Why Schlumberger’s Rally Isn’t Over Yet

Schlumberger (NYSE: SLB  ) , the largest oil services company in the world, is not used to issuing financial guidance. However, in a big change from past practices, the company at a recently held investor day issued specific financial guidance, with a greater degree of granularity than investors were expecting. Markets responded positively to the financial details and the stock is up more than 10% in the last week.

Source: Google Finance

Schlumberger, Halliburton (NYSE: HAL  ) , Baker Hughes (NYSE: BHI  ) , and Weatherford International (NYSE: WFT  ) are the big four oilfield services firms, and while Schlumberger faces stiff competition from its large-cap peers, the company remains the undisputed global leader in oilfield services.

Despite the recent run, I believe there is still meaningful upside potential in shares of Schlumberger. As the near-term macro issues subside, the market should once again focus on tight spare capacity in the oil markets, and as a result should revisit the oil services group. As this happens, Schlumberger, being the market leader, should be a key investment.

Transformation programs
Learning from the leading automotive and aerospace companies, Schlumberger has invested over $350 million over the past six years to completely transform its approach toward R&E. The focus of this approach has been to accelerate the pace of innovation, create a step change in the performance of its new products and significantly reduce the time it takes to bring them to the market. The company continues to introduce new and game-changing technologies that create significant value for both Schlumberger and its customers.

While the company's R&E transformation is helping its technological advancement, the reliability and efficiency transformation programs that the company has embarked upon will further strengthen the competitive position of its product lines. These transformation programs are expected to deliver a ten-fold increase in operational reliability, lower inventory levels by 25%, increase asset utilization by 100%, achieve a 20% improvement in people productivity, and reduce the unit support cost by 10%.

Source: Company Documents 

New technology driving returns
Schlumberger is one of the best-run companies in the sector and an undisputed technology leader. The company's management believes there is even more the company can do to run more efficiently by introducing processes and systems that will not only enhance the development of technology but will also enhance the reliability, utilization, and commercialization of that technology.

Over the next three years, Schlumberger plans to grow its revenue by 8%-9% with 40% incremental margin improvement. This should translate into $9-$10 in EPS by 2017, implying a CAGR of 17%-20% for the 2013-17 period. This is very impressive for a company with a market cap of $154 billion.

Both the new technologies and integrated services are expected to contribute to increases in margins and ROCE. More importantly, new technologies are expected to contribute more than 25% of revenue by 2017. Similarly, activity with some element of integration should exceed 30% of revenue. 

While new technologies are differentiated, they will also allow Schlumberger to charge a premium price and attract higher margins. Similarly, integration creates costs savings both through lower SG&A and through operational cost efficiencies. Both new technologies and increases in integration revenues will help Schlumberger achieve more than 40% incremental margin.

Source: Company Documents 

Returning more to shareholders
While the company's transformation programs are expected to create cost efficiencies, they will also increase cash flow through tighter working capital. This will eventually help Schlumberger achieve the target of free cash flow (FCF) reaching 75% of net income. Schlumberger also plans to lower its capex to approx. 10% of revenue, down from historical levels of 12%.

This increased focus on FCF will allow Schlumberger to return 60%-65% of earnings to shareholders through dividends and buybacks. However, this level of payout will also allow Schlumberger sufficient funds to invest in R&D and strategic initiatives.

Foolish takeaway
EPS CAGR of 17%-20%, new technologies and integration driving incremental margin of more than 40%, and a robust share buyback program driven by ramping free cash flow make Schlumberger an attractive investment opportunity, despite of the recent surge in share price. The company showcased an impressive technology pipeline at its recently held investor day, and I believe this technology will continue to drive superior margins relative to peers.

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