Stormy Weatherford International Ltd Moving in the Right Direction

If you own shares of Weatherford (NYSE: WFT  ) , there have likely been many occasions that left you scratching your head and wondering, "what possessed me to do that?" To management's credit, though, it is no longer pursuing a strategy of bigger-must-be-better and is instead examining where the company's core competencies and profit opportunities really lie.

The second half of 2013 was volatile and largely disappointing as the company missed margin and cash flow generation guidance. This next year is likely to be challenging as well, as the company looks to enact a large headcount reduction as well as the sale/spinoff of multiple non-core businesses. Weatherford's many self-inflicted wounds have obscured that it does in fact do many things well, and investors looking to play a still-undervalued turnaround story in oil services may want to check this one out.

Recent results have been varying shades of ugly
There are not many nice things to say about Weatherford's recent quarterly performance numbers. The Big Three, Schlumberger (NYSE: SLB  ) , Halliburton (NYSE: HAL  ) , and Baker Hughes (NYSE: BHI  ) , have had their own challenges brought on by a sluggish North American market and issues in Latin American markets like Mexico and Venezuela, but Weatherford doesn't stack up all that favorably.

Revenue for the fourth quarter fell 8% year over year and 2% from the prior quarter, worse than the Big Three (Schlumberger up almost 3%, Halliburton up about 2%, and Baker Hughes up 1%). On a more detailed level, Weatherford was in line with Halliburton in North America (worse than Schlumberger, better than Baker Hughes) and far better than the group in Latin America (up 15% sequentially), but much worse in the Middle East (down 20%).

Margins continue to be underwhelming as Weatherford is dragged down by uncompetitive sub-scale businesses. Operating income fell 25% from the third quarter (much worse than the Big Three average of negative 4%), and Weatherford's operating margin of 6.8% was about two points below Baker Hughes, long the laggard of the Big Three (Schlumberger was above 20%, while Halliburton was just under 17%). This is not a new development, though, as Weatherford has generally been at the bottom of the list since 2009.

Taking big swings to close the gap
To see part of Weatherford's problem, look at the revenue these companies generate per employee. Schlumberger, Halliburton, and Baker Hughes have generally tracked around $360,000 to $410,000 per employee per year, but Weatherford has been closer to $200,000. What's more, Weatherford has been paying a very high price for decisions made years ago to buy and build its way into the big leagues, as the spending was largely unfocused and the resulting units were often sub-scale and generated poor returns.

Now management is hoping to turn over a new leaf. Weatherford has bulked up its management ranks with a (relatively) new COO, a new CFO, and a new VP of operations, the latter two of which have significant years of experience at Schlumberger, long seen as the best-run energy services company. In addition to divesting non-core operations, management has targeted a greater than 10% employee headcount reduction for the first half of 2014, a move that the company believes could lead to over $200 million in improved EBITDA.

Getting smaller to get better
Weatherford has identified four key areas (generating about $11 billion in revenue) as core competencies: formation evaluation, well construction, completion, and production.

Weatherford has a leading position in the artificial lift market, where it is well ahead of General Electric, Baker Hughes, and Schlumberger in the rod lift sub-sector, which is import to crude oil production, particularly in shales like Bakken and Niobrara where the decline rates are quite steep.

Weatherford is also strong in areas like well construction, where it has a virtual duopoly with Frank's International in tubular running services. Although areas like completion don't look as strong today from a market share perspective, Weatherford has been gaining ground with new offerings like the ZoneSelect customizable completion system.

One the flip side, Weatherford is looking to wind down and dissolve its money-losing early production facilities (EPF) business and auction off drilling fluids, pipeline/specialty services, testing/production services, and wellheads later this year. Weatherford is also looking to spin off its international drilling rig business through an IPO in late 2014; this is the largest OUS fleet in the world and could bring in over $400 million in proceeds.

In a potentially controversial move, Weatherford is keeping its pressure pumping business and looking to repair it. On one hand, this makes sense as pressure pumping pulls through demand for other products and services. On the other hand, Weatherford is a very distant rival to Hallburton, Schlumberger, and Baker Hughes with only single-digit market share. Perhaps Weatherford could spin this into a joint venture, as execution risk here still seems above average.

The bottom line
Weatherford shares have already jumped on hopes that the company has put its years of underperformance behind it and that management has cleared the decks for much stronger margins and cash flow generation going forward. Given the company's past, though, a little bit of skepticism seems fair.

I continue to hold Weatherford shares, as I do believe that the company's core competencies (like artificial lift, TRS, and underbalanced drilling) are undervalued. Likewise, I like the company's large exposure to Latin America, as Mexico's liberalization of the energy sector could lead to major service spending increases in the coming years.

A 7.0x multiple to 2014 EBITDA points to a fair value of about $19, and that seems like a reasonable trade-off between past underperformance and potential near-term improvements. A discounted cash flow analysis suggests a fair value in the low $20s, though, as next year's EBITDA does not capture the company's long-term improvement and growth potential.

I remain bullish on Weatherford shares and believe there is some worthwhile value here. More value-conscious readers may want to hold off in the hope of another sell-off led by an execution hiccup (not an unreasonable expectation), but the long-term improvement potential is significant.

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