Don't Count Out Oil Services Stocks Just Yet

The bulk of the results are in from the oil and gas services sector, and Industry Focus brings you an investor's-eye view of what it all means. International exposure was an advantage this time around; Tyler Crowe discusses the differences between Halliburton (HAL -1.71%) and Schlumberger (SLB -0.79%), and how the upcoming Baker Hughes (BHI) merger will play into that dynamic.

Then, discover which two companies' reporting resulted in immediate stock jumps, and learn why it's so important that investors distinguish between manufacturers and service providers in times like these. Finally, one company in the sector is in the clear when it comes to return on invested capital; join us to find out which.

A full transcript follows the video.

Sean O'Reilly: It's earnings galore in the oil services sector, on this energy edition of Industry Focus.

[INTRO]

Greetings Fools! I am Sean O'Reilly, joining you here from beautiful Alexandria, Virginia, at Fool Headquarters. I am joined with the incomparable Tyler Crowe. How are you today, sir?

Tyler Crowe: Why do you do that, every single time we do this? You're going to sound so bright and cheery and then I'm like the Eeyore where I'm just like, "Oh yeah, I'm here too."

O'Reilly: You need to go through the Sean O'Reilly regimen, which involves a shot of espresso right before the show.

Crowe: That might help, actually.

O'Reilly: I'm just putting it out there. You're very cheery and I like you, but...

Today we're talking about the latest results from the oil services sector. We got a plethora of results this past week. Is it pretty much done now?

Crowe: We've still got a couple that are left to go. Obviously one of the larger ones, National Oilwell Varco, has yet to announce. They announce next week, so I'm sure we'll be talking about that.

But by and large, of the 7-10 largest companies in the oil and gas services space, pretty much all of them have reported by now.

O'Reilly: OK. Obviously we're going to talk about the Halliburtons, the Schlumbergers, the Baker Hughes. What are some of the things that stood out to you in this report? As we all know, eight months ago oil prices decided to crash about 55-60%. How are these guys doing?

Crowe: To the surprise and delight of a lot of Wall Street, better than abysmal, actually. Well, that sounds a lot worse than it actually was.

O'Reilly: They're still here.

Crowe: They're still here, they're still alive. They're still doing actually rather well, all things considered going on in the oil space right now.

O'Reilly: Does that owe itself to the fact that they do long-term contracts?

Crowe: It is a lot to do with that. That's one of the big things that we saw over the earnings for these. Let's talk about the big three at first; your Halliburtons, your Schlumbergers, your Baker Hughes.

The big oil services companies do a little bit of everything. What we saw more than anything else over this period was companies with greater exposure to the international markets had a tendency to do a little bit better this period than companies that were a little bit more involved in North America -- which makes a whole lot of sense.

If you look at the international markets, anything outside of the U.S. and Canada, it's going to be a much slower-moving market than what we have here in the United States.

That's where you have your large offshore development projects, it's where you have your mega LNG development projects, as well as companies that are national oil companies; your Saudi Aramco, things like that.

O'Reilly: That was actually going to be my next question. Are their customers countries? Is that basically what we're talking about here?

Crowe: Basically, yes. If you look at somebody like a Qatar or the Saudi Arabia national oil company, they are going to be paying services to somebody like a Schlumberger, a Halliburton, anybody like that.

What we saw is, companies with greater exposure to the international markets had a tendency to do a little bit better. Like we just said, because those projects take a little bit longer, they're on contract for considerably longer.

Just as an example, especially in the Middle East we actually saw some revenue and earnings growth at all three of these companies, in the Middle East, in large part because...

O'Reilly: Saudi is still pumping.

Crowe: Anybody that's OPEC is actually trying to pump a little bit more than anywhere else in the world.

O'Reilly: What did Saudi Arabia just hit, 10.3 million barrels last month?

Crowe: Yes, they went up about 300,000 barrels per day, basically kicking any potential reductions that we're going to see here in the United States over these things, kind of evening things out. Still keeping it a little bit flooded, enough to scare enough people away, in the United States, from bringing on any more production.

Compared it to the United States. A new rig or a new well can be drilled in the United States in 3-10 days, which makes the cycle that much shorter, and the ability for earnings to decline now much more rapidly, because people can shut in that much faster.

We saw that in the earnings for all these companies. Halliburton saw their operating income drop 33%, and so much of it was related to its North America operations.

In last quarter, 60% of Halliburton's operational income came from North America exclusively. When that dropped off as much as it did -- as much as 50% -- that's why we're seeing a larger drop at Halliburton.

Versus, at Schlumberger, only 20-30% of their operational income on a quarterly basis comes from North America, so their operational dip isn't as great, even though their specific North American market saw as much of a dip as Halliburton.

O'Reilly: Halliburton -- you're talking about how two-thirds of their revenues come from North America -- had they been outperforming Schlumberger over the last five years because of the shale boom and everything? Is this just the chickens coming home to roost?

Crowe: It is slightly related to that. Halliburton has done rather well because there's been this massive boom in the United States because of shale, but now that it's not looking as attractive as it once did, we're starting to see a little bit more of a pullback there.

One of the things that is actually a concern for me as an investor, if I'm looking at this Baker Hughes/Halliburton merger...

O'Reilly: Why are they doing that? Is it a cost-cutting thing?

Crowe: There's a cost-cutting element to it, but one of the biggest concerns for me is the fact that by doing so, the combined company will be even more tied to the success of what happens in North America.

O'Reilly: It seems to be the opposite of what they should be doing.

Crowe: I can definitely see how they can get some advantages. They can get a little bit better pricing power, combining the two largest...

O'Reilly: Fewer competitors.

Crowe: The two largest competitors in the North American space coming together, there are a lot of efficiencies there, where you're going to be able to gain better pricing, a little bit more market share, maybe even push out some other people in the space.

There's that, but at the same time they're tying themselves to the wild fluctuation that is the North American market versus the slower, a little bit steadier, international market.

O'Reilly: I also have to wonder, a lot of the EIA reports show U.S. shale production peaking at the end of this decade. Where is this combined entity going to be in the early 2020s? Is this long-term?

Crowe: The lucky thing is that, that far away, a lot of companies can make adjustments and make changes, and that's what I'm going to bank on.

O'Reilly: Wall Street isn't thinking that far in advance.

Crowe: I guess that could be your thought -- Wall Street doesn't think that far ahead anyway. They're only looking at next quarter, next six months anyway.

But all of these companies, they've been around for 70, 80, 100 years. They will adjust. They will make whatever is necessary to move on in the market. Maybe some will struggle a little bit more getting away from shale maybe 15-20 years from now, when that really starts to decline or peak.

Some will get better, and moving into international markets where there are other options.

O'Reilly: We've got 7 out of 10 companies that have reported. Who's doing the best right now?

Crowe: If we look at what the market said, two really big winners that we saw were both Core Labs (CLB) -- which, as of the taping we're doing right now, are up about 7% from reporting last night on their earnings -- and FMC Technologies (FTI -0.57%), who reported yesterday, and on the day that they reported, stock jumped 16 %.

The biggest thing with these two guys, more than anything else, is they all saw a decline in revenue. They all saw a slight decline in earnings. But one of the things that surprised people more than anything else was the fact that it didn't decline as much as they thought.

Core Labs actually produced a record amount of cash flow. They were able to do so because of some timing, because of a little bit less in the capital expenditure route. It helped them produce some of the best cash flow that they've ever produced.

FMC Technologies, same thing. Earnings not as great, cash flow was very strong. One of the things with FMC Technologies is they manufacture subsea equipment; things like blowout preventers, underwater distribution hubs, and things like that for offshore projects.

Since they're a manufacturer, they have the ability to have a backlog of projects. They can only build out so much. It gives them a little bit more consistency when it comes to revenue.

That's really a big thing when it comes to oil services companies. You want to know the difference between an equipment manufacturer and a service provider, because an equipment manufacturer will normally have what is called a backlog.

That backlog will help them cushion their way through these downturn cycles because they basically say, "We've got a whole bunch of projects. We can work through those." The backlog will decline, but at least it keeps revenue steady during the down cycle. Then hopefully by the time it picks back up again, people will start ordering more stuff and that backlog will increase.

O'Reilly: Let's just project. This may or may not happen, but if oil prices are still at $55 two years from now, will that backlog get dried up, and then these guys will be in trouble? Where are we on the danger scale with things like this?

Crowe: Let's talk about three major equipment manufacturers that we have in the space. You have the largest of them all, National Oilwell Varco. You have FMC Technologies, and another one who is a very large offshore contractor is Cameron International.

If you look at these three companies and you look at their backlogs, they are taking in less orders than they are producing -- but they are still taking in orders.

If you consider the fact that they're still taking in orders, while slightly dwindling down their backlog, based on the backlogs they have right now and what's gone on in the past 6-9 months, in terms of how that backlog has reacted, it is very difficult to see any of them really, really struggling to find work over the next couple of years.

With the large expansion that we saw in offshore drilling with these companies, there is just so much backlog of work that for the next couple of years I don't see them having a huge issue generating revenue.

O'Reilly: All these stocks have still obviously seen a little bit of a pullback because of oil prices. What, of these names, interests you right now -- and what should investors be looking for, more importantly?

Crowe: Well, considering that Core Labs is the largest position that I personally own, I'm going to say that I'm a personal fan of that one. One of the reasons that I like Core Labs, and a couple others that we've mentioned today, is their ability to generate free cash flow and make a return on investment.

Core Labs, on a return-on-invested-capital basis, not only is it the best player in the entire oil and gas equipment and services space, but it beats the next best competitor by almost two times.

O'Reilly: Their returns on equity are in the 50s or something.

Crowe: Yes, the return on invested capital, return on equity, is somewhere in the 50% range, which is absolutely absurd.

O'Reilly: Those are Buffett-type numbers.

Crowe: It has a lot to do with the way that they handle earnings and how much they actually return cash to shareholders rather than retaining earnings.

But when you consider that the amount of money that they pour back into share buybacks for customers, as well a paying a relatively decent dividend -- it's somewhere greater than 2%, so it's good not great when you look at some other players in the oil and gas space.

But if I'm looking at buying my first oil and gas services company, I would look really hard at Core Labs.

O'Reilly: Very interesting. The final takeaway seems to be that these oil services names, it isn't Armageddon for these guys.

Crowe: It is not Armageddon. They're going to be OK. We're in a down cycle, but guess what?

O'Reilly: They'll be here tomorrow.

Crowe: They'll be here tomorrow.

O'Reilly: Five years... yes.

Crowe: When the market turns back up, they're going to be in pretty good shape.

O'Reilly: Very good. Thank you for your thoughts, Tyler.

Crowe: Thanks for having me.

O'Reilly: Have a good day.

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That's it for us, Fools. For Tyler Crowe, I am Sean O'Reilly. Thanks for listening, and Fool on!