Halliburton Company (NYSE:HAL) CEO Dave Lesar was pretty up-front with investors on the company's fourth-quarter conference call. He sees pain in the year ahead as the dramatic drop in oil prices will have a deep impact on the company over the next several months. Here's a breakdown of his market commentary.
Oil isn't the only thing dropping at the moment
Lesar led off his market comments by saying:
Obviously commodity pricing has dropped dramatically over the last several months with oil prices now at levels not seen since early 2009. The North America rig count and activity levels held up through most of the fourth quarter as customers executed against the remainder of their 2014 budgets. However, over the last 60 days, the U.S. land rig count has fallen by 250 rigs, or close to 15%. Capital expenditure budgets from our customers remain fluid, but so far on average have been reduced 25% to 30% as they adjust their spending to operate within their cash flows in response to a continued drop in commodity prices.
He notes that activity levels were pretty good in the fourth quarter, which is what drove the company's strong results. However, as the calendar flipped to 2015, the industry has really slowed down as the rig count has fallen rather dramatically over the past few weeks. He expects activity to continue to slow down as most of his customers have reduced their spending plans by 25%-30% over last year's level. That said, those cuts might not be the end, as some of its customers could cut their budgets even more if oil prices keep dropping, which Lesar pointed out:
As a result, we expect activity declines for North America land to accelerate further in the first quarter, impacting all of the key liquids basins. What is creating even more uncertainty for the service industry is that many customers have continued to revise down their capital budgets through further capital reduction announcements. This makes it difficult to size your business in today's U.S. market in particular because it is such a fast-moving target.
Falling rig counts mean falling margins
Lesar then went on to address how this slowdown in activity will impact Halliburton. He noted that producers are now actively seeking price discounts:
So while we did not experience price weakness during the fourth quarter, price discount discussions with customers did begin in the fourth quarter and have accelerated over the past several weeks. And price reductions are now occurring across all product lines.
He notes that the company didn't experience any margin weakness in the fourth quarter, but that will not continue as customers are demanding price reductions. However, Lesar notes that these reductions shouldn't squeeze margins as deeply as past downturns have been known to do:
Now we expect pricing concessions to be less severe when compared to previous cycles and therefore believe our decremental margins should be lower. That is because our margin improvement this cycle was largely driven by our focus on gaining efficiencies and getting increased labor input cost recovered more quickly, not through net pricing increases.
Lesar notes that the company entered the downturn on a high note as its current margins are strong thanks to operational efficiencies instead of price increases. Because of this, its margins shouldn't compress as deeply as during previous downturns.
Here's how bad things will get, and when they'll get better
He then made some comments about where the industry is in the current cycle, and then notes when the industry's unease should begin to settle:
Based on our experience in previous downturns, we expect that it will take a couple of quarters to see how the interplay of pricing declines, volume reductions, and equipment efficiency deterioration plays out relative to our ability to lower labor and input costs and to right size the organization, and therefore reach an equilibrium in the market. The first quarter of any severe downturn is almost always the most challenging quarter to predict because pricing concessions usually impact our results in real-time. Volume declines can be erratic as customers' rig plans are uncertain and can change daily. [...] In this environment, we would expect to see most of our margin degradation occurring over the first couple of quarters, and more margin stability in the back half of the year.
Lesar notes that the first quarter is always the worst as there is so much uncertainty. However, over time, the market reaches equilibrium again and settles down, which in his view will be the back half of the year. However, he goes on to note that the industry is in for some tough days:
But we have to be real about it. The North America market is going to see volatility and pain for a few quarters. However, in this scenario, I like our chances.
He ends by noting that it will be a painful few quarters for the company and the industry, but he thinks Halliburton will come out ahead of the game when all is said and done. The company entered the downturn strong and should emerge even stronger.
Matt DiLallo has no position in any stocks mentioned, but is starting to get interested in Halliburton despite the pain it sees ahead. The Motley Fool recommends Halliburton. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.