Is Halliburton a Sell?

Halliburton's (HAL +1.36%) third-quarter results revealed a faster erosion of its operating margins as compared to rival Schlumberger's (SLB +2.67%). With crude oil prices continuing to be lower for longer than initially anticipated, Halliburton's relatively larger exposure to North American operations creates significant downside risk to its stock price.

Numbers don't lie
Third quarter pre-tax operating margin for Halliburton fell 739 basis points from last year's third quarter, to 10.1%, after booking an operating profit of $564 million on total revenue of $5.6 billion. In comparison, Schlumberger's operating margin dropped only 424 basis points within the same period, to 18%. Here's a comparison of operating margins of the two biggest oil-field services companies:

Source: Company earnings press release, author's calculations.

While the above chart gives a snapshot of the companies' overall profitability, breaking up revenue and operating income by region and product offerings gives a deeper insight into each of their business models.

North American profitability drops drastically for Halliburton
For the third quarter, North America accounted for nearly 45% of Halliburton's total sales -- a drop from 54% a year ago. For Schlumberger, the same region contributed 27% of its total sales, a slide form 34% in the third quarter of 2014. Clearly Halliburton is more exposed to North American oil-field servicing activity.

In absolute sales, however, North American operations contributed similar dollar values -- $2.5 billion and $2.3 billion for Halliburton and Schlumberger, respectively.

A closer look at the operating income, though, reveals a startling fact: Halliburton's pre-tax operating income fell to a measly $8 million, for an operating margin of just 0.3%. On the other hand, Schlumberger's operating income stood at $202 million, at an operating margin of 8.9%. The chart below should make it clear:

Source: Company earnings press release, author's calculations.

In short, North American operating margins plunged a whopping 1,886 basis points for Halliburton versus a lower (if not insignificant) 1,050 basis point-drop for Schlumberger. This is despite similar revenue profiles for both companies.

To make it an apples-to-apples comparison, these adjusted operating profits are prior to accounting for corporate expenses, impairment charges, interest expenses, and Baker Hughes acquisition-related costs. In other words, we arrive at the adjusted operating profits for both companies by simply subtracting cost of sales and services and SG&A costs from total revenue.

Why such a great fall?
A deeper analysis reveals that a bigger chunk of Halliburton's overall operations fall under its completion and production segment -- a relatively low margin business. In comparison, the bigger share in Schlumberger's revenue pie constitutes its high margin drilling and reservoir characterization businesses.

The following chart breaks down third quarter performance by business segment for both companies.

*For Schlumberger, drilling and evaluation values are the sum total of its drilling and reservoir characterization segments.
Source: Company Earnings press release, author's calculations.

While a region-wise breakup of their product verticals isn't available, the overall break-up gives us a clear reason why Schlumberger's operations are more profitable. For Halliburton, the low margin completion and production segment contributed to 57% of its total revenue in the third quarter, whereas for Schlumberger, the same division constituted only 35% of its total sales.

Another reason -- though not as compelling -- that might have contributed to Halliburton's dismal operating margins could be its impending merger with Baker Hughes. It's likely that in order to comply with antitrust regulations, Halliburton may have been forced to divest some of its more profitable business units. In a recent press release, the company announced additional divestitures of businesses to satisfy regulators. The combined revenue associated from all divestitures are of the tune to $5.2 billion -- or almost 18% -- of  2013 revenue.

Foolish bottom line
Halliburton's comparatively large exposure to North America, and its relatively lower margin completion and production segment contributing to a bigger share of revenue, stand as major impediments to its stock price growth.

In a sustained low oil price environment, Halliburton stands to lose out more than Schlumberger. The corollary is that, should crude oil prices inflect and start moving north, and shale oil producers commence drilling, there would be huge upside to Halliburton's share price. But until then, Halliburton's margins could shrink further causing a major drag on its stock price.