Top Service Stocks, 2010

Energy analysts say 2010 will be a year of recovery for the oilfield-service sector. Last year, the majority of service stocks performed well, as the U.S. and international rig counts recovered from disastrous lows. Can that strong performance be repeated in 2010?

Some analysts expect names with strong domestic exposure will gain traction as activity in the shale plays rises. Others look to international and deepwater markets to support long-term growth. Yet, all agree that 2010 will bring increases in energy demand, driving service needs for exploration, drilling and production.

Energy Information Administration (EIA) statistics support the growth story. According to its recent report, energy demand will be supported by rising gross domestic product (GDP) and higher commodity prices. Real U.S. GDP will increase by 2% in 2010 and 2.7% in 2011, while world oil-consumption-weighted real GDP will grow 2.5% and 3.7%, respectively.

That economic growth will drive oil prices. The price for West Texas Intermediate is expected to average $76 in March, rise to $82 in late spring and settle near $85 by next winter.

Total natural gas consumption is expected to remain relatively unchanged in 2010 and increase by just 0.4% in 2011. This slight rise will be met with an estimated 3% decline in 2010 production, according to the EIA. The estimate is based on steep decline rates of newly drilled shale-gas wells and the lagging effect of reduced drilling activity in 2009. Together, these factors will cause an increase in the annual average Henry Hub spot price to $5.36 per thousand cubic feet for 2010 (an increase of $1.30 from 2009) and to $6.12 in 2011.

Should the forecast hold true, analysts say oilfield-service providers will begin to see demand for drilling and associated services recover, and will likely enjoy higher margins as a result.

Even Houston-based Halliburton Co. (NYSE: HAL), despite being one of the largest providers, was hard hit by the downturn and resulting overcapacity of service-company capabilities. Nonetheless, the company’s stock is a top pick by analysts. Other favorites include Weatherford International Inc., Ensco International Plc, Key Energy Services, National Oilwell Varco and Noble Corp. Here are more details on the five analysts’ picks.

“We think that Halliburton managed the North American downturn better than any of its peers,” says Bill Sanchez, Houston-based senior oilfield service analyst and co-director of research for Howard Weil Inc.

Halliburton Co. “We think that Halliburton managed the North American downturn better than any of its peers,” says Bill Sanchez, Houston-based senior oilfield-service analyst and co-director of research for Howard Weil Inc., an energy-investment boutique headquartered in New Orleans. “It has a distinct competitive advantage with its bundled services, which should lead to outsized margin expansion.”

Also, Halliburton “has a meaningful international presence,” says Sanchez, referring to its North Sea, Brazil and Middle East footprints. Due to its global operations and long history (it was formed in 1919), the $31-billion market-cap company has become one of the bellwether service names in the global market. Yet, after a 66% return in 2009, the stock “could experience some near-term headwinds,” he says.

“Because Halliburton is a favorite of many institutional investors, there is a danger of disappointment in the trajectory of its business recovery that could cause the stock to come under pressure,” says Sanchez, who forecasts a $42 target price for the shares in 2010.

Greenwich, Connecticut-based Weeden & Co. senior energy analyst Geoff Kieburtz also has a $42 target price on Halliburton. “There are several key factors contributing to the company’s success,” he explains. “It has built a track record of profitable growth over the past several years; it has done a superior job of protecting profitability; and it is at the top of its peer group due to growth and return on capital invested. We think that will continue to be the case as the industry cycle starts to turn upward in 2010.”

Kieburtz notes that, in addition to being a strong provider of drilling services and technologies, Halliburton is a leading provider of pressure-pumping service with a strong position in North America. “It benefited from the changing mix of drilling techniques and the current increase in demand for hydraulic-fracturing services for unconventional gas resources,” he says, and notes that isolated instances of pricing improvement in the fracing market will also benefit the company.

“The major risk for Halliburton would be a double-dip recession causing a decline in oil and gas demand. That could certainly take the wind out of its sails,” he says. Conversely, should legislators add stricter safeguards to fracing procedures, such regulations would likely favor Halliburton as a leading solution-provider.

Angie Sedita, New-York based managing director for UBS AG, also taps Halliburton, with a $42 price target, as her top stock pick for this year.

“Halliburton is clicking on all cylinders,” she asserts. “It is gaining share in the international markets while maintaining a strong presence in the North American market, which is beginning to recover. The company also has steadily gained market share in key product lines such as drillbits, fluids, wirelines and completions. It is well positioned for the long term. Even the expected moderate improvement in U.S. natural gas drilling will provide some tailwind for the company.”

However, she cautions, Halliburton could be challenged if it shows slower-than-expected margin improvement in international markets.

Weatherford International Ltd. Sedita picks Houston-based Weatherford International Ltd. (NYSE: WFT) as her other favorite. She gives the $13-billion market cap a target price of $24, saying it has been a top performer in international growth-rate charts.

“For the 2009 to 2012 period, I think it will grow its earnings by 40% to 45%, versus its peer group, which is showing about 20% growth. Weatherford has historically grown its bottom line more than its peer group, especially during the past three years, driven predominately by international expansion.”

Although Weatherford has a compelling story, it has some risk due to its operations in Mexico, where contract awards have slowed, she says. The company is focused on Chicontepec Field in northern Mexico, going head-to-head with Schlumberger, which has been working there since mid-2007. Weatherford entered the play in mid-2008. Both companies have already learned the ropes in an area industry experts describe as one of the most difficult oil projects on land, worldwide.

“The main risk to Weatherford’s success is the challenge it faces in Mexico,” says Robert MacKenzie, managing director for Arlington, Virginia-based FBR Capital Markets Corp.

Managing director for Arlington, Virginia-based FBR Capital Markets Corp., Robert MacKenzie, while also selecting Weatherford as a top pick, is also concerned about the service firm’s Mexican operations.

“The main risk to Weatherford’s success is the challenge it faces in Mexico,” he says. “Pemex is unhappy with its production results in its Chicontepec Field. Weatherford is participating as a turnkey driller in that development.”

Pemex has yet to identify a plan for restructuring that operation, but MacKenzie’s analysis shows that, based on which wells have been successful, Pemex might take a more sophisticated approach and apply more technology.

“By spending about $1 million more per well, it could boost production as much as five to 10 times per well,” he says, adding that the Mexican oil company will have a choice of providers when current contracts expire.

“Included in any change of operations is an uncertainty of choice of suppliers,” he says. “This poses a risk for Weatherford, if it loses part or its entire share of work during the reshuffling. The Mexico operation represents about 23% of Weatherford’s income.” On the other hand, the reshuffling might favor Weatherford with an opportunity to gain a greater share of work and higher-margin, high-technology sales, he says.

In addition to challenges in Mexico, Weatherford must build up its Russian operations, the analysts say. In May 2009, TNK-BP announced the sale of its oilfield-services enterprise to Weatherford.

Says Sedita, “I think it will take time for the Russian TNK acquisition to grow into the revenue expectations that have been put out to the investment market. I think Russia will have moderately slower growth in 2010 than is generally expected.”

MacKenzie agrees, but sees opportunity in the acquisition as well. “Weatherford acquired TNK-BP’s service business at the trough of the downturn of Russian oil service at an excellent price. Now there is tremendous potential to capture market share using that business as a foundation to start doing more work for other operators in the region.”

Sedita also looks for improvement in Weatherford’s capital discipline. “The company has a heavier balance sheet than its peer group. The market, including myself, is eagerly hoping the company will show some improvement in its working-capital management in 2010.”

MacKenzie thinks it will, saying, “We believe, based on investments and acquisitions the company has made, that its revenue and earnings will grow faster than its peers between now and 2011. We expect its EBITDA (earnings before interest, taxes, depreciation and amortization) to grow 64%, versus its large-cap peers’ growth of 41%.” He gives Weatherford a target price of $38.

Ensco International Plc MacKenzie picks Dallas-based Ensco International (NYSE: ESV) as another top stock for 2010, with a target of $66, because he sees the company “putting rigs back to work,” especially during the latter half of the year.

“We also see them as recipients of recovery in pricing as the jackup market has passed the trough of the rig cycle. While recovery will be slow, given the overcapacity present this year, it will begin in earnest late this year and proceed through 2011.”

In January, Ensco International took delivery of Ensco 8502, the third of seven ultra-deepwater semisubmersible rigs built by Keppel FELS Ltd. in Singapore. After mobilizing to the Gulf of Mexico, the rig will commence a two-year drilling program for a subsidiary of Nexen Inc.

MacKenzie predicts the $6-billion market cap’s stock will rise in anticipation of a rapid recovery in earnings. The risk to such a scenario is a possible oversupply of new rigs beginning to be delivered from shipyards. The current excess capacity is a result of demand decline driven by the recession, rather than oversupply, he says.

FBR data show that, through 2009, demand was equivalent to supply on a forward-looking basis, even with new deliveries. The analyst concludes that when spending recovers, some rigs will ultimately be put back to work. But not all rigs.

MacKenzie prefers oil-focused rigs and advises investors to avoid rigs stocks heavily weighted to gas, despite recent reports of as much as a 12% increase in U.S. E&P spending, which he calls “misleading.”

He predicts that all of the increase, “and then some,” is going to deepwater drilling in the Gulf of Mexico and onshore drilling for oil. Gas-focused spending is likely to be down from 2009 by 7% to 13%. “We base that on announced budgets that we’ve seen,” he says.

“Is there enough demand to soak up all the new builds as well, in 2010?” he asks. “With all the projects around the world, it is not a huge stretch to think we can get there. Particularly if some of the rigs that have been cold-stacked or mothballed do not return to work.”

MacKenzie explains that most rig suppliers that have cold-stacked rigs tend to be disciplined about bringing them back, to avoid cannibalizing the return generation of their working rigs.

“For example, Transocean (Ltd.) was very proactive in cold-stacking jackups as they became idle during the downturn,” he says. “That company almost single-handedly prevented jackup day rates from bottoming lower than $100,000 per day. They are now near $120,000 per day, well above the cash costs of $50,000 per day.”

Judson Bailey, managing director in Jefferies & Co. Inc.’s Houston office, picks Ensco International Plc as a top stock, but cautions, “They could be challenged if the jackup market becomes soft in some markets during the coming year.”

Judson Bailey, managing director for New York-based Jefferies & Co. Inc., also lists Ensco as a top pick.

“Our Ensco target price for 2010 is $57. Ensco has abundant free cash flow and earnings growth,” he says, adding, “They could be challenged if the jackup market becomes soft in some markets during the coming year.”

Other top picks. Bailey’s other top pick is Sugar Land, Texas-based Noble Corp. (NYSE: NE) with a target price of $53. The $11-billion market cap is a hybrid provider, leasing both jackups and deepwater rigs. While its stock has underperformed in the past, the price has increased more than 100% since March 2009.

Noble has a fleet of 63 mobile offshore drilling units and provides labor contract drilling, engineering and consulting, and project management services. It diversifies risk exposure by operating in the U.S., Middle East, India, Mexico, the North Sea, Brazil and West Africa.

Despite the market’s current optimism, Bailey advises investors to be selective. “Oil-service stocks, overall, nearly doubled during 2009, so the easy money has been made. Investors should seek service companies that outperform.”

Sanchez names Key Energy Services (NYSE: KEG) as a top performer, giving it a target price of $13. “Key is the largest player in the U.S. well-service-equipment market based on asset market share,” he says. “It is well positioned for the coming recovery of oil-service fundamentals.”

Sanchez sees opportunities this year for Key’s $1-billion market cap to grow via market gains in utilization and pricing. Some of the company’s other product lines, such as pressure pumping, fluids and a rentals business, will also support its growth. While those businesses were soft in 2009, Sanchez expects “marked improvement” in 2010.

“It also has a strong well-service presence in Mexico. Given the country’s challenges in growing its production, we think well services will be a growth opportunity for Key and a source of strength for its financials. The risk to its execution will be a pullback in oil and gas prices and a contraction in E&P spending.”

The analyst’s other top pick is $6-billion market cap, Houston-based Smith International Inc. (NYSE: SII) with a target price of $36. “We like this stock because the company’s share price was a notable relative underperformer in 2009, compared to other diversified service companies,” he says.

Since Smith acquired Houston-based W-H Energy Services Inc. in 2008, the service provider has had a more U.S.-intensive onshore revenue stream than before. As a result, its rig-count-sensitive business segments, such as directional drilling, coiled tubing, and cased-hole wireline, “really suffered in 2009,” says Sanchez. With a rig-count recovery under way in North America, the reverse could be true this year. Also, Smith has a significant presence in the deepwater fluids market, a sector with substantial growth potential.

“We see that segment continuing to strengthen in 2010 as newbuild deepwater rigs come into the market,” he says, adding that the company’s challenge will be to reverse poor quarterly-earnings returns it has posted since the downturn.

Weeden & Co.’s Kieburtz chooses Houston’s National Oilwell Varco (NYSE: NOV) as a top pick, with a $60 target, due to its market position, opportunity for growth, and cash flow. The $19-billion market cap leads in rig technology and is the largest provider of drilling packages for deepwater rigs, he says.

“We think the deepwater market is one of the strongest segments of the industry. We believed that even through the downturn during the past year and a half,” he says.

Kieburtz explains that deepwater drilling has continued to grow because the universe of land and offshore drilling rigs consists of equipment that is 20 years old or older. From the 1970s through the early 1980s, the offshore rig count increased from 100 to 650 worldwide. He expects a replacement cycle to materialize during the next few years, which would benefit National Oilwell.

“National also has a services-and-supply portfolio where it is a leading provider of consumable capital equipment such as mud systems, metering and top-drives,” says Kieburtz. As drilling activity recovers, he predicts demand will grow for National’s products, driving the company’s sales volumes and margins.

“The third piece of this is the company’s strong cash flow. It has ample resources to pursue its M&A strategy and it has also built a sizable cash balance—so large that it recently introduced a special dividend of $1 per share along with its regular dividend. That move has opened up the stock to a new class of investors who are looking for yield,” he says.