4 Stocks That Could Supply Good Returns

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Unless you don't drive, don't use electricity, and generally live off the grid, you know how much money is spent on oil and gas each year. Whether it's paying your electric bill, filling up at the gas pump, or having your heating oil refilled, millions of people notice the changes in the oil and gas industry pretty quickly. While everyone knows names like ExxonMobil and Chevron, some lesser known companies benefit from the constantly growing demand for these fuels. Like the people that sold picks and axes to the gold miners back in the day, companies that sell supplies to the oil and gas industry could be an attractive way to play the growth in this booming business. However, I'm not satisfied with just finding a company to invest in, I want the best of the best. With this in mind, I ran a screen on Fool.com CAPS Screener for energy related companies with 20% EPS growth and at least 10% revenue growth over the last three years. Only two companies made the cut. 

The two companies that met my test were Baker Hughes (NYSE: BHI) and Halliburton Company (NYSE: HAL). However, I didn't want to only consider these two, so I also threw in two other oilfield service companies that didn't meet these criteria in Schlumberger Limited (NYSE: SLB) and Weatherford International (NYSE: WFT). This gives us a good cross section of the industry and hopefully will lead us to the best investment idea. Most investors look at the valuation of stocks and their expected growth rate to start their research, so we will start there as well:

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>P/E on '12 Earnings</strong></p> </td> <td> <p><strong>Growth Expected</strong></p> </td> <td> <p><strong>PEG</strong></p> </td> </tr> <tr> <td> <p>Baker Hughes</p> </td> <td> <p>12.97</p> </td> <td> <p>16.08%</p> </td> <td> <p>0.81</p> </td> </tr> <tr> <td> <p>Halliburton</p> </td> <td> <p>11.48</p> </td> <td> <p>14.81%</p> </td> <td> <p>0.78</p> </td> </tr> <tr> <td> <p>Schlumberger</p> </td> <td> <p>17.63</p> </td> <td> <p>18.15%</p> </td> <td> <p>0.97</p> </td> </tr> <tr> <td> <p>Weatherford</p> </td> <td> <p>12.42</p> </td> <td> <p>16.00%</p> </td> <td> <p>0.78 </p> </td> </tr> </tbody> </table>

Interesting results as you can see the market is apparently somewhat skeptical about the future growth rate that analysts are predicting. It's not unusual for companies that show consistent earnings growth to sell for a PEG of 1.0 or more. Fast growing companies in many cases sell for a premium like 1.5 or even higher. Since each of these companies sell for less than their respective growth rates, this could be an undervalued industry, or investors are being cautious. Normally I would say that Halliburton and Weatherford tie for first place, but for reasons we will get to in a minute, I'm placing Weatherford in third place behind even Baker Hughes. Trust me, there is a good reason this should be the case. For now this leaves Halliburton our winner. (Baker Hughes – 3, Halliburton – 4, Schlumberger – 1, Weatherford – 2)

The primary reason I'm uncomfortable giving Weatherford more credit for its expected growth, has to do with the company's past performance. Knowing if you can trust analysts expectations in the future is surprisingly tied quite a bit to their past performance. It's not unusual to see companies string together multiple quarters of outperformance or underperformance. Look at the difference between the companies results compared to analyst estimates over the last four quarters: 

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>Beat Estimates</strong></p> </td> <td> <p><strong>Missed Estimates</strong></p> </td> <td> <p><strong>Avg. Beat or Miss</strong></p> </td> </tr> <tr> <td> <p>Baker Hughes</p> </td> <td> <p>2</p> </td> <td> <p>2</p> </td> <td> <p>6.63%</p> </td> </tr> <tr> <td> <p>Halliburton</p> </td> <td> <p>3</p> </td> <td> <p>0</p> </td> <td> <p>3.10%</p> </td> </tr> <tr> <td> <p>Schlumberger</p> </td> <td> <p>3</p> </td> <td> <p>1</p> </td> <td> <p>1.20%</p> </td> </tr> <tr> <td> <p>Weatherford</p> </td> <td> <p>1</p> </td> <td> <p>2</p> </td> <td> <p>-11.48% </p> </td> </tr> </tbody> </table>

As you can see, Weatherford has consistently missed estimates in the last four quarters. If the company continues this streak their future growth rate would come in lower, which accounts for their lower ranking above. Baker Hughes has beaten estimates by the most and scores first place, followed by Halliburton and Schlumberger. (Baker Hughes – 4, Halliburton – 3, Schlumberger – 2, Weatherford – 1)

I've heard arguments about how free cash flow isn't critical because a company might be investing for its future. The problem is, I would rather see a company have actual cash flow to pay for its future rather than hoping this will happen somewhere down the line. With this in mind, Schlumberger is our winner because on a relative basis the company produces more free cash flow than its competition. In the last year, Schlumberger generated $0.05 of free cash flow for each $1 of sales. Halliburton was the only other free cash flow positive company at $0.03 per $1 of sales. Both Baker Hughes and Weatherford showed negative free cash flow both last year, and so far this year. (Baker Hughes – 1, Halliburton – 2, Schlumberger – 3, Weatherford – 1)

Since three of the four companies pays a dividend, let's look at that next. This is a close race with Halliburton paying a lower yield at 1.02%, but with a lower free cash flow payout at 45.14%. Schlumberger pays a higher yield at 1.47%, but with a higher payout at 60.38%. Baker Hughes pays a yield of 1.28%, but shows a negative payout ratio, and Weatherford loses by default with no current yield. Some might argue, but Schlumberger wins this round because of its higher yield. (Baker Hughes – 2, Halliburton – 3, Schlumberger – 4, Weatherford – 1)

Last but not least, let's look at each company's balance sheet. Since this industry requires a lot of capital expenditures, we don't want to see too much debt. Using a debt-to-equity calculation, Baker Hughes takes this category just barely at 0.23 versus 0.24 at Schlumberger. Halliburton shows a debt-to-equity ratio of 0.33, and Weatherford come in last again with a ratio of 0.60. (Baker Hughes – 4, Halliburton – 2, Schlumberger – 3, Weatherford – 1)

When we add up the totals, Baker Hughes and Halliburton tie at the top with a score of 14, Schlumberger comes in second with a score of 13, and Weatherford comes in last at 6. Given the choice, I personally favor Halliburton. The company is priced at the cheapest relative level and has been beating earnings estimates. The company also is one of the only two companies to generate free cash flow. While some might argue that Schlumberger is more attractive, the market is already pricing the stock at a premium to its competition. In addition, you could argue that if Halliburton raised its payout ratio to match Schlumberger, that the company would have a similar if not higher yield. No matter what company you choose, the constant demand in this industry argues that investors should consider some exposure to these “pick and axe” sellers. Add one or all four to your own personalized Watchlist to keep up with developments.

MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of Halliburton Company. Motley Fool newsletter services recommend Halliburton Company. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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