For the past few years, the investment thesis for Schlumberger (SLB 0.41%) has depended largely on a recovering international oil and gas market. That recovery has been arduously slow, though, and it's showing in the company's results. So much so that some investors may be questioning if the company will be able to keep paying its rather generous dividend.
So let's look at the oil services giant's most recent quarterly numbers and management's outlook to see if these concerns are warranted or if this stock is perhaps ready for a long-term recovery.
By the numbers
|Metric||Q1 2019||Q4 2018||Q1 2018|
|Revenue||$7.9 billion||$8.2 billion||$7.8 billion|
|Pre-tax income||$509 million||$648 million||$643 million|
|Free cash flow||($283 million)||$1.41 billion||($152 million)|
The first quarter for oil services almost always tends to be weaker than the preceding quarter. Companies in this business are building up inventories and working capital for the rest of the year. Conversely, the fourth quarter tends to have lots of end-of-year software and license renewal revenue. So take any comparisons between this quarter and the prior one with a grain of salt.
Compared with the previous year, though, results were a mixed bag as revenue increased slightly, but margins contracted as more and more of its sales are coming from its drilling and production segment, which have lower margins overall.
Another reason for the weaker margins was the decline in North American shale drilling. Even though production numbers have remained strong, drilling activity over the past six months has declined significantly, which translates into lower utilization rates for Schlumberger's assets and less pricing power. All of the gains in revenue came from its international markets offsetting a 3% year-over-year decline in North American revenue.
Worrying about Schlumberger's free cash flow in the first quarter is probably an overreaction because of the reasons mentioned. However, the sharp drop in free cash flow from this time last year is enough of a red flag that investors should keep a close eye on the company's ability to generate cash through the rest of the year.
What management had to say
For all the oil price volatility and uncertainty around the oil services business, CEO Paal Kibsgaard's outlook for the industry has remained consistent for the past year or so. While he has little faith that the North American market will generate large returns for the company, he foresees international markets picking up:
We also continue to see clear signs that E&P investments are starting to normalize as the industry heads toward a more sustainable financial stewardship of the global resource base. Directionally, this means that higher investments in the international markets are required simply to keep production flat, while North America land is set for lower investments with a likely downward adjustment to the current production growth outlook.
Our view of the international markets is consistent with recent third-party spending surveys, suggesting that E&P investments will increase by 7 to 8% in 2019, supported by a higher rig count and a rise in the number of customer project FIDs. In line with this, offshore development activity plans continue to strengthen, with subsea tree awards reaching their highest level since 2013 last year. We are also seeing the start of a return to exploration activity on renewed interest in reserves replacement. Notably, new discoveries in 2018 were at the lowest level since 2000.
Conversely in North America land, the higher cost of capital, lower borrowing capacity, and investors looking for increased returns suggest that future E&P investment levels will likely be dictated by free cash flow. We, therefore, see E&P investments in North America land down 10% in 2019.
You can read a full transcript of Schlumberger's conference call.
The "if" around Schlumberger's recovery
In the long run, international market growth will be the catalyst for any revenue growth or margin expansion for Schlumberger. The company's business is much more heavily weighted toward the international and offshore markets. The hope is that international market growth will accelerate because, at these current revenue and margins results, it will be hard for Schlumberger to maintain its dividend. The company's debt level has increased drastically over the past several years, in large part because of the acquisition of Cameron International in 2016, but since then the number has only increased, and cash on the books has been slowly dwindling away.
That acquisition was made with the idea in mind that it would take some time for the oil and gas market to recover. Unfortunately for Schlumberger, that recovery has taken much longer than expected. As much as management has been saying that it expects spending rates to normalize or grow, it's hard to say with conviction that the company will be able to return to operating margins in the mid to high teens that it produced for a decade preceding the 2014-15 oil crash.
If Schlumberger can ride rising international growth over the next few years and get back to those kinds of margins, then concerns about its dividend are probably overblown, and then its stock is drastically undervalued. The ability to get back to those margins is looking tougher and tougher by the day, though, and the market may not recover fast enough for the company to avoid a minor cash crunch. So while it's certainly worth keeping this stock on your radar and watching how the international market grows, it may be a little risky to buy shares right now.