Top Service Stocks, 2009

?Weatherford International is attractive in part because it has a growing share of business in markets outside the U.S., according to Dan Pickering, co-president and head of research for Houston-based Tudor, Pickering, Holt & Co. Securities Inc.

T?his is not going to be a gangbuster year for energy stocks, says Dan Pickering, co-president and head of research for Tudor, Pickering, Holt & Co. Securities Inc. in Houston. “If 2008 was the ‘Year of Extremes,’ 2009 will be the ‘Year of Moving Sideways.’”

View analysts' comments on their outlook for the oil and gas industry

Amidst the volatility in commodity prices, there will be “intermittent waves of joy and angst among investors, while providing trading opportunities for the bold and/or the short-term oriented.”

Don’t be surprised to see stock prices fluctuate 20% to 40%, and the oilfield-service sector return to 2008-like lows beginning this summer and fall, particularly “when gas storage is likely to be full and spot-market gas prices are pressured well under $5,”?he adds.

Pickering is among research analysts with seven firms who were polled on their top service-stock picks for 2009. Weatherford International Ltd. (NYSE: WFT) was picked five times, among 20 service companies named, or mentioned, by the analysts.

Weatherford International Ltd. Weatherford, which provides mechanical solutions, technology and services for drilling and production, has a growing share of business in markets outside the U.S., Pickering says, for E&P customers looking for service providers other than the “Big Three”—Schlumberger Ltd., Halliburton Co. and Baker Hughes Inc.

?Precedents of three major 40% to 50% rig-count declines during the past 20 years suggest that only a 20% decline in rigs at work may be a best-case scenario relative to the recent 71% sell-off in the OSX, says Pritchard’s Mark Brown.

Having paid off a great deal of debt with cash flow, Weatherford doesn’t have any notes maturing for a few years, he adds. Worthy of note, however, is that its stock price may be affected this year by a short-term investor flight as the name may be dropped from the S&P 500 index, due to it moving its headquarters to Switzerland for an improved tax-liability profile. Some fund managers will not be able to buy the stock, and some individual index players will overlook it.

Pickering has a $25-plus target price on Weatherford shares.

Calyon Securities (USA) Inc. oil-services and -equipment analyst Mark Urness has a $17 target. “Weatherford enjoys leading market positions in several oilfield segments, including artificial lift, casing and tubing services, cementation products, and rental and fishing services,” says Urness, based in New York.

“Helping to drive above-trend revenue and earnings growth in coming years will be its focus on products and services for unconventional oil and gas E&P in North America, leveraging its infrastructure in the Eastern Hemisphere and pulling through products and services acquired recently from Precision Drilling, and developing new technologies to enhance its organic growth opportunities.”

Michael Urban, director of oilfield-services and -equipment research for Deutsche Bank Securities Inc. in New York, says his $26 target for Weatherford shares is based on a historical peak multiple applied to estimated 2009 earnings, assuming these are peak earnings.

“We believe late-2008—for North America-leveraged names—or early 2009—for international-leveraged names—earnings will be peak earnings for the service companies in the current cycle.” Risks to Weatherford’s performance include its execution of and the pace of market acceptance for its new-technology offerings, its ability to reduce costs and improve efficiency in the face of rising materials costs, and its execution on its huge international ramp-up.

Land drillers, equipment manufacturers and production-service companies were major beneficiaries in past cycle upswings, says Pritchard Capital Partners’ Mark Brown. Offshore drillers and other companies with Gulf of Mexico exposure also had strong returns.

James C. Crandell and James C. West, oilfield-services analysts for Barclays Capital (formerly with the Lehman Brothers energy- research group, which Barclays purchased in 2008) in New York, have a $26 target on Weatherford shares.

“Weatherford has been the most aggressive company in expanding its international business, both through acquisitions and through internal growth—supported by high R&D spending. This should allow the company to show superior revenue growth to its peers internationally through the anticipated slowdown.”

Its net debt to total capitalization is 35%. “However, liquidity is strong with cash and borrowing capacity of $1.7 billion. In addition, the company can materially cut back on its capex and pull money out of working capital,” West and Crandell add.

Mark W. Brown, senior research analyst for Pritchard Capital Partners LLC in New York, has a $26 target for Weatherford. “We assume revenues will decline 20% in North America and be flat in international markets in 2009.”

In anticipation of reduced revenues from operations in North America, Weatherford is reducing its capex in the region some 30%. “As a result, the company expects to be free-cash-flow positive by approximately $500 million in 2009,” Brown says.

More top picks

Also receiving multiple citings are Halliburton Co., Cameron International Corp., Diamond Offshore Drilling Inc., Nabors Industries Ltd., Oceaneering International Inc. and Schlumberger Ltd.

Halliburton Co. Ben P. Dell, senior E&P and oilfield-services analyst for Bernstein Research in New York, favors Halliburton (NYSE: HAL), which focuses on completion/production and drilling/evaluation, due to its exposure to the U.S. gas market. He has a $23 target on the stock.

“While domestic drilling activity is set to slow dramatically, Halliburton is a provider of high-end well-stimulation and directional-drilling services and, thus, faces less downside, compared with that faced by lower-quality service providers,” he says.

“More importantly, the cyclicality of the domestic gas market is chronically underappreciated, and the reduction in activity, which will precipitate the next upswing, is unfolding.”

Barclays Capital’s Crandell and West have a $31 target on the shares. “Halliburton has been successful in profitably growing its international drilling and evaluation business.” This record will persist and help to balance reduced revenue it may experience from declining U.S. demand for pressure pumping.

Halliburton’s debt is 27% of total capitalization, they add. “However, the company has nearly $1 billion of cash and should generate in excess of $1 billion in free cash flow in 2009.”

Cameron International Corp. Calyon’s Urness has a $32 target on shares of Cameron (NYSE: CAM), which specializes in pressure- and flow-control equipment and has a 12% share of the subsea-equipment market. “There have been some recent concerns surrounding subsea market growth in 2009,” he adds.

“We believe these concerns are unfounded and the subsea market will continue to grow rapidly. The price of subsea packages has doubled during the past two years to close to $20 million per subsea tree and this has added to the company’s revenues.”

West and Crandell have a $38 target on Cameron shares. “While Cameron’s distributed-valve, surface-wellhead and centrifugal-compressor businesses could feel some impact from a steep downturn in North American E&P spending and a stabilization internationally, it would be muted and offset largely by strength in its subsea and BOP (blowout preventor) businesses.”

They add that Cameron has $1.4 billion of cash on hand—roughly equal to its debt—and its reduced capex in 2009 will result in throwing off more cash.

Diamond Offshore Drilling Inc. Urness and Deutsche Bank’s Urban also pick Diamond Offshore (NYSE: DO). The company has 43 drilling rigs in the Gulf of Mexico and in waters elsewhere, and it is the second-largest deepwater operator, “which puts the company in a very good position to benefit from the strength of this segment, in which rigs are receiving long-term commitments at record high dayrates,” says Urness, who has a $95 target on the stock.

Urban has a $79 target on the stock. “The biggest risk to this story is the company capping, cutting or suspending the cash-distribution policy. A further commodity-price correction and deterioration of deepwater rates as new supply enters the market—particularly given Diamond Offshore’s older-than-average fleet—is an additional risk,” Urban says.

Oceaneering International Inc. Crandell and West, as well as Urness, cite Oceaneering International (NYSE: OII) among their favorites. The underwater-services contractor focuses on deepwater ROVs (remotely operated vehicles) and subsea products. Urness has a $36 target on the stock.

“With 90-plus deepwater rigs under construction, we expect the market for ROVs to remain robust,” Urness says. “Subsea support and construction vessel demand also remains strong.”

Increased demand will require new construction, including by Oceaneering, he says.

Crandell and West, who have a $59 target on the stock, add, “Oceaneering derives 70% of its revenue from two segments—ROVs and subsea products. Much of the remainder is tied to subsea installation and inspection. The company is thus tied into two of the most attractive themes in the oil-service business: deepwater and subsea completions.”

They add that the company is one of the few they cover that may have increased earnings in 2009, primarily driven by the ROV business. While debt is 22% of its total capitalization, its capital requirements are not substantial, they add, and the company is expected to generate $130 million of free cash flow in 2009.

Schlumberger Ltd. Pritchard Capital’s Brown has Schlumberger (NYSE: SLB) on his short list, with a $75 target, citing its limited exposure to North American E&P capex. It holds the strongest credit quality among the large-cap oilfield-service firms. “Despite the anticipated adjustment to Street earnings (forecasts) to reflect the risks to customer spending going forward, Schlumberger will hold up better than most peers due to its defensive characteristics.”

Schlumberger was among the first service firms this fall to caution investors on going-forward expectations. “Schlumberger’s cautious tone marks the beginning of a period in which oilfield-service companies will manage down-cycle expectations,” Brown says.

The company’s North American revenues may decline 10% this year, but revenues from its international operations may post growth—as much as 10%—due to national oil companies’ spending commitments.

Additional gems

Thirteen more service companies are cited once or more by the analysts as among firms that may fare better in 2009 than their peers: Patterson-UTI Energy Inc., Smith International Inc., Baker Hughes Inc., Core Laboratories NV, Dril-Quip Inc., Ensco International Inc., Exterran Holdings Inc., Hornbeck Offshore Services Inc., Pride International Inc., Smith International Inc., Superior Energy Services Inc., Tidewater Inc., Transocean Ltd. and Willbros Group Inc.

Offshore drilling and construction capture a combined 26% of E&P spending on oilfield services, representing the largest share of any type of offering, notes Calyon Securities (USA) Inc.’s Mark Urness.

Bernstein Research’s Dell says, “While the dynamics for land drilling are currently weak we also believe this is now fully discounted in the stock prices of both Nabors and Patterson (Nasdaq: PTEN), both of which we also rate Outperform.” On Nabors, Dell has a $36 target; on Patterson, $28.

Urness has a $33 target on Smith International (NYSE: SII), which provides drilling and completion fluids, waste management, solids-control equipment, drillbits, downhole tools and distribution services, through its M-I Swaco, Smith Technologies, Smith Services and Wilson businesses.

“The company’s Eastern Hemisphere and Latin American service contracts give it good visibility for the next two to five years.”

Urban cites gas-compression company Exterran Holdings (NYSE: EXH) and has a $35 target on the stock. “We value Exterran on a sum-of-the-parts basis, adding up the value of its ownership in Exterran LP, the value of future dropdowns into the MLP, the value of its general-partner interest and applying a peer-group multiple to the ‘stub,’ consisting of the international compression segment as well as Exterran’s fabrication, aftermarket and total-solutions businesses.”

Crandell and West add Dril-Quip (NYSE: DRQ), for which they have a $48 target. The company designs and manufactures offshore drilling and production equipment for deepwater, harsh-environment and severe-service applications. “The company has had a successful history of innovation, and has introduced 16 products in the past 27 years that are well respected in the industry,” the analysts note. And, it has a relatively small amount of debt and about $109 million in cash.

“We estimate operating cash flow for 2009 and 2010 of $130 million and $135 million, respectively, with capex for both years of roughly $50 million.”

They also cite Tidewater (NYSE: TDW), the largest owner and operator of offshore supply vessels. The target price is $59. “We expect utilization to remain high and dayrates strong for Tidewater’s supply-vessel fleet. The 57 vessels under construction are forecast to contribute more than $4.50 to earnings per share, and the company’s strong balance sheet gives it the flexibility to buy additional vessels or groups at attractive prices.”

Pritchard Capital’s Brown has Hornbeck (NYSE: HOS) on his list. “Ongoing inhibition of supply growth due to financing constraints or scrapping of marginal vessels should benefit Hornbeck.”

Spending on land drilling and offshore construction will fall in 2009, while the offshore-drilling, subsea-equipment and rig-equipment sectors will experience growth in receipts, says Calyon Securities (USA) Inc.’s Mark Urness.

And, Brown likes diversified firm Superior Energy Services (NYSE: SPN), citing its healthy balance sheet, strong cash flow and growth catalysts. “We see potential upside from hurricane-related liftboat work, specialized well-intervention projects and deepwater growth opportunities. Although the stock is sometimes miscast as a narrow Gulf of Mexico play, we believe the (price) multiple will expand as Superior gets credit for its revenue diversification.”

Construction firm Willbros Group (NYSE: WG) is another of Brown’s favorites for 2009. He calls it a “unique late-cycle play that should outperform even if North America experiences a natural gas oversupply.

“There is an overwhelming need to build pipelines and related infrastructure to transport oil and gas from producing zones to consuming markets. Even if commodity prices remain pressured, new shale-play developments are altering the map of where pipelines are needed to take incremental oil and gas to market, and this should benefit Willbros in the years to come.”

Tudor, Pickering, Holt’s Pickering, who picked Weatherford, also likes Baker Hughes (NYSE: BHI), with a $60-plus target.

“The stock has been a laggard over the past couple of years as Baker Hughes has had slower international growth than its large-cap peers,” he says. “As part of an expiring Foreign Corrupt Practices Act settlement, Baker Hughes revamped its international-distribution efforts by replacing third-party agents with its own personnel.

“This has been an expensive and time-consuming process, but one that ultimately gives Baker Hughes more control of its own destiny.”

?Investors should have exposure to both land and offshore sectors, says G. Allen Brooks, managing director of Parks Paton Hoepfl & Brown, Houston.

G. Allen Brooks, managing director of Parks Paton Hoepfl & Brown in Houston, cites some of these stocks, and a few more.

“Given the industry and stock market environment we foresee in 2009, we would favor oilfield-service companies that offer technological products, services and knowledge in finding, developing and enhancing recovery of oil and gas resources.”

These companies include Core Laboratories (NYSE: CLB), Halliburton and Schlumberger. “All three have large international exposure that tends to be less disrupted by commodity-price changes and credit-market turmoil.”

As for drillers, investors should have exposure to both land and offshore sectors. Nabors is his land-driller pick due to its geographic spread and its modern and technologically sophisticated rigs. Offshore, he likes Transocean (NYSE: RIG) for its deepwater exposure. However, he also notes the impact of its headquarters move to Switzerland.

Other offshore drillers of interest are Pride International (NYSE: PDE) and Ensco International (NYSE: ESV), he adds, each having high-quality equipment and shifting fleet compositions—Pride through the possible split-off of the company’s shallow-water fleet and Ensco with its growing floating-rig fleet.

In summary

Brooks makes several points oil-service-stock investors should recognize. First, earnings estimates for the companies probably have not been reduced sufficiently to reflect how difficult the 2009 business environment may be, making the stocks not as “cheap” as many investors believe, he says.

“Second, energy stocks tend to be better stock-market performers in the spring. We attribute that performance to investors feeding off winter weather and the earnings leverage of the companies to offer investors the potential of a high-octane bet in their portfolios early in the year, which could help them outperform their measurement bogeys.”

Also, oil-service stocks tend to rise well ahead of the improvement in company earnings and often even before industry fundamentals improve.

“Lastly,” he concludes, “the sector’s liquidity is limited by a number of large-market-capitalization companies offering the potential of an explosive price rise if money managers embrace the industry.”