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Good Buy Halliburton

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By: Darren Gold
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Executive Summary:

The oilfield services and equipment industry outlook is positive; the expectation is that oil prices will most likely remain high because oil producers are expected to continue producing oil at low spare capacity. Moreover, oil demand will increase, fuelled by economic growth in emerging countries like China and India. Halliburton Company (HAL), with its geographical diversity, is well-positioned to continue to reap the benefits of high E&P spending around the world.

Halliburton has been the primary beneficiary of the shale gas boom in the US. With their future outlook focused on international geographical diversification, they will leverage their technological advantages to gain contracts, especially in Saudi Arabia, where tenders are being sought currently.

Company Profile:

Halliburton is the second largest oilfield services company, after Schlumberger Limited (SLB). It serves oil companies involved in the exploration and production (E&P) of crude oil and natural gas, and its customers range from independent E&P companies like ConocoPhillips Co. (COP), to integrated oil companies and national oil companies like Chevron Corporation (CVX) and Petróleo Brasileiro S.A (PBR).

Halliburton’s operations are divided into two segments: Drilling and Evaluation (D&E), and Completion and Production (C&P). The D&E segment refers to the first phase of its overall operations: activities like field evaluation and modeling, drilling and wellbore construction fall in this segment. The C&P segment deals with the development of proven reserves: this includes cementing drilled wells, extracting energy resources and monitoring production by keeping a check on pumping pressure.

Haliburtan

A snapshot of Halliburton’s Historical Financial Performance:

Market Capitalization: $46.3bn

Revenues for fiscal year (FY) 2012:  $28.7bn

Revenue CAGR (FY07-FY12): 13.5%

Earnings (FY12): $2.64bn

Earnings CAGR (FY07-FY12): -5.51%

Operating margins (FY12): 14.6%

Geographic Breakdown (FY12):

hallibarton

Revenue breakdown in term of services and products (FY12):

Haliburtan

Industry Analysis:

Overview:

Energy equipment and services is the broader industry in which Halliburton operates. Energy equipment and services processes fall in the initial stage of the oil and natural gas production process. The industry supports upstream activities in two main ways: oil and gas drilling, and oil and gas services. The drilling sub-industry, as the name suggests, is involved in the drilling of wells. The services sub-industry, on the other hand, provides services such as seismic imaging (to explore reserves), well construction (cementing) and well maintenance.

A financial snapshot of the industry is given below:

Market capitalization:  $550.5bn

Revenue:  $313bn

Revenue growth year over year (YoY): 24.96%

Expected revenue growth (CY12 –CY13): 12.0%

Note: All industry calculations are based on data of the top 50 companies, ranked according to their market capitalization.

Industry Trends:

Technology is the primary growth driver for the energy equipment and services industry. Innovative new technologies in well construction and pressure pumps that increase productivity and efficiency are highly sought-after by E&P companies.

In the drilling sub-industry, the type of rigs used by the operator determines the day rate (the daily cost charged by the drilling company to the operator), with newer and more specialized machinery rented at higher rates. In case of oilfield services companies, cost efficiency is the deciding factor in securing contracts from E&P companies.

There are three main markets of particular importance that need to be considered when analyzing trends in the oilfield services and equipment sub-industry:

The US:

Drilling activity in the US onshore/land market has increased over the past five years. This rise in drilling activity, which is expected to continue in the future, has stemmed mainly from increased exploitation of shale plays. Within the onshore drilling market, there is a shift towards liquid (oil) production, as higher oil prices pave the way for greater E&P spending.

In the off-shore market, headwinds in the form of lower day-rates can be expected for owners of fifth-generation and/or older rigs. The industry’s preference for relatively newer ultra-deep-water floating rigs means that prices of older rigs will eventually fall. Currently, only around 16% of the ultra-deep-water rigs are used for drilling at depths of 7,500 feet (ft) and deeper.

Despite the availability of mid-water and deep-water rigs, and the relatively low utilization rates of these rig types, ultra-deep-water rigs are preferred at those water depths because of their high efficiency. Companies that operate such rigs are expected to charge higher day rates in the future.

Canada:

Development of midstream infrastructure – such as pipelines for transporting oil and gas – is increasing in Canada. Coupled with the arrival of E&P companies and an increasing number of export permits issued, huge E&P investments are looming on the horizon.

Saudi Arabia:

E&P spending is expected to ramp up in the Middle East. Saudi Arabia is seeking tenders for jackups (a type of offshore rig which is attached to the sea floor), as it continues exploring in the Red Sea.

Key Players:

Halliburton’s three main competitors in the oilfield services industry include Schlumberger, Baker Hughes (BHI) and Weatherford International Ltd (WFT).

halliburton

The combined revenues of the four players have increased 124% over the last six years, from $47.8 billion to $107.2 billion. Schlumberger is the market leader in all regions except North America, where Halliburton is the dominant player.

Stock Price Drivers:

E&P Capital Expenditure:

Halliburton’s earnings and revenues are entirely dependent on the exploration and development activities. Our research shows that the correlation between Halliburton’s earnings per share (EPS) and E&P companies’ capital expenditure is nearly 0.7.

Haliburtan

Crude Oil Prices:

E&P companies’ capital expenditures are, in turn, dependent on the prices of crude oil and natural gas. Therefore, crude oil prices indirectly affect Halliburton’s earnings. The correlation between Brent crude oil prices and Halliburton’s EPS is 0.67.

Haliburtan

Natural Gas:

The Henry Hub natural gas price, which is a global benchmark for gas prices, indirectly affects Halliburton’s earnings in the same way as the Brent crude oil price does. Halliburton’s earnings followed Henry Hub gas prices until the shale gas boom in 2010. Due to increased oil production, Halliburton’s earnings continued to improve even after the boom, even though Henry Hub natural gas prices dropped significantly thereafter.

henry hub

Rig Count:

The rig count is indicative of drilling activity in a region. A higher rig count (assuming that the rig utilization rate remains the same) means E&P companies have increased drilling activities in the region, which in turn means greater capital expenditures. The correlation between Halliburton’s EPS and the US rig count is 0.81, slightly higher than the correlation between the Halliburton’s EPS and the worldwide rig count (0.80).

rig count

Number of New Drill Permits:

As drilling activity is a function of the number of new drilling permits authorized, Halliburton’s EPS is correlated to the number of new drill permits issued.

The correlation can be seen from the third quarter (3Q) of calendar year (CY) 2010. The correlation broke after 2QCY12 because of the Macondo oil well fire and explosion, which resulted in a sharp decline in the number of new drill permits issued during the quarter, even though only 5% of Halliburton’s total revenues are generated from the Gulf of Mexico region, where the Macondo well was located.

drill permit

Comparable Valuation Sheet:

table

**N/A because of negative earnings in FY12.

The company’s earnings have been falling at an annual rate of 5.51%, whereas its competitors have fared comparatively better in this regard. However, its three-year earnings growth from FY12 to FY15 is expected to be almost 25%, so the falling historical growth rate should not put off potential investors.

Other than that, Halliburton’s operating margins are better than the group average. It’s PEG ratio of 0.48 shows that the company’s growth can be bought cheaply.

matrix

Sell Side Expectations:

month

The sell side forecasts a low target price of $45, a high target of $76, with a mean target price of $58.50.

table

Dividends:

Halliburton’s quarterly dividends per share have increased since the start of this year by 39%, rising from $0.09 per share to $0.125 per share. The dividend yield at the end of FY12 was 1.04%.

Cash Flow Growth:

cash flows

Halliburton’s cash dividend coverage was 5.6x at the end of 2QFY1, and free cash flows are expected to grow at rate of 250% over the next three years. The free cash flow growth will help the company increase dividends or repurchase shares.

Debt:

dbt to equity

Halliburton’s debt to equity ratio has fallen for the last few years, and touched 31% in FY12. With the current share buyback program and issuance of debt, the ratio is estimated to rise to 64.8% by the end of 3QFY13.

Risks:

Halliburton’s revenues are entirely dependent on E&P spending and E&P spending is more or less dependent on crude oil and natural gas prices. Thus the volatility of oil and gas prices poses significant risks to oil equipment and services industry.

Geographical diversification is an issue as well: North America is the main source of Halliburton’s revenues and earnings as it contributes around 55% of its total revenues and 61% of its earnings. Moreover, its main production and construction segment generates around 70% of its revenues from North America. Any potential decreases in drilling permits and rig counts in North America – for example, due to government policies – will have a greater negative impact on Halliburton’s performance as compared to its competitors.

Halliburton’s aggressive share repurchase program has been funded by debt, and the subsequent rise in its debt to equity ratio can make the stock a risky investment. Moody’s has revised its ratings outlook for the company from stable to negative, and the lower credit rating means Halliburton will have to offer higher interest rates to incentivize any future borrowing.

Halliburton has also been under scrutiny for alleged gross negligence in the Gulf of Mexico oil spill incident. Halliburton had been hired by BP for various services, which included cementing the Macondo well: the investigation team for the Macondo incident has reported that “primary cement failure was the direct cause of the blowout”, according to the SEC 10-K filings. When the case is settled, it is expected to have a negative impact on Halliburton’s earnings.

Conclusion:

As Halliburton’s 25% earnings growth translates into cash flows, the company’s outlook will improve. Halliburton’s strength lies in its expertise in new techniques such as hydraulic fracturing, and the cost efficiencies it has achieved through pad drilling. It can use these strengths to secure more contracts in the international market.

The Halliburton management aims to increase the company’s exposure to international markets to around 50%, which will reduce its dependence on the North American market. The company can capitalize international opportunities, such as those present in Saudi Arabia. Considering the growth potential of the industry, which Halliburton leads in terms of its cost-efficient techniques, the stock is a buy.

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