SLB - Favorable Risk to Reward

In recent weeks volatility in the market has picked up substantially. Many investors are looking for ways to protect themselves in case of a market downswing. I believe that one way in which you can accomplish this is by looking at the underperforming sectors of the market. However in this value seeking strategy an investor must be cautious to avoid ‘value traps.’ Many of the companies which have not recovered from the market lows, are currently bleeding cash.

With that thought in mind, I am looking for a company who’s stock price has been severely discounted, but which is still cash flow profitable in spite of the difficult environment. Schlumberger (SLB) fits the profile. Over the past year, SLB is down over 50%. By way of comparisons Southwest Airlines (LUV) is down around 30%. I find these valuations to be absurd. After all an airline industry with no fuel, has no value. A fuel industry with no airlines at least still has some value. In the case of SLB, it would seem quite a bit of value.

Current Analyst Median Forecast for 2020 indicate an expectation of 780M in Net income. For 2021, Median of 935M and for 2022 a Median of 1.658B. While these incomes are significantly reduced compared to 5 years ago, SLB is still a profitable business which can sustain it’s dividend. In addition, SLB offers some potential as a risk hedge for a number of reasons:

1.) 72% of revenue earned is earned outside of the United States. This means unlike most US listed companies, SLB has a wider base for revenue source and is less exposed to a downturn in the US economy.

2.) Natural disasters and political tensions in certain parts of the world tend to favor the oil sector.

3.) SLB is politically neutral and does not lobby or donate to political candidates. In the coming years it is quite likely campaign donating, lobbying and super PACs will receive renewed scrutiny as election security and interference will likely surface again once the pandemic subsides. SLB’s absence in these conversations will protect shareholders from changes due to negative sentiment.

4.) SLB has a favorable environmental record relative to it’s peers in the space. While regulatory risk exists for the entire space, regulation could actually favor the oil services industry at the expense of other sectors of the petroleum and gas industry. By forcing companies to drill more responsibly, companies will need to depend more on the experience and data that companies like SLB can offer to reduce excessive waste and unnecessary drilling.

5.) SLB’s recent decision to divest it’s fracking business for a stake in Liberty Oilfield allows them to focus on the future of their business — digital technologies. Specifically the cloud and software aspects of that business will offer a higher margin recurring source of revenue to supplement existing businesses. In fact in 2019 technology sales accounted for 26% of all sales.

This is not to say that SLB doesn’t carry a fair amount of risk. The oil industry is still facing headwinds due to regulatory risk, increasing alternative clean energy sources and impairment of demand in the travel industry. Also SLB has seen a significant amount of impairments over the past few years and will likely see more in the next 6 months to a year. It is possible and maybe even PROBABLE that leisure and especially business travel does not ever return to normal. However even if this were to occur, the essential nature of the oil services business to the drillers and frackers means that there will always be some floor on the demand curve and costs inevitably will be passed down to maintain margins.

Using our excess cash flow models, we believe SLB is trading at a 33% discount to it’s current 12 months trailing cash flows, relative to historical valuations of the company. (including 2 of the worst quarters for oil on historical record). This indicates to us that while the market justifiably sold off on SLB (50% down in the past year), the sell off has been overdone. We do not see much more downside risk for SLB due to this and assume that within the next 12 months the stock will rebound to over $20 per share. Current cash flows are likely the bottom for SLB, and at it’s current valuation, SLB and all of it’s investors and lenders could be made whole in a span of 8-10 years.

For investors looking for a stock to balance out a portfolio high in technology stocks, or for a dividend investor looking for a safe dividend yield with upside potential until interest rates are raised, we believe SLB is definitely a stock worth considering.

Of course this isn’t investment advice and you should always consult with your financial advisor and consider your personal situations before making any investments. All investments carry the risk of loss of some or all invested capital.