I am assigning Schlumberger (NYSE:SLB) a positive risk/reward rating based on the early stage of a new growth cycle, an exceptional multi-year earnings growth trajectory, the company’s global leadership position, and an unusually asymmetric potential return profile.
Risk/Reward Rating: Positive
Schlumberger reported its second consecutive quarter of year-over-year revenue growth on October 22, 2021. The Q3 2021 financial report marked an inflection point in the 6-year bear market for the energy services sector and signaled the beginning of a new growth cycle. Given the early stage of the nascent energy services growth cycle, Schlumberger represents an intriguing cyclical growth opportunity as the global leader in the space.
The scale and duration of the new upturn remains highly uncertain due to the global focus on decarbonization and the resulting negative sentiment surrounding the traditional oil and gas sector. As a result, investors appear to be cautious compared to prior cyclical upturns. Ironically, the negative sentiment and cautious investor behavior sets the stage for an unusually strong upcycle for the group.
The Inflection Point
If early indications are indicative of the new energy growth cycle, the defining feature is likely to be well-above average profitability compared to prior cycles. The following table was compiled from Schlumberger’s Q3 2021 10-Q filed with the SEC. It depicts Schlumberger’s revenue and operating income performance across each of its four business segments through Q3 2021. The top section is Q3 only, while the bottom section is year-to-date or YTD for the first nine months of 2021. Please note that “Op Inc” stands for operating income and “YoY %” stands for year-over-year percentage change.
I have highlighted the summary data to illuminate the key findings. Notice that total sales through the first nine months of 2021 remain 2% lower than that of 2020 (highlighted in yellow). The sales decline reflects the fading effects of energy producers slashing their capital expenditure budgets in response to the COVID-induced decline in energy demand through Q1 2021. Importantly, operating income has grown 36% (highlighted in blue) compared to the first nine months of 2020. This rapid operating income rebound even as sales continued to decline is a strong signal that the coming growth cycle will feature higher than normal profitability compared to recent cycles.
Q1 2021 was the final sales contraction period while Q2 2021 was the first quarter of stabilization year-over-year. The 16% sales growth (highlighted in yellow) posted in Q3 2021 in comparison to Q3 2020 is a clear inflection point. Again, notice the operating leverage that Schlumberger has created with operating income expanding 58% in Q3 2021 (highlighted in blue).
Please note that Schlumberger divested some of its Reservoir Performance segment (*) North American assets in 2020. I have removed the divestitures from the 2020 sales figures (25% of North American sales in 2020) in order to view the results from a continuing operations perspective. Its North American fracturing and stimulation business was the largest divestiture and is now part of Liberty Oil Field Services (NYSE:LBRT). Schlumberger received 37% ownership of Liberty Oil Field Services in exchange for the asset. The divestitures were lower margin, higher capital intensity operations with more volatile earnings profiles. This is an excellent example of Schlumberger managing its portfolio for higher margin, more stable profitability businesses which lend themselves to higher valuation multiples.
Interestingly, while North American drilling activity remains muted, Schlumberger’s North American operations are leading the rebound at this important inflection point for growth. This is likely due to North American oil and gas activity being shorter cycle in nature. North America has smaller but more numerous shale wells compared to larger conventional wells internationally. As a result, shorter cycle here means that the wells can be quickly placed online for production. The following table was compiled from Schlumberger’s Q3 2021 10-Q and displays the performance by business segment and geography in millions of US dollars. I have highlighted the standout performers.
It should be noted that North American oil and gas producers are behaving very conservatively in the current environment. The restrained capital budgets of the North American producers compared to Schlumberger’s excellent growth points toward the possibility of market share gains and new business wins. Schlumberger is at its core a technology company, which is an excellent fit for the current state of the North American marketplace. In fact, in the Q3 2021 financial report Schlumberger’s CEO Olivier Le Peuch had this to say about the Well Construction and Reservoir Performance segments leading the way:
We are starting to see signs of improved service rates in both of these Divisions driven by our technology, which is creating visibly higher value for our customers and resulting in stronger technology adoption and activity share gains—particularly in the international markets.
The North American market should be fertile ground as it has turned its focus toward maximum efficiency and away from maximum growth (more technology, less drilling). This bullish take is somewhat tempered by the North American market being more short cycle in nature and thus it may be responding more rapidly to the strengthening in global energy markets.
I have highlighted in blue the powerful operating margin expansion in three of the four divisions. Please note that bps stands for basis points (for example: 784 bps = 7.84%). The margin expansion is impressive in light of the subdued rebound thus far in the international markets. The substantial growth differential between North American and international markets calls for a more granular look at geographic performance. The following table was compiled from Schlumberger’s Q3 2021 10-Q and displays greater geographic detail.
Please note that the “% of Tot” column stands for percentage of total sales. I have highlighted in blue the most interesting trend. Latin America is leading the initial growth inflection with 30% growth year-to-date. This is compared to all other regions which are contracting through the first nine months of 2021. Latin America offers tremendous growth opportunities as evidenced by Brazil’s massive offshore oil fields. This market is likely to produce robust growth for many years given the longer cycle nature of the asset base and the recent underinvestment. The North American market joined Latin America in the growth cycle inflection during Q3 2021 (highlighted in yellow). The remainder of the world has yet to reach the growth inflection point and represents 61% of sales.
These trends are important because 80% of Schlumberger’s markets had not inflected toward growth as of the end of Q2 2021, while only 39% had reached the growth inflection point by the end of Q3. 61% of Schlumberger’s markets have yet to join the new growth cycle as of the end of Q3. At the same time, Schlumberger’s operating income is already growing rapidly at 36% year-to-date. This expanded to 58% in Q3 with the addition of North America to the new growth cycle. When the remaining 61% of Schlumberger’s markets enter the new growth cycle, operating income growth could become explosive and may surprise on the upside.
Schlumberger’s strong international position bodes extremely well for the future. The North American shale revolution dominated the investment landscape in the first two growth cycles of the twenty-first century. This new cycle looks highly likely to be more balanced globally as ESG and decarbonization policies favor sustainable regional development. Schlumberger’s 81% weighting to international markets ideally positions the company for market share gains and above average growth over the coming cycle. In the Q3 2021 financial report Schlumberger’s CEO Olivier Le Peuch affirmed this:
The combination of Schlumberger’s fit-for-basin strategy, digital technology innovation, and scale puts the company in the best position to leverage the anticipated shift of spending growth toward the international markets.
Consensus Growth Estimates
With the above information in hand, the consensus growth estimates for Schlumberger can be placed in the context of existing and historical trends. Please keep in mind that Latin America and North America are the only two markets to cross over to the new growth cycle. Latin America is up 30% through Q3 and North America is down 2% through Q3 of 2021. The following consensus sales growth estimates were compiled from Seeking Alpha while the historical data was compiled from Schlumberger’s 2011 10-K and 2014 10-K filed with the SEC.
The left side of the table displays consensus sales estimates while the right side displays actual historical performance at a similar juncture at the beginning of the last growth cycle. I have color coded the years that I believe are comparable from a cycle perspective. Notice that expectations for 2022 are subdued compared to 2010’s actual results (highlighted in yellow). This is interesting because the 2010 upcycle began after a brief and shallow industry correction.
The 6-year energy bear market that culminated in negative oil prices in 2020 creates an entirely different baseline from which to grow in comparison to 2009. For perspective on the depths of the recently completed 6-year bear market, notice that Schlumberger’s sales in 2021 are expected to be on par with sales in 2009. The more depressed initial conditions in place for the current cycle point toward the possibility that sales growth expectations in the early phase of this upcycle could be materially too conservative.
The negative sentiment today toward the oil and gas sector is on full display in the estimates for 2023. In the second year of the new growth cycle, analysts currently expect only 12% sales growth compared to 44% during the second year of the prior industry upcycle (highlighted in blue). Following a 6-year bear market and subsequent deferred investment and maintenance that resulted from it, 2023 sales growth estimates look to be very conservative.
Placing consensus estimates in the context of historical performance sheds light on whether current market expectations are too aggressive or too conservative. This is important because the current share price reflects consensus estimates and whether market participants agree or disagree with those estimates. The following table displays select income statement data and was compiled from Schlumberger’s 2020 10-K, 2017 10-K, 2014 10-K, and 2011 10-K filed with the SEC. I have color-coded critical details from a cycle perspective.
The bear market from 2015 to 2021 reached incredible depths. Sales in 2020 were half the level reached in 2014 (highlighted in yellow). Sales are expected to end 2021 even lower and be on par with 2009. I have highlighted in light orange the impairments between 2015 and 2020 to emphasize just how brutal the last downcycle was for the oil and gas service companies.
I have highlighted in blue the historical gross profit and operating profit margins. Notice that margins were stable during the 2009-2014 growth cycle. As a result, an operating margin expectation of 18% to 20% appears to be a reasonable baseline projection for the coming cycle. Given that the company has reorganized its portfolio toward higher margin businesses, I suspect these historic margin figures will prove low in the current growth cycle. In fact, with sales still contracting in 2021, Schlumberger’s margins are rapidly expanding as can be seen in the following table compiled from its Q3 2021 10-Q.
Schlumberger’s gross profit margin is back to 17% compared to the prior cycle peak of 23%. The company’s operating profit margin is back to 13% compared to the prior cycle peak of 18%. There remains material margin expansion on the horizon which I believe will surpass the high-water mark of the prior cycle.
Valuation and Earnings Estimates
The current consensus earnings estimates for Schlumberger reflect an incredible 35% per year growth rate over the coming three years. This level of growth is in league with most of today’s top growth stocks. The lower portion of the following table displays consensus earnings estimates and was compiled from Seeking Alpha. In the upper section of the table, I have compiled Schlumberger’s historical high share price and PE ratio for each year during the prior industry upcycle from 2009 to 2014. The historical data was compiled from the 2014 10-K and 2011 10-K filed with the SEC as well as the daily price history of Schlumberger’s shares. Please note that the average and median PE during the 2009-2014 growth cycle was 24.
I highlighted in blue the PE ratio based on consensus estimates through 2024. Schlumberger is currently trading at a steep discount to its prior growth cycle PE of 24. The earnings growth associated with these valuation multiples is highlighted in yellow. At minimum, Schlumberger’s current valuation offers growth at a very reasonable price. More optimistically, Schlumberger is an industry leader entering a stable, long-duration cyclical uptrend in global energy development while trading at an incredible discount to comparable growth stocks.
The next question is: are consensus earnings expectations reasonable? Remember from earlier that consensus revenue growth expectations are very conservative compared to the prior upcycle. Additionally, recall that Schlumberger had very consistent operating margins of 18% to 20% during the last growth cycle. The following table displays consensus revenue and earnings estimates compiled from Seeking Alpha (“Sales” and “Est.” columns) and my approximation of earnings per share assuming both an 18% and 20% operating profit margin (“EPS” column). My earnings per share approximation under each scenario assumes that the consensus revenue estimates are achieved.
Based on Schlumberger’s historical operating margin of 18% to 20%, current consensus earnings estimates (“Est.” column) appear to be quite conservative. Please view the highlighted cells in the “EPS” column in comparison to the “Est.” column. If historical margins are achieved, there is upside potential of 24% to 40% compared to current consensus estimates for 2022 (highlighted in yellow) and 2023 (highlighted in blue).
Schlumberger is trading at a PE multiple of 12x the 2023 consensus earnings estimate. This for a company that is expected to grow earnings at 32% in 2023 with realistic potential to beat estimates by 24% to 40% (the blue highlighted cells above). It is a compelling situation that warrants an estimation of upside potential. The following table provides several potential return scenarios using the earnings estimates from the above tables and applying the prior cycle average PE of 24 and the PE average of the past five years of 35 (not shown here).
The yellow highlighted cells bracket what I would consider to be high-probability return scenarios and range from 62% to 196% through 2023. I view the average PE valuation of 35x over the past five years to be too optimistic of a baseline expectation. That said, a 35x earnings valuation through 2023 is in the realm of possibilities given the 32% growth rate expected in 2023 and the reasonable likelihood of beating those numbers. If this upside scenario plays out, the return potential is incredible at 332%.
The technical picture offers strong support for the upside scenarios discussed above. More importantly, the technical backdrop suggests the downside risk for Schlumberger is quite minimal given the fundamental upside potential. I have highlighted the major support and resistance levels with horizontal lines in the 5-year weekly chart below. The green and blue lines represent substantial support levels that have been carved out by a major W-bottom pattern in 2020 and 2021.
The blue line near $24 represents only 14% downside potential. While Schlumberger could test lower levels near $20, this appears unlikely given that this price level reflects the depths of the COVID pandemic. The following 2-year daily chart provides a closer look at the support levels.
The break beneath the blue line coincided with the economic shutdowns of 2020. It is highly likely that the $24 area will offer incredibly strong support.
In terms of technical upside potential, the nearest resistance is at the orange line near $35 per share or 25% above the current price. This area is likely to offer short-term resistance, however, it should not represent heavy resistance in the intermediate term given the lack of trading history at this level.
The area between the purple lines on the 5-year weekly chart is likely to be the first strong resistance zone on an intermediate time frame. If this area is reached, the return potential ranges from 118% to 189%. This aligns very well with the high-confidence return potential range of 62% to 196% based on the fundamentals discussed above.
The 20-year monthly chart below offers a comprehensive look at the technical backdrop for Schlumberger. Notice that the area between the orange line and the first purple line represents little trading history. Schlumberger fell from $60 to $35 over just three months in late 2018 and has not traded in this range since that time. Furthermore, the stock last traded in this range in 2009. As a result, resistance prior to reaching $60 should be mild.
It is clear that the world is transitioning to a low carbon future. In fact, this is the bullish case for conventional energy markets in the coming decades. The global regulatory framework is creating a moat of sorts around the oil and gas industry. These conditions should limit competition and the risk of overinvestment, which will create more stable growth than in previous cycles. In essence, new growth capital is being diverted to other energy solutions while traditional energy assets are in a rate of return harvesting mode. This harvesting mode looks to be a dynamic, secular growth trend as global oil and gas demand is expected to grow for the foreseeable future. With a high confidence expected return profile of -14% to +196%, Schlumberger offers a rare, high-quality, asymmetric growth opportunity.
Price as of report date 12-21-21: $28
Schlumberger Investor Relations Website: Schlumberger Investor Relations Website