Schlumberger: Drilling for Value

Barron’s

The technologically savvy oil-services giant is a well-oiled money-making machine.

Americans lamenting high crude oil prices might want to hedge their misery with shares of oil-services giant Schlumberger. Though the price of crude in recent weeks has fallen off recent highs — to about $100 per barrel recently — forecasts for sustained high prices over the long term should spur exploration and production by large integrated multinationals, such as Chevron (ticker: CVX) and Exxon Mobil (XOM), national oil companies in countries like Saudi Arabia and Venezuela, and a host of independent producers. These companies turn to Schlumberger (SLB) to provide services and technologies to help them extract oil from under land and sea.

Schlumberger gets around three-quarters of its revenue from overseas, significantly more than North America-centric competitors Halliburton (HAL) and Baker Hughes (BHI), with roughly 40% and 55% of 2010 revenues coming from overseas, respectively. This positions Schlumberger, the largest oil-services company by revenue, to benefit from the ramping up of drilling by government-owned national oil companies in areas like the Middle East, Russia, Venezuela and Brazil, which tend to lag behind the North American market in a typical economic recovery cycle. The company is also a technological leader in subsea exploration and drilling, which should give it an edge over competitors as multinational oil companies pursue growth through technically challenging deepwater projects.

Though Schlumberger’s shares trade at a seemingly steep 20 times expected forward earnings, analysts say the company’s scale, technology leadership and degree of market penetration justify a premium valuation. Moreover, analysts expect earnings to grow 30% from 2010 to 2011. And shares are roughly flat year-to-date, held back by political uncertainty in key areas like the Middle East. The company’s recently-raised 1.2% dividend yield is a promising development. And analysts expect Schlumberger to use its substantial cash to buy back stock. « They have the best technology and the greatest penetration into the national oil companies, » says Matthew D. Conlan, an analyst covering oil-services stocks for Wells Fargo Securities. « For 2011 we expect Schlumberger to generate almost as much revenue in Asia as its three largest competitors combined. »

Schlumberger shares could merit less of a premium over time than they have historically. For years, it was the only option in a number of international markets, notes Mike Urban, an analyst with Deutsche Bank Securities, but its competitors have become a lot more viable. Still, Urban says, Schlumberger is likely to maintain some degree of a premium valuation. « It has the inherent advantage of incumbency, and it carries higher margins in these international markets than competitors, » he says. « If there is any volatility, people will flock to it as a high quality name. »

Saudi Aramco, the national oil company of Saudi Arabia, has said it is looking to ramp up its drilling activity 30% from current levels, probably over the next 12 to 18 months, says Urban. The move by the Saudis is an important catalyst in prompting other countries or publicly traded companies to move forward with their own projects, he adds. Wells Fargo’s Conlan estimates that 23% of Schlumberger’s 2011 revenue will come from the Middle East and Asia; 27% from Europe, Africa and Russia; 17% from Latin America; and the remaining 33% from North America. There can be some political risk when relying on national oil companies’ decisions, notes Dan Neiman, co-portfolio manager of the Neiman Large Cap Value Fund, which owns Schlumberger shares.

But Neiman argues that Schlumberger, as an international company with extensive experience, should deftly navigate such perils. That expertise and the company’s efforts—through acquisitions and intensive research and development—to assemble a more complete range of services for the life cycle of the oil field should help it earn and keep the national oil companies’ business. Schlumberger’s acquisition of oil-services company Smith International, completed last August, will help it build on a group of products used for drilling the well, known as the bottom-hole assembly.

Schlumberger used to own only the analytical tools for drilling and the tools to steer the drill bit, while Smith provided the drilling mud and the bits. Now that Schlumberger owns the entire package, the company should be able to not only achieve cost synergies but also boost its own research and development efforts in the drilling arena, according to Brad Handler, an analyst with Credit Suisse. Handler also likes Schlumberger’s technological dominance in offshore drilling, which should generate substantial opportunity as higher fuel prices, lower drilling costs and resource nationalism (the tendency for national oil companies to lay exclusive claim on a country’s oil) drive multinational companies to seek oil in more undersea locations.

« For multinationals to grow, they need to reach into deepwater, » Handler says. Investors looking to get a piece of that growth and to profit from rising oil prices would do well to drill deeper into oil services with Schlumberger shares.

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