Schlumberger in a Balancing Act

Despite big gains in sales, increased costs will greatly impact this oil-service giant's margins.
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Approximately 70% of current oil production comes from fields that are 30 years old and require new technology to maintain production. In this sector,

Schlumberger

(SLB) - Get Report

stands as No. 1 or No. 2 worldwide in most lines of business that benefit from increased spending in the exploration-and-production, or E&P, areas.

For its first-quarter earnings report on Friday before the bell, current Street estimates expect revenue to have grown 31% to $4.15 billion and earnings to have grown 67% to 55 cents per share. The company should also report strong cash flow, which it has been paying to shareholders through dividends and share repurchases.

Onshore work will constitute the bulk of the company's rig count, which will restrain sales until new builds are activated in 2007-08. This liability will be compounded by shortages in labor and equipment, which will result in higher costs and project delays. This may be a good news/bad news scenario for Schlumberger. The company is one of the most reliable providers of services worldwide, but the increased costs will impact margins despite the big gains in sales.

On Friday's call, Schlumberger needs to address several areas. Five mobile drilling units were put out of service by last year's hurricanes and are still offline. In addition, a shortage of offshore rigs has limited growth in upstream areas such as the North Sea. Russia, which has experienced tremendous growth, is slowing production dramatically, and there is no sign of improvement in Iraq's production levels. Can these constraints be offset by aggressive investment from Saudi Arabia, as it searches for new oil and gas production?

New drilling efforts are expected in North Africa, India, Malaysia and West Africa. Capital expenditures spending by E&P companies (up over 30% year over year) and governments has grown to its highest level in three years. We will also see the real effect of the mild winter on the gas business in North America.

Although Russia is slowing, it will remain one of the fastest-growing areas, and Schlumberger will continue to benefit for an additional five months from PetroAlliance revenue. The Middle East will be strong, with the area's rig count expected to increase to 100 from 70. Of these, 29 belong to a 35-year-old venture, Arabian Drilling Company, of which Schlumberger owns 49%.

Schlumberger's technology will become vital as services for nonconventional hydrocarbon recovery and production take on increased importance. This will hopefully offset the limited amount of new equipment Schlumberger can deliver. Items such as pumps and some electronic components will not be available for delivery in 2006.

WesternGeco, the company's seismic company, should see enormous growth. The company's so-called Q-Technology, a suite of advanced seismic services and technologies for enhanced reservoir delineation, characterization, and monitoring, doubled revenue in 2005 and has backlogs north of $800 million.

The resultant free cash flow will likely be allocated to share repurchases and another double-digit dividend increase. I would expect an additional $1 billion authorization is forthcoming. Returns on capital have averaged 26% in the previous four quarters. Returns on sales in the oilfield business have been hovering around 17%, while WesternGeco's returns have steadily increased from around 17% to nearly 24%.

Schlumberger may surprise on the upside and provide solid guidance for the remainder of the year. The main risk to the company's shares is a drastic drop in oil prices. The possibility that Schlumberger may use some of its excess cash and appreciated stock to acquire another company to maintain its growth trajectory is another risk shareholders face. The firm's management is one of the best in the business, however, and I believe any acquisition will not be overly dilutive.

Editor's note: This column by Ed Stavetski is a special bonus for

TheStreet.com

and

RealMoney

readers. It appeared on

Street Insight

at 10:11 a.m. on April 20. To sign up for

Street Insight

, where you can read Stavetski's commentary in real time, please click here.

At the time of publication, Stavetski had no position in Schlumberger.

Edward J. Stavetski founded Pembroke Capital Management in 2002. He is the chief investment officer and manages money for individuals, small business pensions and small foundations. PCM's investment style is large-cap and small-cap value. Before founding PCM, Stavetski was director of research for Pitcairn Trust Company, a family office and mutual fund company; chief investment officer and managing director of PNC Advisers, the investment management and trust division of PNC Bank and senior portfolio manager for Rorer Asset Management, an investment advisory firm managing individual and institutional portfolios. He graduated with a bachelor's degree from West Virginia University. He is a member of the Association for Investment Management & Research (AIMR) and the Financial Analysts of Philadelphia. He is also a board member of Financial Analysts of Philadelphia and serves as vice-chairman of AIMR's professional development committee.