(Weatherford International energy stock analysis story, updated with Sterne Agee analyst comment)NEW YORK (TheStreet) -- Oil services company Weatherford International (WFT - Get Report) received the classic "buy on the dip" endorsement this week from several Wall Street firms after the company disclosed the need to restate four years of financial statements, but the analyst ranks are split on whether the company deserves its valuation discount -- and if this week's flap is just the latest indication of why the discount exists.

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A knee-jerk reaction from investors is all but assured when a company says the words "material weakness" in tax accounting. Weatherford witnessed that law of trading on Wednesday. Roughly 14% of outstanding shares of Weatherford were traded, or a whopping 105 million shares. A selloff after a negative headline can be expected, but analysts also note that a typical selloff might represent 2% of a company's outstanding shares. "Lots of people voted with their feet," said Tudor, Pickering, Holt & Co. analyst Joe Hill.

For every trading action there is also an equal and opposite reaction, and in this case it was the "buy on the dip" recommendation. Weatherford saw that action, too, with some analysts putting out buy recommendations by Wednesday afternoon, and shares rebounding from Wednesday's intraday low of $19.56.

Other analysts remain on the fence with Weatherford, though, and can't help but view this week's "four-year glitch" as one more issue for a company with a history of accounting issues and surprise one-time charges to earnings, not to mention the ongoing foreign corruption probe by the federal government that alleges business dealings between Weatherford and a list of countries on the U.S. government's no-no list, including Cuba, Iran, Sudan and Syria. This case will likely result in one more big negative headline for Weatherford, when a settlement is reached -- though this has long been expected by investors and analysts.

David Havens, analyst at Sterne Agee, downgraded Weatherford to neutral on Thursday, and after the big selloff conceded that, "While the utility at this point of a downgrade is degraded," it could not advocate a "buy on the weakness strategy."

In any event, for those who share this more cautious perspective on Weatherford shares, the valuation is right where it should be, around $21. Both Tudor, Pickering, Holt and Pritchard Capital have $21 price targets on Weatherford International (Pritchard lowered its price target from $24 to $21 on Thursday). Sterne Agee removed its price target, which had been $25, and which Weatherford shares had recently reached. Weatherford International shares were retreating by 3% on Friday -- though all the big oil service stocks were down -- and its shares were recently trading slightly below $21. For the week, Weatherford shares are down 14%.

To make a long, boring (and confusing) tax story short, Weatherford racked up approximately $500 million in accounting errors for the periods from 2007 to 2010, which will require $100 million to $150 million in annual adjustments.

To its credit, Weatherford didn't attempt to play down the magnitude of its mistake. In a conference call with investors and analysts on Wednesday, CFO Andy Becnel conceded, "This mistake -- the embarrassment of which is difficult, if not impossible to quantify -- highlights that we have work to do on strengthening the process piece."

The real kicker here for analysts and investors frustrated by the Weatherford announcement is that it comes four years after Weatherford International relocated its headquarters to Switzerland in an effort to create a more efficient multinational tax structure. Weatherford not only revealed that its lack of internal controls missed a big accounting error in 2007, but that the company let the error linger for four years.

It's not just that the accounting flap will require four years worth of financial restatements, either, but that it will result in a higher tax rate, potentially higher than Weatherford's tax rate had been when it decided to reincorporate in Switzerland.

The company declined to quantify a new tax rate for investors, saying it needed more time, and added that its "high level" conclusion from the discovery of internal control weaknesses is that the multinational tax structure will be in the company's best interest long-term. On the other hand, analysts on this week's conference call said it's not unreasonable to assume that the tax rate could go back up to 30% from current management guidance of 20%. According to energy analysis firm Tudor, Pickering, Holt, Weatherford's 2006 tax rate was 28%, and since 2003, the tax rate has always been 30% or less. Weatherford officials were specifically asked if the new tax rate will be 30% during the conference call, but declined to comment.

Bill Conroy, analyst at Pritchard Capital, said that a 30% tax rate was a fair "do the math" calculation based on the Weatherford's previous guidance of a 20% tax rate, however, since the company gave no guidance on what the new tax rate will be, it could come in lower than 30%.

Sterne Agee analyst David Havens wrote, "The conference call was appropriately mea culpa, but there was the hanging chad ... what is the effective tax rate? The prior 20% guidance is no longer relevant, but management did not appear to be subscribing to the 30% level, rather somewhere in the middle ground."

The answer is expected once Weatherford files its 10K within the next 15 days.

To put the tax rate trend at Weatherford into perspective, here are some estimates for effective tax rates of energy stocks that are domiciled both inside and outside the U.S., courtesy of Argus Research data.
  • Transocean (RIG) (also domiciled in Switzerland, like Weatherford): 15%
  • Schlumberger (SLB - Get Report) (domiciled in the Dutch Antilles): mid-20% range
  • Noble Corporation (NE) (also Switzerland): 18%
  • Nabors Industries (NBR) (Bermuda): 20%
  • Halliburton (HAL - Get Report) (U.S.-domiciled): 32%-33%
  • Baker-Hughes (BHI) (U.S.-domiciled): 35%
  • .

    A few important caveats to keep in mind about tax rates in the energy sector are: One, that deepwater drillers like Transocean will typically have a lower tax rate than an oil services company given the tax treatment of offshore assets specifically. And two, that a specific company's tax rate is difficult to compare apples-to-apples even with companies in its peer group because each company has a different mix of business in various countries which has to be taken into account.

    Nevertheless, even putting to the side Transocean's 18% tax rate, the new tax rate to which some analysts think Weatherford is headed, 30%, would place it much closer to the tax rate of its oil service peers, Baker Hughes and Halliburton -- which are domiciled in the U.S., the market Weatherford left for tax purposes -- than to any of the internationally based oil service companies.

    "It's headed back there 30%. They laid an egg, even if it doesn't change the long-term fundamentals, the whole point of moving to Switzerland was to bring down the taxes," said Tudor, Pickering, Holt analyst Joe Hill.

    The comment from the Tudor, Pickering, Holt analyst demonstrates the divide in which Weatherford investors or potential investors now find themselves: distinguishing between the fundamentals of a sector and a company's portfolio of business, on the one hand, and a history of issues related to management credibility.

    Bill Conroy, analyst at Pritchard Capital summed up the divide: "Look at the price of oil and underlying demand for oil services and Weatherford's portfolio and you reach one conclusion, but that has to be weighed against its historic record, and that's less consistent."

    Tudor, Pickering, Holt's Hill said the latest issue came out of left field, but does reinforce Weatherford's credibility issues. While other analysts are saying its discount to peer stocks makes it a compelling buy, Hill said the fact that investors have come to expect certain things in terms of accounting issues and aggressive management guidance is exactly why Weatherford trades at a discount. "It's not cheap enough for me yet to jump in and it will be in the penalty box for a little while. Lots of people voted with their feet, frustrated with the accounting issues and credibility." The analyst does, on the other hand, believe that long-term there is a case to be made for Weatherford as a $24 stock, more or less where it began the week trading before its accounting flap. The stock's 52-week high was in mid-February at just over $26.

    The Pritchard Capital analyst Conroy remarked that he was neutral on Weatherford before this week's events and remains neutral on the stock with a lower price target of $21. "One of the concerns around this stock has been that it seems to be a challenge for the company to report with consistency," Conroy said.

    The Pritchard Capital analyst disagrees with the positive commentary on Weatherford predicated on its valuation discount relative to oil service peers, like Schlumberger, Halliburton and Baker-Hughes, saying, "For me, the valuation gap isn't big enough."

    Tudor, Pickering, Holt's Hill thinks that given the history of issues with Weatherford, a $21 price is fair price for the stock.

    Here are the current valuations and trading multiples based on next year's earnings for the four main oil services plays (and based on Street consensus numbers from Yahoo!Finance):
  • Weatherford International: 11.5x 2012 consensus earnings
  • Halliburton: 13.3x 2012 consensus earnings
  • Baker Hughes: 14.8x 2012 consensus earnings
  • Schlumberger (which historically trades at highest multiple in group): 18x 2012 consensus earnings
  • Sterne Agee views the oil services stocks on an enterprise value/EBITDA basis and wrote on Thursday, "While the earnings outlook is coming down largely due to the higher expected taxes, a pretax evaluation, i.e. a 2012 EV/EBITDA comparison, yields an in-line multiple with Halliburton, at approximately 6.7 times.... Given the circumstances and the renewed skepticism, this is not a relative level that is appropriate or supportive of adding exposure in our view."

    Some analysts and investors have pointed to a history of surprise one-time charges in Weatherford earnings as endemic of its management style. "The company does have a history of having, fairly regularly, charges of a seemingly non recurring or unusual nature," Pritchard Capital's Conroy noted. "It's difficult for investors to get their arms around this risk and so the stock trades at a discount and the discount is warranted," the analyst added.

    An analyst who dropped coverage of Weatherford International some time back and can no longer be quoted on the name said, "One of the reasons I dropped them was I didn't have a ton of investor interest and, secondly, to me it often felt like management was trying to twist things. I'm not a big fan of one-off charges and management did that a lot and seemed aggressive in accounting. I felt that if I had done more scrubbing of financials I would have found things," the analyst noted after the tax revelations.

    The analyst provided an example of the divide that remains in the investment community over Weatherford International, remarking that at one energy sector meeting for investors and analysts, the question of "favorite oil services" stocks came up.

    "One guy said Weatherford, and myself and another person at the table looked at each other and said 'no way we're touching that one.' In a sector where fundamentals are good, the fundamentals are good for everyone and I've learned to stay away from companies that are always trying to explain away earnings misses with financial items," the analyst added.

    -- Written by Eric Rosenbaum from New York.


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