1 Oil Services Stock to Avoid and 2 Better Alternatives

The global oil services market is over $600 billion/year and growing quickly. Oil services companies are a great way to cash in on the oil production mega-trend of the next few decades. However, investors must be cautious about their investment picks.

By Adam Galas – May 19, 2014 at 12:01PM EST

As the world's population and economy grow so does its thirst for energy, specifically oil. A recent study by Morgan Stanley and Rystad Energy estimated that global oil demand by 2035 will likely rise to over 100 million barrels per day, up from today's 87 million barrels per day.

The price of oil is expected to average $125-$150/barrel in 2035. Given this megatrend, oil companies are racing to keep up with the growing demand. Global spending on or exploration and production has grown by a compound annual growth rate of about 15% over the last 11 years and in 2013 totaled about $650 billion. Into this ocean of money step oil services companies, which help oil companies locate, drill, expand, and maintain maximum production from their oil and gas assets.

However, all oil services companies are not created equal, and this article is meant to warn investors away from one particular company, with management that has proven itself shareholder-unfriendly, while offering two superior alternatives.

An oil-services company to avoid
Weatherford International (NYSE: WFT) is a mid-size oil services company that investors may want to steer clear from. The problems with this company can be summarized in three parts.

First, the company has a long record of questionable financial restatements, government allegations of criminal activity, and what I feel to be very shareholder-unfriendly practices.

In 2011 it announced that it would have to restate earnings going back to 2007 due to tax-accounting irregularities.

Numerous goodwill writedowns, earnings restatements, and annual "one time charges" have added up to over $1.4 billion (since 2010) and resulted in a credit downgrade.

The company also recently settled with the U.S. Department of Justice for $253 million due to multiple alleged legal violations. These included allegations of bribing foreign officials and export sanctions violations (DOJ claims they did business with Cuba, Iran, and Syria).

It recently voted to move its corporate headquarters to Ireland (from Switzerland) ahead of a new law that allows shareholders to make binding votes on executive pay.

Company	3 yr revenue growth	3 yr earnings growth	ROA	ROE	Operating Margin	Net Margin	Debt Interest Coverage
WFT	14.3	na	-1.5	-4.1	3.4	-2.3	2.59
BHI	15.8	10.5	4	6.3	8.7	4.9	21.62
SLB	17.4	16.4	10.5	18.1	19.6	14.5	28.05
IND AVG	15.8	14.6	5.7	10.6	12.1	7.4

Source: Morningstar

The second reason why investors should stay away from this company is poor operating efficiencies and unprofitability. Management at Weatherford has proven that it can't invest shareholder money wisely and has loaded up the company with massive debt. This brings me to my third argument against owning its shares.

Weatherford's debt/EBITDA ratio is 7.08, which compares to the industry average of 1.92. In order to bring down the debt load management has announced a multi-billion dollar divestiture plan in which it will sell off seven "non-core" businesses that accounted for 23% of its 2013 revenue. Along with a 10% reduction in workforce, the company is hoping to cut its debt by $3 billion-$5 billion over the next 18 months.

Company	P/Cash flow	Historical P/CF	Discount
WFT	9.4	18.8	50%
BHI	9.5	15.6	39.1%
SLB	13.2	16.2	18.5%

Source: Fastgraphs

Today Weatherford is trading at a 50% discount to its historical price/cash flow ratio. However, given management's poor operational record as well as dubious legal activity and shareholder-unfriendly behavior, I believe this discount is well deserved and likely to continue for the long-term.

Better choices

Schlumberger (SLB 1.10%) and Baker Hughes (BHI +0.00%) are two superior alternatives to Weatherford.

Baker Hughes recently reported 10% revenue growth and 29% growth in adjusted EPS. This strong growth is coming from high demand in North America, the Middle East, and Asia.

One of the company's strengths is its advanced technology. This includes LWD, or logging while drilling, services which allow oil companies to monitor subterranean pressures in real time. These have been big sellers in Brazil, Nigeria, and the Gulf of Mexico. Baker Hughes also recently installed the world's deepest subsea artificial lift system (which helps increase pressure and production from oil wells).

Meanwhile, Schlumberger faced harsh weather in the U.S., China, and Russia yet still announced 24% growth in operating earnings (year over year).

When these latest results are combined with Schlumberger's above-average growth rates and superior operating efficiencies and profitability (its net margins are double the industry average), a strong case for owning shares can be made. That case is further strengthened by its 1.6% dividend, with a 14.3% average growth rate over the last three years and a 26% payout ratio providing room for future dividend growth.

Finally, when looking at the historical price/cash flow valuations of Baker Hughes and Schlumberger one sees incredible undervaluation. This combination of high-caliber companies, industry growth potential, and undervaluation results in a recipe for long-term market outperformance.

Foolish takeaway

When it comes to the promising oil services sector there are simply too many high quality, undervalued names (many of which pay growing dividends) for investors to own. Weatherford International is trading at rock-bottom valuations -- but for good reason. In my opinion its management has proven itself untrustworthy with investor capital. This stock may prove a success in the short-term due to low expectations, but for long-term investors, the opportunity cost of investing in world class companies like Schlumberger or Baker Hughes is simply too high for me to advocate even a small position.

1 Oil Services Stock to Avoid and 2 Better Alternatives

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