Oil Service Stocks: Pain Now, Gain Later?
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Times are tough for oil service companies and they may not be getting better any time soon. These firms have seen demand fall as North American drillers have cut back and with plenty of oilfield service supply added during the 2011 fracking boom, pressure on profits has increased. But as these companies work their way through a tough 2013, the future may be less painful.
Increased supply and falling demand equals pressure on profits
The substantial increase in supply of service equipment is a big headwind for the industry. Data from three firms I follow closely, Nabors Industries (NYSE: NBR), Baker Hughes (NYSE: BHI) and Halliburton (NYSE: HAL), show the rise in capital spending.
Nabors increased their equipment spending of $930 million in 2010 to $2.0 billion in 2011. Though reduced, they still expended a sizable $1.5 billion in 2012. Baker Hughes boosted equipment outlays of $1.5 billion in 2010 to $2.9 billion in 2012 and Halliburton jumped their purchases from $2.1 billion in 2010 to $3.6 billion in 2012.
This level of expenditure has saddled the industry with a significant oversupply of equipment at a time when oil rig service demand has declined. March year-over-year data shows the number of North American drilling rigs rising from a low of 1,301 in 2009 to a peak of 2,287 rigs in 2011. But since, the counts have dropped to 1,994 rigs this past March.
The combination of increased supply and falling demand has hurt pricing and profits. Baker Hughes put it best when they said: "Our fourth quarter results (2012) reflect the challenges faced by the industry as North American activity declined sharply towards the end of the year, and we continue to deal with unfavorable pricing conditions in the pressure pumping market. As a result, we experienced a decline in North America revenues and margins this quarter."
These unfavorable conditions look to continue in 2013. Large oil service player Schlumberger said, at a recent industry conference, that activity in North America has been below expectations in the first quarter. They’ve seen customers activating fewer rigs than they had previously indicated. Nabors seemed to have a similar view, stating: "… we expect the first quarter to show a marked decline in income given the current low rig count and depressed spot market rates, largely as a consequence of numerous speculative rigs entering the market at spot rates with minimal durations."
Better times after 2013?
However, there are some good signs for the industry. Firms have started to reduce spending on new equipment. Nabors estimates outlays of only $1.1 billion in 2013 with Baker Hughes anticipating around $2.0 billion and Halliburton $3.0 billion.
Also helping are good offshore and international markets. Baker Hughes noted that their Gulf of Mexico business expanded over 30% in 2012 and international operations increased revenue by 11%. Halliburton’s international regions saw fourth quarter 2012 revenue and operating income growth of 20% and 39%, respectively, and both their Latin America and Middle East/Asia regions achieved record operating income.
Companies in the industry also look to have a lot of the bad news already discounted in their share price and valuations may be getting favorable. For example:
Baker Hughes offers drilling & evaluation services (getting to and analyzing the oil reservoir) and completion & production services (getting the oil out of the reservoir) and it generates about 51% of sales from North America. The company posted revenue for the fourth quarter of 2012 of $5.2 billion, down 1% compared to $5.3 billion in the prior year and flat compared to $5.2 billion for the third quarter of 2012.
The company’s fair business value, based on expected cash earnings times a market capitalization multiplier, looks to be around $58 per share. This calculation assumes revenues of $21.0 billion and average cash earnings of $1.8 billion at a 14x multiplier. This can be compared to the company’s actual 2012 result of $20.9 billion in revenue and about $2.0 billion in earnings and a historical multiple of 20x.
Halliburton is another well-diversified services company that gets about 56% of revenue from the North American market. Its revenue in the fourth quarter of 2012 was $7.3 billion, compared to $7.1 billion in the third quarter of 2012 and $7.1 billion in the prior year.
One caveat on Halliburton’s valuation is an exposure to the 2010 Deepwater Horizon explosion and oil leak. The company performed services on the rig and has been named in more than 400 complaints. Though it has reserved for some of the potential claims there may be additional financial risk.
The company posted $28.5 billion in revenue and about $3.3 billion in cash earnings for its latest year and has a historical 17x multiplier. A Halliburton conservative valuation assumes $29.0 billion in revenue and about $3.0 billion in earnings. Using a 14x multiple produces a reasonable intrinsic value around $46 per share.
Nabors is the world’s largest land drilling contractor and generates around 81% of its revenue from North America. Its main business is providing rigs and drilling services, which accounted for roughly 66% of revenue with the remaining coming from its completion & production services business.
Expecting $6.8 billion in revenue and $808 million in cash earnings at an 8x multiple produces a fair value around $22 per share. This estimate may be conservative relative to full year 2012 results of $6.9 billion in revenue and about $845 million in earnings and a historical 12x multiple but may also be slightly optimistic compared to an expected weak first half of 2013.
Times are tough for the oil services industry and it might not be getting better soon. But companies are taking steps to improve their pricing power and with some of the downside already priced in, opportune buying of these shares might turn out well in the long run.
Bob Chandler has a long position in Baker Hughes. The Motley Fool recommends Halliburton. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!