues belie the strength of the company’s underlying business. We continue to like Weatheford International’s leading position in artificial lift, a suite of services that enhance production from mature fields.

Like Schlumberger, the firm’s international operations enjoyed a strong quarter, posting a 12.7 percent sequential increase in revenue and expanding profit margins by 218 basis points.

Shares of Weatherford International trade at valuations last seen in 2008, when oil prices plummeted and the global economy was mired in a severe recession.

Dramatically undervalued because of nonoperational bungling, the stock could surge if the company resolves its alleged FCPA violation, finally fixes its ongoing accounting issues or senior management is replaced. At these levels, the company could also be an acquisition target. Weatherford International rates a buy up to 17.50.