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Stock Strategist

Our Favorite Oil Services Firm

Schlumberger is a best-in-class name being treated as one of the herd.

 Schlumberger's (SLB) third-quarter results didn't reflect the drop in oil prices over the past few months--revenue growth was strong and margins expanded, leading to a $0.03 beat versus our earnings per share estimate. We believe Schlumberger's wide moat is safe even if oil stays at current levels. We see a greater threat to our $145 fair value estimate the longer that oil stays near $80 a barrel. We are not changing it at this time, but we are closely monitoring producers' 2015 capital budgets to gauge whether a cut will be appropriate.

Revenue growth in North America was robust, while international activity varied by location. Revenue in North America was up 9% sequentially as the firm continued to benefit from higher stage counts on unconventional wells, as well as recent acquisitions' artificial lift. International revenue growth was 3% versus the second quarter, with Latin America leading at 10% sequential growth. Project delays in Russia, as producers exercised caution in the wake of sanctions, held back growth in the Europe/Commonwealth of Independent States/Africa region. Unrest in Kurdistan caused a slowdown in Iraq that kept the Middle East and Asia segment's revenue sequentially flat.

Margins were resilient, despite obstacles in international activity. Overall pretax operating income reached $2.8 billion for the quarter, up 7% sequentially and 12% year over year. International operating margins expanded 55 basis points to nearly 25%, continuing their steady ascent from around 15% over the past five years. In North America, operating margins increased 137 basis points to 19.4%--not the high-water mark we saw in 2011, but still an improvement. We are unsure to what degree unconventional activity might decrease in the near term. A sharp reduction in new wells would probably kill services companies' hopes for continued recovery in pressure pumping pricing, and North American revenue growth and margins would clearly suffer. Early indications are that 2014 remains stable, but 2015 is still uncertain.

Even with near-term headwinds, Schlumberger still sees oil supply and demand as balanced over the long term. The company acknowledged the threat of lower economic growth in Europe and China cutting the global oil demand outlook, as well as OPEC's unwillingness to support oil at $100 a barrel. However, during Friday's earnings call CEO Paal Kibsgaard said he expects oil production will still need to increase 1.1 million barrels per day to meet demand in 2015 while non-OPEC international production growth has struggled to increase, and he was skeptical of the sustainability of spare production capacity from OPEC. Where production growth would come from (that is, deep-water versus unconventional versus lower-cost production in currently unstable regions) is more dependent on where oil prices eventually settle. Schlumberger's unparalleled international scale provides it considerable opportunity to capitalize on any of these outcomes, and consequently the firm remains our favorite pick in the oil field services sector.

Schlumberger Dominates Oil Services
Schlumberger is the global leader of oil services in terms of size and scope of operations, providing everything from wireline and reservoir characterization to drill bits to artificial lift. In addition to being the dominant firm in the sector, the company operates in a growing industry, thanks to the increasing service intensity of Arctic drilling, deep-water exploration, global proliferation of unconventional drilling, and mature field management.

Over the long run, we are bullish on the prospects for the oil services industry. The cost of oil exploration and production has risen dramatically, as the low-hanging fruit has now been plucked. Producers face the challenge of finding new reserves in increasingly remote locations and greater water depths offshore. The need to quickly and accurately locate, assess, and exploit these hard-to-reach reserves places greater importance on the capabilities of oil services firms--a trend we expect to continue for the foreseeable future.

We believe Schlumberger's size and reputation will allow the firm a greater degree of consideration for service work relative to peers, which will continue to support the firm's growth rates and margins for decades. The firm's size has allowed it to gain experience in all geographies and oil reservoir types (conventional onshore, unconventional, offshore, and deep water). Additionally, size is an important factor to state-owned oil companies, which are increasingly seeking project management for oil fields facing production decline and deep-water operators offering multiyear service contracts tied to exploration efforts.

As a result, we expect Schlumberger to deliver stable financial results, lagging the industry when peers are playing catch-up in high-growth opportunities (like deep-water exploration currently) and outperforming when the price of oil dips and producers tighten their belts on capital spending. Likewise, we expect the firm to experience lower volatility in operating margins as the industry goes through normal expansions and contractions.

Switching Costs and R&D Set Schlumberger Apart
We award Schlumberger a wide moat based on the breadth of products and services it offers, which creates meaningful switching costs through process and product integration, as well as its research and development efforts, which drive the creation of intangible assets in the form of new processes and technologies.

Schlumberger splits its 15 product lines into three segments: reservoir characterization, drilling, and production. The breadth of Schlumberger's products and services allows the company to package its offerings, creating cost efficiencies for the customer by streamlining processes and reducing delays. The company claims it holds a leading market share in nine of its product lines, mostly in the characterization and drilling segments. Increased customer adoption of products, services, and software across the exploration and production process strengthens overall customer relationships and discourages competition because of the time customers would lose adapting to new products from Schlumberger's peers.

The financial rewards of strong customer relationships support the firm's ability to spend more than $1 billion per year on research and development, well in excess of its competitors. R&D efforts in turn create a virtuous cycle for the company, which introduces new technologies more rapidly, increasing its offerings to customers and further strengthening ties. While we do not believe that any specific technology provides Schlumberger with an intangible asset capable of driving its wide moat, we do think the switching costs linked to its strong customer relationships and the intangible asset derived from continued R&D spending are interwoven and will provide the company with a durable competitive advantage for decades.

Lower Oil Prices or Demand Could Be a Problem
The greatest risk facing the oil services industry is lower oil prices for a prolonged period. Lower oil prices would immediately constrain oil producers' capital spending budgets, which would lead to lower (or negative) revenue growth. In terms of company-specific threats, a catastrophic event or a series of failures with the firm's physical products that call into question its quality or reputation could seriously damage Schlumberger's customer relationships and ability to win new service contracts.

Outside of short-term economic contractions, which could temporarily depress the price of oil, there is the threat that improvements in energy efficiency could lead to slower oil consumption growth. Lower or falling demand could call into question the necessity for higher-service-intensity projects, such as ultra-deep-water drilling. Likewise, the success of alternative hydrocarbon production (international unconventional development or improved recovery of existing producing reservoirs, for example), could damp the oil services industry's hopes for deep-water market as a driver of growth over the next decade.

Also, there could be adverse effects on the company's revenue related to U.S. and European Union sanctions on Russia that specifically target technology associated with oil exploration and production. At this time, we think the impact to Schlumberger is limited because (1) the company does not manufacture or deal in many of the banned products, (2) the regulations ban exports to Russia, and Schlumberger's business is fairly self-contained and independent within the country, and (3) the sanctions are tied to deep-water, shale, and arctic exploration and production, in which there is very little activity at present. As further details emerge, or if there is not a resolution to the conflict in the near future, this risk could evolve into a more meaningful point of consideration for investors.

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