Why You Should Buy Oil Well Service Stocks

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

From oil spills to a politically risky international markets, oil well service companies are trading at a discount due more to fear that weak fundamentals. In fact, I find the fundamentals of several undervalued players to be very compelling. As the economy picks back up, I believe more investors will put aside concerns and back these high-growth producers.

A Friendly Reminder To Buy Halliburton (NYSE: HAL)

I have been bullish on Halliburton for some time, and, over the last three months, it has returned nearly 20% to shareholders. Fortunately, shares are still attractively priced against growth. It is the leading provider of oil well service equipment, but is worth only 10.2x past earnings despite an industry average multiple of 17x. The producer is overly discounted for two main reasons. First, it bears partial guilt for the Macondo oil spill, which has hurt investor sentiment. Second, the business is only starting to pick up domestically.

While analyst estimates have fallen by almost 28% from the year-ago quarter, Credit Suisse recently upgraded the stock to "outperform" with a $44 price target (~30% above the current market valuation). This positive outlook was attributed to Halliburton's strong position in an industry with improving activity and pricing. It should be further noted that EPS has been above analyst expectations for all of the last 4 quarters.

Over the next 5 years, Halliburton is expected to grow EPS by 18.1% annually. If this ends up being the case, 2016 EPS will come out to $5.50. At a multiple of 16x, the future value of the stock will be $88. Discounting backwards by 10% yields a present value of $54.64 - a significant premium to the company's market cap. Coupled with high double-digit ROA, ROE, and ROI despite operating in a high capex industry, this makes for very strong risk/reward.

Baker Hughes (NYSE: BHI) & Schlumberger (NYSE: SLB) Also Undervalued

These two stocks also look meaningfully undervalued against the future. Analysts are much more optimistic about Schlumberger, which currently trades at a premium to competitor Baker Hughes. Over the last 4 quarters, Baker Hughes has had 2 earnings misses. By contrast, Schlumberger has had one very minor miss. Rightfully, Baker Hughes shares have underperformed during the past 12 months.

All things considered, Schlumberger merits its premium. Top-line growth of 16.7% for the year is 350 bps better than the industry average and supported by a leading ROE. Meanwhile, international momentum has held up well, with top-line sequential growth of 8% and 161 bps worth of margin expansion. And even though Brazil was flat in the recent quarter, numerous rigs are being commissioned there. Moreover, poor Latin American performance was offset by strong sequential growth in China, where penetration now will secure sustainable free cash flow into the future.

Dahlman Rose, in my view, unreasonably cut earnings forecasts for Baker Hughes based largely on a negative outlook on domestic pressure pumping price. Fortunately, the oil well service provider is meaningfully diversified abroad. And, at a PEG ratio of 0.79, the worst is factored in amidst the firm's turnaround. The company has a historical 5-year average PE multiple of 18.6x, so there is plenty of room for upside. While free cash flow has fallen from $215 million for the TTM ending March 2010 to -$1.3 billion two years later, capex investments have covered up the impressive momentum in operating cash flow. I recommend buying now to capitalize on the returns arising from those capital expenditures.

TakeoverAnalyst 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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