Analysis: SLB

On Friday morning, before the opening bell, Schlumberger (SLB) reported a mixed headline result with its fourth quarter earnings. Revenues of $8.2 billion (flat year over year) topped the consensus of $8.03 billion, and earnings per share ex items of $0.36 (down 25% year over year) matched the consensus.

Before getting into the results, we want to reiterate the importance of management's commentary on the state of the oil markets that go along with its quarterly reports. While the current numbers are always critical to how the business has performed, investors treat management's forward-looking comments on the conference call as canon in their evaluation of the energy sector. Although Schlumberger's management has gotten tougher to trust as of late due to the delayed investment cycle, they are still the industry leaders in their field with the best technology and an ear to the ground on future exploration and production investment flows.

Broadly, Schlumberger CEO Paal Kibsgaard commented on the press release: ""From a macro perspective, the dramatic fall in oil prices in the fourth quarter was largely driven by the US shale production surprising to the upside as a result of the surge in activity earlier in the year, and as geopolitics negatively impacted the global demand- and supply-balance sentiments. The combination of these factors, together with a large sell-off in the equity markets due to concerns around global growth and increasing US interest rates, created a near perfect storm to close out 2018."

"Looking forward to 2019, we expect a more positive supply- and demand-balance sentiment to lead to a gradual recovery in the price of oil over the course of the year, as the OPEC and Russia cuts take full effect; the effect of lower activity in North America land in the second half of 2018 impacts production growth; the dispensations from the Iran export sanctions expire and are not renewed; and as the US and China continue to work toward a solution to their ongoing trade dispute."

"In the meantime, the recent oil price volatility has introduced more uncertainty around the E&P spending outlook for 2019, with customers generally taking a more conservative approach at the start of the year. This will once again push out in time the broad-based recovery in E&P spending that we expected only three months ago."

"However, based on our recent discussions with customers, we are seeing clear signs that E&P investments are starting to normalize and reflect a more sustainable financial stewardship of the global resource base. For the North America land E&P operators, this means that future investments will likely be much closer to the level that can be covered by free cash flow. Conversely, in the international markets apart from the Middle East and Russia, after four years of underinvestment and a focus on maximizing cash flow, the NOCs and independents are starting to see the need to invest in their resource base simply to maintain production at current levels."

"For Schlumberger, this means that even with the current oil prices, we expect solid, single-digit growth in the international markets while in North America land, the increased cost of capital and focus on aligning investments closer to free cash flow has introduced more uncertainty to the outlook for both drilling and production activity."

"In this environment, we have built significant flexibility into our operating plan for 2019, which gives us the means and confidence to address any investment and activity scenario. Furthermore, the foundation for our 2019 plans is a clear commitment to generate sufficient cash flow to cover all our business needs, without increasing net debt. After a very strong free cash flow performance in the second half of 2018, we are confident in our ability to further improve our liquidity position in 2019, through our focus on top-line growth, incremental margins, capital discipline, and careful management of working capital."

As for the specific results by region, on a sequential basis, revenues declined 12% in North America to $2.82 billion, were flat in Latin America at $978 million, grew 1% in Europe/CIS/Africa to $1.842 billion, and increased 2% in Middle East & Asia to $2.464 billion. When we take a look at the full scope of Schlumberger's International business, excluding Cameron, revenue for the second half of 2018 increased by 3%, the first signs of a positive activity trend after three straight years of declining revenues.

By business segment, Reservoir Characterization revenue of $1.651 billion represented a 1% decline sequentially and a 1% increase year over year. Meanwhile, pre-tax operating margin of 22.0% was down 15 basis points sequentially but increased 17 basis points year over year.

Drillings revenue of $2.461 billion represented an increase of 1% sequentially and 13% year over year. However, pretax operating margin was 12.9%, representing a decline of 105 basis points sequentially and 170 basis points year over year.

Production revenue of $2.936 billion represented declines of 10% and 5% on a sequential and year over year basis, respectively. Pre-tax operating margins were pressured too, as the fourth quarter's rate of 6.8% represented a decline of 310 basis points sequentially and 351 basis points year over year. 

Finally, Cameron revenue of $1.265 billion represented a decline of 3% sequentially and 11% year over year. Pre-tax operating margin of 10.0% was 140 basis points lower from the previous quarter and 432 basis points below the fourth quarter's result of 2017.

As for cash, fourth quarter cash flow from operations and free cash flow were $2.3 billion and $1.4 billion, respectively. Both were well ahead of the FactSet consensus of $1.55 billion and $819 million, respectively, and this is a key reason why shares are trading significantly higher on Friday. We continue to keep a watchful eye on cash, and the company ended the year with $2.77 billion in cash and short-term investments, down from about $5 billion a year ago. But more importantly, as Kibsgaard said in the release, the company plans to live within its free cash flows and make its 2019 commitments without increasing debt. Further decreasing cash concerns, capex (excluding multiclient and SPM investments) for the full year 2019 is expected to be $1.5 billion to $1.7 billion, which is about 27% lower than what was spent in 2018. This should further ease fears that the dividend is at risk.

Putting it altogether, the upside in cash flow, the pledge to not increase debt, and the capex flexibility (which we've previously suggested management has) should help investors gain comfortability with the sustainability of the dividend, which was put into question during the stock's precipitous drop in the last quarter of 2018. During the call, CFO Simon Ayat reiterated that "profit is an opinion, but cash is a fact," as he highlighted the $3.2 billion of cash returned to shareholders in 2018 through dividends and buybacks

Overall, we believe the main takeaway from the quarter came from the positive cash flow commentary. Since the direction of oil prices has gotten more volatile and harder to predict, investors needed greater certainty that the dividend would be sustained. We think management accomplished just that as they provided a convincing tone on flexibility, even as earnings have appeared to reset in this new-age oil environment where the U.S. has taken over as a top producer. Shares are outperforming in early trade Friday, and we reiterate our TWO rating.