Bottom Line: If the preeminent oil-field services company has little visibility on oil prices or the timing of a recovery, individual investors shouldn’t try to be a hero and try to pick a bottom in the energy sector’s hardest-hit industries. Better opportunities await patient investors.
Some pundits have argued that Schlumberger’s undemanding valuation makes the best-of-breed services giant a screaming buy at about 14 times trailing earnings—conveniently, the stock last traded at this multiple in the second quarter of 2009, when oil prices traded at the levels that prevail today. By comparison, the S&P 500 trades at 18.1 times trailing earnings.
On a forward basis, Schlumberger’s stock trades at almost 21 times the Bloomberg consensus estimate for 2015 earnings—roughly in line with its 10-year average.
But trailing earnings don’t reflect the severe decline in energy prices that occurred in the final months of 2014.
Meanwhile, the consensus earnings estimate for 2015 remains too high; analysts usually take months to lower their projections to reflect deteriorating business conditions.
Over just the past four weeks alone, analysts have cut their consensus 2015 earnings per share estimate for Schlumberger by about 20 percent. And given that Wall Street is still coming to grips with the implications of spending cuts and the potential for an extended period of lower energy prices, the downward revision cycle should have legs.
Some of the takeaways from Schlumberger’s fourth-quarter earnings release and conference call can help to generate a more useful valuation.
The company plans to cut its capital spending to $3 billion this year, compared to $4 billion in 2014. At its heart, this reduction reflects an effort to match spending with projected revenue, implying internal expectations for a roughly 25 percent decline in sales.
With visibility so poor in the industry, even Schlumberger’s internal estimates will evolve rapidly as the year progresses.
By the same token, our rudimentary calculation based on the firm’s planned capital expenditures shouldn’t be regarded as gospel; for one, the company’s efficiency gains mean that the oil-field services firm doesn’t need to spend as much to support revenue.
Those caveats aside, this rough estimate provides useful insight into the stock’s valuation. Specifically, a 25 percent decline in Schlumberger’s annual revenue would translate to a forward price-to-sales ratio of 2.9—well above the trough valuations during previous down-cycles in 1998, 2002 and early 2009.
The stock’s behavior in past down-cycles suggests that the valuation would need to test prior troughs of about 1.8 to 1.9 times sales. Based on a potential 25 percent decline in sales, history suggests that Schlumberger’s stock could fall as low as $55 per share.
Even if you assume that Schlumberger’s revenue falls 15 percent this year and the firm repurchases shares at roughly the same pace as last year, the stock would need to trade at $65 to match the trough valuations from the past three down-cycles.
During Schlumberger’s fourth-quarter earnings call, CEO Paal Kibsgaard asserted that the “decrementals” in this cycle would be “significantly better” than the 2008-09 down-cycle, but demurred from sharing the company’s internal estimates.
Decremental refers to the extent to which declining revenue will affect profits. For example, when Schlumberger’s revenue shrank by $4.461 billion between 2008 and 2009, the firm’s earnings before interest taxation depreciation and amortization (EBITDA) dropped by $2.609 billion—a decremental of about 59 percent ($2.609 billion divided by $4.461 billion). That is, during the last major collapse in energy prices, a $1 decline in Schlumberger’s revenue resulted in a $0.59 decline in EBITDA.
Let’s take our back-of-the-envelope calculations a step further. A 15 percent drop in Schlumberger’s annual revenue would reduce sales by $7.3 billion to $41.3 billion. Applying a 40 percent decremental to this revenue estimate would reduce the company’s 2015 EBITDA to about $8.9 billion.
At the lows of the 1998 and 2002 bear markets in energy, Schlumberger found a bottom at roughly 6.75 times trailing EBITDA before bottoming out. During the 2008-09 cycle, the stock troughed at less than 5 times EBITDA.
If Schlumberger were to trade at 7 times our 2015 EBITDA estimate of $8.9 billion, the stock would need to fall to about $50 per share—significantly lower than the current quote of about $80 per share.
The point of this exercise isn’t to develop an accurate model of Schlumberger’s earnings over the coming year or to project the stock’s trough valuation. Rather, these scenarios give us an idea of where the stock could go in a normal cyclical downturn for the energy patch.
If oil prices drift toward $30 per barrel over the next few months and then recover gradually to between $60 and $65 per barrel, Schlumberger’s stock could easily slip to the neighborhood of $50 or $60 per share—a cautionary tale for overeager pundits prematurely sounding the bullhorn.
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Elliott and Roger on Aug. 31, 2020
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