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2019-10-18 22:26:58

Prepared by Tara, Senior Analyst At BAD BEAT Investing

Energy-related names have been hammered lately. While we have an ongoing position in a few names, we recently started pounding the table on oil service stocks. You see our investing philosophy centers on buying the right stocks and sectors when there is blood in the streets. Timing it, however, can be difficult as one does not want to catch 'the falling knife'. That said, we are calling the bottom here for Schlumberger (SLB), or the Slob as we like to call it. We think the $30 level marks the bottom, barring global economic recession. As such, the risk-reward is compelling even as the name starts to rally. We like to pick up trades when we think the market is mispricing assets. That necessitates considering oil service ideas.

The market priced SLB as if oil will stay down and get to the $40s, making it so that SLB will have to cut back to the bare bones as it did 5 years ago. We, however, think that although supply is high, demand is likely to keep pace. We think that with winter approaching, oil and gas demand will remain strong. We will discuss the just-announced quarter and the performance and such in this column. We believe you can enter the name and prepare for sizable medium-term upside. A little help from oil prices and continued operational strength will be a benefit. Here is the one-year chart:

Source: BAD BEAT Investing Chartist

Pretty ugly chart here. That said, Schlumberger's stock has slowly fallen the last year as oil and gas prices have moved lower and lower off highs of last spring. That said, the company had extremely slashed expenses to maintain a profit in the past, and we can expect it again. Operationally, the company is strong, but with oil down so much, it has been painful. We have run a few trades on the name, and think it is time to get back in once again because we believe that the performance of the name and our expectations moving forward for oil to settle and bounce again justify a buy rating. We think $35 per share is in the near future, representing 10% upside from the time of this analysis (current price $32.01), while in the medium term (a year plus out), investors should be looking at $45-plus exit targets. This is upside of at least 40%.

When oil does eventually rebound back toward, let's say, $70, it is not outside the scope of reason for this stock to double. We simply do not see oil remaining depressed for years and years. To be clear, we will need help from oil prices, of course, but we like buying here.

The play

Target entry: $31-33

Target exit short term: $36

Target exit medium-term: $45

Note from authors: Possible double when oil gets its legs. Well-timed very long-dated call options could result in exponential gains; in this case, it is best to wait for some positive momentum in oil.

Discussion

Make no mistake, oil prices matter. Schlumberger remains our favorite choice for an oil service stock overall, but it needs help from pricing. As you will recall, the name had been battered until 2017 when the oil market started turning. Strong profits were made into 2019, but now, the fall has taken the stock back to new lows and oil prices are still hurting. Make no mistake, SLB is at a generational low here, even lower than the Great Recession. However, the bulk of the action here is oil price driven.

Source: Oilprice.com

As you can see, the one month chart is ugly. Go back and look at the last month of SLB in the chart above. Look familiar. Now, here is the one-year oil price:

Source: Oilprice.com

Another familiar pattern right? As oil came down, so did SLB. Ultimately, we believe equilibrium is in the mid $60 range and that is our target for oil. We could test $50 before a sustained rebound starts, which is why we are encouraging a buy a bit lower, but the low $50s have been strong support for the slob.

An oil rebound?

The answer is yes, it will. We just do not know when. Attacks on production facilities and tankers have helped pricing see bumps, but the gains are usually given back. Global conflict boosts oil generally. However, oil could turn sharply, but it needs to see supply come down. A cold winter could be a benefit. A real big rally could take months since the market forces are simply out of whack and are not sustainable. Sometimes, the data is bad and oil rises. Sometimes, it is great and falls. Right now, the data does support a price in the mid- to upper-$50s. But a $5 move higher in oil should take SLB back to the upper $30 range easily. To get there, we suspect demand will need to rise, but we also caution you to watch production and supply.

Recent oil data

We believe the best source of oil supply, demand, and projections is the U.S Energy Information Administration. According to the latest weekly petroleum status report:

U.S. crude oil refinery inputs averaged 15.4 million barrels per day during the week ending October 11, 2019, which was 221,000 barrels per day less than the previous week's average. Refineries operated at 83.1% of their operable capacity last week. Gasoline production decreased last week, averaging 10.0 million barrels per day. Distillate fuel production decreased last week, averaging 4.7 million barrels per day. U.S. crude oil imports averaged 6.3 million barrels per day last week, up by 70,000 barrels per day from the previous week.

Over the past four weeks, crude oil imports averaged about 6.3 million barrels per day, 18.2% less than the same four-week period last year. Total motor gasoline imports (including both finished gasoline and gasoline blending components) last week averaged 651,000 barrels per day, and distillate fuel imports averaged 197,000 barrels per day. U.S. commercial crude oil inventories (excluding those in the Strategic Petroleum Reserve) increased by 9.3 million barrels from the previous week.

At 434.9 million barrels, U.S. crude oil inventories are about 2% above the five year average for this time of year.

According to the latest data release of the short-term energy outlook:

Brent crude oil spot prices averaged $63 per barrel in September, up $4/b from August and down $16/b from the September 2018 average. Brent spot prices began September at $61/b and increased to $68/b after attacks on major Saudi Arabian oil infrastructure disrupted the country's crude oil production. However, Brent spot prices have subsequently fallen, reaching $58/b on October 4, as Saudi Arabia restored the shut-in production and concerns about oil demand based on the condition of the global economy rose.

EIA forecasts Brent spot prices will average $59/b in the fourth quarter of 2019 and then fall to $57/b by the second quarter of 2020, which is $5/b lower than forecast in the September STEO. Despite the recent increase in supply disruptions, EIA expects downward oil price pressure to emerge in the coming months as global oil inventories rise during the first half of 2020. EIA forecasts balances to tighten later in 2020 and expects Brent prices to rise to an average of $62/b in the second half of next year. The resulting forecast average price in 2020 is $60/b, $2/b lower than forecast in the September STEO. EIA's October forecast recognizes a higher level of oil supply disruption risk than previously assumed, more-than-offset by increasing uncertainty about economic and oil demand growth in the coming quarters, resulting in a lowered oil price forecast.

Combining these data suggest that while supply is still high, demand is solid, though EIA sees pricing that SLB can turn a solid profit on. Should supply dampen and demand remain strong, we could see a push toward surpassing the $60 level.

Q3 performance

Obviously, with the weakness in oil, we expect the present operating quarter to be weak when reported. Overall, Schlumberger stock remains at highly depressed valuations for operating cash flow and free cash flow. Debt remains manageable. The dividend is still being covered by free cash flow, but we want to hone in some of the key performance results.

Revenues up in Q3

Oil was volatile in Q3, and we expected a lot of weaknesses. We were expecting a year-over-year decline in revenues, however, the company really delivered and were pleasantly surprised. Revenues did, in fact, grow in Q3 to $8.54 billion:

Source: SEC filings, graphics by BAD BEAT Investing

As you can see, this is very slight top-line growth. Still, this is OK because the company is handling expenses.

In Q1, the company brought in an additional $154 million over our projections of $8.4 billion. Revenues were up 0.5% as a result. Can this continue? We think Q4 may see some pain, but stocks price 6 months in advance, and so we need oil to rally a bit and even beyond EIA's forecasts for the stock to really get moving. However, we think the bottom is in, given the pricing outlook for oil and the data above. Operationally, the company continues to do well. Expenses have been slashed in the last three years, and we expect solid margins and earnings to improve compared to if expense levels were where they were years ago, more reasons to be long the name at these depressed levels.

Expenses

Remember, back when oil prices declined from 2014 to 2016, Schlumberger worked to cut expenses to the bare bones to maintain profits. The company was back to normal operations in late 2018 but has since been scaling back in certain areas to control expenses. That said, with the small rise in revenues from last year, we were surprised to see the degree expenses increased, but we believe that this rise in expenses will not last and it is very likely that the company will cut from here. Costs of revenues rose nearly 1.5%:

Source: Q3 earnings release

When revenues rise, we usually expect a rise in costs. Here, we saw a minimal rise in both. That is the cost of doing business. We were pleased to see expenses barely rose from a year ago. That said, when we factor in the cost of revenues with other expenses, we see total expenses were $7.38 billion. The company saw flat research and engineering expenses and a slight increase in administrative expenses. Overall, earnings fell.

Profit pressure

As you saw, the top line surpassed our expectations while expenses were in line. Margins were pressured from last year, coming in at 21.8% versus 22.7% last year. They did bounce from 20.3% in Q2 2019, however. When we consider operating income and taxable expenses, earnings per share were above our expectations for $0.39 when adjusted for items. This is down from the $0.46 last year:

Source: SEC filings, graphics by BAD BEAT Investing

This was a solid adjusted earnings result. The big adjustment was a ~$12 billion write-down. This was almost entirely non-cash and primarily related to goodwill, intangible assets, and fixed assets. Although EPS was down from last year, we do want to point out that it was a nice bounce from Q2 2019.

Shareholder-friendly

We would like to see Schlumberger take advantage of low share prices to heavily buyback stock. It did repurchase 2.2 million shares in Q3, but we want it to step up big time with shares at $32. The company does have a fairly respectable amount of debt, however, given the company believes in a recovery, now would represent a good chance to buy back a lot of shares. Assuming the company can borrow money for close to its fairly respectable dividend, that should still help the company going forward. Schlumberger has a fairly impressive financial position overall still and should be well-positioned as a company for a recovery.

Take home

Factor in the dividend and ongoing share repurchases, and Schlumberger is a winner. We need help from oil pricing, but we think the bottom is in for the stock at $30 and see a compelling risk-reward opportunity.

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Disclosure: I am/we are long SLB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.


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