Weatherford International Rebuilding Trust, but Needs to Rebuild the Business

For a company with a long and unfortunate history of disappointing its shareholders, Weatherford International has come back strong on the back of a comprehensive turnaround and restructuring plan that is seeing the company sell or spin off lower margin and less competitive businesses. Weatherford is by no means finished with this process and still needs to prove that it can maintain its leadership in areas like tubular running, cementation, and artificial lift as well as improve operations like pressure pumping. Even so, and despite a good run over the past year, these shares still hold some appealing upside.

Mostly hitting the marks for Q2
Weatherford's second quarter was less a blowout and more a "did what needed to be done" quarter. Revenue declined 4% year over year and rose 3% quarter over quarter, but did come in about 2% shy of expectations. The miss was driven by the Latin American operations (revenue down 26% year over year) and the Mideast/Africa operations (revenue down 18%) as lower activity levels in Mexico, Brazil, Argentina, and Iraq all factored in to drive a disappointing result. North America (up 9%) and Europe/Russia (up 10%) were both solid, though, and ahead of expectations.

Weatherford continues to make headway with its margins. Gross margin improved about three points on a year-over-year basis, and EBITDA rose 20%, beating expectations by about 3%. Given that Weatherford has been a perennial margin underachiever for over five years, this profitability improvement will likely carry more weight with the Street than the revenue shortfall. At the operating income line, Weatherford saw a 40% year-over-year improvement and a three and a half point margin improvement with strong results in North America and Europe and surprisingly good results in the Mideast/Africa/Asia segment.

Still work to do in the second half
Weatherford still carries the legacy of being an "over-promise, under-deliver" company. With that, I have a few concerns about management's guidance. Management is looking at some fairly bold targets for full-year free cash flow and net debt relative to where the company stands today. While I don't dismiss the potential for improving end markets and improving internal performance to drive results to those levels, the twin targets of $500 million in FCF and $7 billion in net debt are ambitious.

Helping the net debt target, management should have several more asset sale announcements to make in the next two quarters. The well testing business could be sold for $300 million to $400 million in the third quarter, with announcements for the wellheads and U.S. drilling fluids businesses also expected in Q3 and Q4.

Management is also taking a more proactive approach to its working capital management. Being a large energy services company like Weatherford, Schlumberger, Halliburton, or Baker Hughes means dealing with a lot of state-owned energy companies, and these companies are not always good about paying bills on time. Weatherford recently signed an accelerated receivables payment agreement with Venezuela's PDVSA that should see the company collect $250 million by May 2015, and management is also hopeful that it can accelerate the repayment of $100 million to $150 million owed by PEMEX.

Improving the global mix
A couple of weeks ago, Weatherford announced that it had agreed to sell its Russian and Venezuelan drilling and workover rigs to Rosneft for $500 million in cash. That was a very good price (10x EBITDA) for a collection of old and underutilized assets. With this exit, Weatherford shrinks next to Nabors in terms of who operates the largest international drilling fleet, but upgrades the quality. Utilization will improve significantly after this sale, and the transaction reduces the risk exposure to potential Russian sanctions. All told, this should make the company's planned international drilling IPO go a little smoother and get a better multiple.

It's not all about slimming down at Weatherford, though. In May the company announced a joint venture with Sinopec's Sinopec Oil Services Company (or SOSC) that will see the companies collaborate on high-end products and technologies for high-temperature/high-pressure shales. China is rapidly emerging as a major market opportunity for service providers; just as the exploitation of unconventional shales in North America has created significant demand for pressure pumping, evaluation, cementation, artificial lift, and other services, the same is likely to be true in China where an intense demand for domestic natural gas production is driving exploration and production plans.

Weatherford continues to hold attractive positions in many key markets. Even with the sale of its drilling rigs, the company remains one of the largest Western service providers in Russia (alongside Schlumberger) and looks well-positioned in China as well. Overall, the company continues to lead Schlumberger and Baker Hughes in artificial lift due to its strong presence in rod lift (Baker Hughes and Schlumberger are stronger in ESP), leads in casing, tubing, and rental tools, and is a legitimate player in completion. As Weatherford's turnaround progresses, it could yet be a serious acquisition prospect for Halliburton or Baker Hughes.

The bottom line
With half of 2014 in the books, I'm transitioning to a 12-month EBITDA outlook (versus year-end 2014) and lowering the multiple from 9.0x to 8.5x to account for the progress seen to date both in the restructuring and end market recoveries (service companies no longer deserve the same "recovery multiples"). An 8.5x multiple to 12-month EBITDA suggests a fair value of over $27, which I believe argues that there is still upside to these shares so long as the turnaround/restructuring stays on track and the global energy markets continue to see production growth.

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