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Gloomy 2015 Overshadows Halliburton's Solid Quarter

But our valuation already accounts for deteriorating conditions.

Halliburton emphasized its strong financial and market position as a bulwark against the current downcycle. One particular argument made by management resonates with us: Drilling and completion technology that reduces cost per barrel for producers is likely to experience less pricing pressure. For instance, Halliburton plans to take advantage of the downturn to increase the penetration of its Frac of the Future equipment from 30% of its fleet today to 50% by year-end, positioning the firm well for the eventual upswing.

Halliburton is saying the right things at this stage, focusing on managing the business quarter by quarter, looking to drive costs down through vendor negotiations, and collaborating with customers to help improve efficiencies while reducing costs. Where oil finds a floor and when it will rebound remain very uncertain, but for investors expecting a quick industry turnaround, we think Halliburton is the most attractive services name at this time.

Merger With Baker Hughes Will Create Value Halliburton is one of the top oil services companies in the world. It is the clear leader in North American unconventional services, and we expect it will continue to build international presence as it increases activity in deep-water and mature fields. Its proposed merger with Baker Hughes will cement its place as number two in the industry, rivaling Schlumberger SLB in breadth and depth of services offerings.

Halliburton is the 800-pound gorilla in the North American unconventional services market, thanks to its dominance in pressure pumping. The firm is still vulnerable to market forces, however, which leave pricing outside its control and an unlikely driver for higher revenue, in our opinion. Deep-water drilling is an oft-cited driver of growth for oil services, and Halliburton expects to grow 25% faster than the industry average annually. Given current market weakness, this may take a couple of years to become reality. The good news for Halliburton is that deep-water service contracts generally run for eight years, long enough for the company to realize two to three product development cycles. Profitability may be slim in initial years, but the introduction of new technology will allow the firm to increase prices over time.

The final part of Halliburton's strategy is to triple mature field services revenue to $9 billion by 2016. We find this to be the most exciting part of the growth story because state-owned oil companies are facing field decline, which represents a growing market; consulting to increase field production is high-margin work; and contracts can be structured so there is minimal up-front investment cost (development capital would still be the field owner's obligation) but they include ongoing payments--effectively, a royalty interest on production.

Switching Costs Are Meaningful We award Halliburton a narrow moat on the basis of its ability to provide integrated drilling and completion solutions to customers, which create meaningful switching costs, as well as the intangible assets related to its portfolio of proprietary software suites.

In the North American unconventional market, Halliburton offers a suite of services related to exploration and development drilling. The company says it is number one in cementing, drilling fluids, drill bits, and cased-hole products and number two in its remaining product lines. Its integrated offering allows customers to reduce delays related to waiting on third-party suppliers at the well site, thereby saving money by employing Halliburton for a greater share of work. Complementing the firm's services at the well site is proprietary software, which allows customers to assess and design reservoir exploration and development programs. Increased customer adoption of services and software across the exploration and production timeline strengthens customer relationships and discourages competition because of the time customers would lose adapting to new products from Halliburton's peers.

Deep-water exploration and production represents another moat-worthy business for Halliburton. Deep-water is highly service-intensive, and only a handful of companies have the size and knowledge base to win competitively bid contracts. Deep-water contracts are also long term, with commitments for up to eight years. Winning bids may come with lean margins initially, but they provide exclusive opportunity for increased sales at more favorable margins as technology develops and new products emerge, improving returns in the later years of the contract.

Oil Prices Are Biggest Question Mark 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 for Halliburton.

We also believe Halliburton faces ongoing operational risk, which was brought to the forefront of public attention in the wake of the Macondo disaster. The risk of a catastrophic failure bears not only the sunk investment cost but also potential civil and criminal penalties--costs far greater than the switching costs that support Halliburton's moat. If the firm is associated with another high-profile disaster, even if it is found not responsible, future revenue could be lost because of diminished reputation, and existing customers could move current projects to Halliburton's competitors.

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