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From Standard & Poor's Equity ResearchWe believe that Schlumberger (SLB
; $62) will outperform its oilfield-services peers given its strong position in the faster-growing Eastern Hemisphere. This region, in our view, has the most attractive and lowest-cost drilling prospects for companies that explore for and produce oil and gas—the so-called "upstream" customers—and thus it's likely to see a growing share of upstream capital expenditures.
We also think that upstream customers place a very high importance on reputation and reliability, and thus are willing to pay a premium for improved performance and reduced downtime, particularly to the larger services players such as Schlumberger, which, in our view, possess strong, longstanding track records of performance. Combined with what we view as a compelling valuation, our recommendation is 5 STARS (strong buy).
INCENTIVE FOR NEW WELLS. As oil and gas wells increase in age, it becomes increasingly difficult (i.e., more expensive, and/or less technically viable) to maintain or expand production, typically requiring more advanced production techniques or equipment to do so. This 'decline rate' is, in our view, accelerating at mature oil and gas reservoirs worldwide, such as in the U.S. Gulf of Mexico and the North Sea. On the demand side, strong economic growth rates in several regions, including the U.S. and China, helped to create a surge in global oil demand in recent periods.
Combined, these supply-demand dynamics have, in our opinion, contributed to the ongoing persistence of elevated oil and gas prices, as supply struggles to keep pace with demand. Thus, we believe that upstream oil and gas companies have an incentive to continue their high levels of capital spending on both the drilling of new wells, and on techniques to enhance the productivity of existing wells.
Higher hydrocarbon prices, all else being equal, help to support capital spending plans by oil and gas exploration and production companies, by international oil companies, and by nationalized oil companies. In our view, it is this spending which fuels oilfield-services companies' revenue streams.
NUMEROUS OPERATIONS. Founded in 1927, Schlumberger is the world's largest oilfield-services company, employing over 60,000 people in more than 80 countries around the world. The company focuses on the provision of technology, project management, and information to the international oil and gas industry.
The company's two operating segments are Oilfield Services (88% of total 2005 revenues) and Western Geco (12%), a provider of seismic data services. Oilfield Services are divided into six technology groups: Wireline, Drilling & Measurements, Well Services, Well Completions and Productivity, Data & Consulting Services, and Schlumberger Information Solutions.
Wireline operations utilize downhole tools to provide information useful in evaluating formations, in planning well construction, and in monitoring existing production. Drilling & Measurements provides directional drilling, measurement-while-drilling, and logging-while-drilling services. The Well Services group assists in the construction of oil and gas wells, and helps to maintain optimal production levels over a well's lifespan using a variety of products and services, including stimulation, pressure pumping, coiled tubing, and cementing. The Well Completions group offers production optimization services, including perforating, intelligent completions, and artificial lift.
EASTERN PRESENCE. The final two technology groups offer a variety of information-management and consulting services. A seventh service, Integrated Project Management (IPM) leverages technologies from the other six groups and offers comprehensive project management and engineering services.
The Western Geco segment focuses on the provision of reservoir imaging, monitoring, and development services, complete with seismic crews, data-processing centers, and one of the leading multiclient seismic libraries. In April, 2006, the company acquired the remaining 30% stake in Western Geco that had formerly been held by its then-partner, Baker Hughes (BHI
In 2005, Schlumberger generated a higher percentage of its oilfield-services revenues from the Eastern Hemisphere (52%) than did either of its two largest competitors, Halliburton (HAL
) (39%), or Baker Hughes (48%). In absolute dollars, Schlumberger's oilfield-services revenues from this region (approximately $6.6 billion), are considerably higher than either Halliburton ($3.9 billion) or Baker Hughes ($1.0 billion). With a stronger presence in the Eastern Hemisphere—and our view that this region should grow relatively faster in the future—we think Schlumberger is well-positioned for growth.
COMPETITIVE ADVANTAGES. We believe Schlumberger's strong local foundation in frontier countries lends a competitive advantage in enabling it to grow market share in such markets. In Russia, for example, the company now has more than 8,000 employees, of whom 95% are Russian. Schlumberger's recent acquisition of PetroAlliance, one of the largest independent Russian oilfield-service companies, further deepens its presence in this important oilfield market. Global Insight projects that crude oil production from Russia will account for 11.4% of 2007 global supply.
We like Schlumberger's acquisition of the remaining interest in Western Geco, for two reasons. First, it should enable the company to leverage its existing portfolio of technologies from Oilfield Services to this segment without sharing such technologies with a primary competitor. Second, we believe, as the race to keep pace with hydrocarbon demand continues, and as maintaining existing supply remains a struggle, we see the likelihood of growing exploration spending, which typically requires advanced seismic services.
Based on continued high projections for oil and natural gas prices, and continued high levels of capital spending by E&P outfits, international oil companies, and nationalized oil companies, we project that Schlumberger will increase total revenues by approximately 32% in 2006, and an additional 19% in 2007. We expect EBITDA margins, which averaged approximately 29% in 2005, to reach 34% in 2006 and about 36% in 2007.
STRONG OPERATING MARGINS. We project Schlumberger to generate approximately 54% of total oilfield-services revenues, and 59% of total oilfield-services operating income, in the Eastern Hemisphere in 2007. We see operating margins of more than 30% in the Middle East/Asia region, and in the high 20% range in the Europe/CIS/West Africa region. Latin America is expected to trail at about 20% operating margins. In North America, we see operating margins in the mid-30% range.
Overall, we expect earnings per share of $2.97 in 2006 from continuing operations and excluding one-time items, and $3.83 in 2007.
Schlumberger has adopted accounting standard FAS 123R, thus expensing stock options on its income statement, and generating no impact on S&P Core Earnings. However, we deduct from operating EPS estimates 7 cents per share in each of 2006 and 2007 for projected pension adjustments. As a result, we see S&P Core EPS of $2.90 and $3.76, respectively, implying Core EPS divergence from operating EPS of about 2% in each year.
Our intrinsic value estimation is derived by calculating a sustainable growth rate for the company for the next 10 years, plus a terminal growth rate. We then discount the resulting free cash flows by the estimated weighted average cost of capital. Our calculations indicate an intrinsic value of about $81 per share.
TARGET PRICE. Given the company's leadership position in the industry, we believe that Schlumberger merits a premium valuation to peers, and historically the stock has been valued this way. Currently at a 9.6 times multiple to our estimated 2007 EBITDA (earnings before interest, taxes, depreciation and amortization), Schlumberger is trading at a 35% premium to our peer group average of 7.1 times. However, we believe that using a 14 times multiple (maintaining its premium above the 9.8 times projected peer average) is appropriate, and implies a value of $88 per share.
On a price to operating cash flow basis, Schlumberger trades at a 12.5 times multiple, about 17% above the 10.7 times peer group average. Using a 15 times multiple on projected 2007 operating cash flows—also a slight premium to the projected group average of 12.9 times—yields a value of $72 per share.
Blending these relative valuation metrics with our discounted cash-flow model yields a 12-month target price of $80 per share.
GOOD GOVERNANCE. We believe that Schlumberger's corporate-governance practices are generally sound. Independent outside directors represent 11 of the 12 seats on the company's board, and all board members are slated for reelection annually. The audit, compensation, finance, technology, and nominating & governance committees are all comprised solely of such outside directors. Stock option grants vest over four years and are granted at an exercise price equal to the fair market value on the date of the grant.
On the negative side, Andrew Gould serves as both chairman and CEO. In general, we prefer that a non-executive director serve as chairman.
Risks to our recommendation and target price, in our view, include events that would cause substantial declines in upstream oil and gas spending, such as lower-than-expected demand for crude oil and natural gas. Other risks include the potential for further political unrest in key frontier regions, including West Africa, the Middle East, Russia, and Southeast Asia.