The 4.4% dividend yield is attractive but the free cash flow didn't cover the dividend in 2018. Also, during Q1, revenue increased by only 1% year-over-year while pretax operating income decreased 7%. And management expects land exploration and production (E&P) investments in North America to decline by about 10% in 2019.
At a forward P/E ratio of about 27, its valuation doesn't look like a bargain, either. But investing in the company is actually a bet on the recovery of the international oil and gas E&P expenses. Besides the short-term challenges, the company has the potential to take advantage of an industry upturn.
Recovery From the Bottom of the Cyclical Oil E&P Business
Before the drop of the oil prices about five years ago, Schlumberger was generating impressive margins from its international offshore business. Despite the recent improvement of its EBITDA margin, the company is still far from its peak performance of 2014.
The lack of worldwide E&P investments over the last several years impacted the oil services companies. According to the International Energy Agency, the global oil & gas upstream capital spending amounted to about $450 billion in 2018. In contrast, these investments reached about $800 billion during the peak year of 2014.
Also, the weakness in North America is due to several factors. According to Schlumberger's management:
The higher cost of capital, lower borrowing capacity and investors looking for increased returns suggest that future E&P investments will likely be at levels dictated by free cash flow.
But Schlumberger is in a good position to take advantage of the recovery of the E&P investments. Management is optimistic about the increase in capital spending to compensate for the under-investments over the last several years.Also, while volatile, the recent recovery of oil prices will contribute to increased investments.
One reason for the weak margins Schlumberger has generated over the last several years is due to the low pricing contracts with no critical mass.The goal is to maintain a geographical footprint and keep optionality when conditions improve.In the meantime, management is trying to enhance the profitability of these dilutive contracts.
In the context of lower E&P investments, the first signs of recovery appear, though. The company confirmed the goal of generating high single-digit revenue growth internationally this year thanks to its offshore business.The Q1 results confirmed this objective is realistic as revenue from international businesses increased 8%.Also, the book-to-bill ratio for Cameron, a long-cycle business related to drilling rigs, was 1.5 in Q1, indicating a strong outlook.
And with a reduced 2019 capital program in the range of $1.5 billion to $1.7 billion, management expects the net debt to stay stable while maintaining the dividend.
For the Long-Term Investors
Compared to its peers, the market fairly values the company, as shown in the chart below. The higher PE and EV/sales ratios are due to the higher margins SLB generates.
The EV/EBITDA ratio at about 12 seems high for a cyclical business. But considering the level of E&P investments over the last decade, the peak of the cycle is still far.In this context, the valuation ratios are more reasonable.
I prefer not to invest in the company at a stock price of about $44, however. The potential for a higher stock price is real if the ramp-up of its E&P investments materializes. But the market doesn't offer a significant enough discount for me to invest with a comfortable margin of safety.
Schlumberger has positioned itself to take advantage of a recovery in the industry. Investing in the company is an interesting idea for the long-term investors convinced that the E&P industry will return to its previous peak levels over the medium to long term.
The author doesn't own any of the stocks discussed.