Market Rotates Into Late-Cycle Stocks: Buy Oilfield Services Companies

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The U.S. stock markets seem to be in upheaval this year, yet the S&P is only down 1% year-to-date. So what's going on?

#-ad_banner-#Simply put, we're seeing a rotation in the market -- namely, from growth to value.

In hindsight, this development was easy to predict. We're in the latter stages of an economic cycle, which tends to be characterized by rising interest rates and inflation, combined with lower corporate profit margins. This spells bad news for momentum-based growth stocks, and we've seen the effects of that play out in the past couple weeks.

In an effort to moderate investment risk during cycles like this, investors tend to take a flight to safety, looking for stocks with value, represented by good cash positions, low debt, dividends, low price-earnings (P/E) ratios -- and, of course, earnings growth.

This raises the question: Where exactly should investors be looking right now for safe, value-based stocks?

One of my favorite sectors right now is energy -- specifically oilfield services.

Oilfield service stocks are currently leading the pack in the energy space, spurred on by strong earnings growth and low valuations. Let's take a look at three of my favorite leaders in this field...

Baker Hughes (NYSE: BHI ) is expanding internationally and currently operates in 90 countries. Just more than half its record $22.3 billion in revenue last year came from North America.

Margins are currently expanding in Baker Hughes' Gulf of Mexico projects; and contracting in North American land projects, due to a supply glut which is also affecting its competitors. Is this important? For clarity let's look at consensus earnings growth expectations.

Seeing aggressive earnings growth in a late-cycle stock should please the fund managers and institutions, who've been spoiled in the last couple of years with aggressive growth in biotech and internet company profitability.

BHI's 2014 price-earnings ratio (PE) is 16.0, within a normal range of 11-28, excluding aberrations. And this is where the value shows up. Because undervalued stocks typically have PE's which are lower than their earnings growth rates.

In Baker Hughes, we're expecting earnings growth of 54% this year, and we have a PE of 16. You're rarely going to see a more stunning disparity when measuring value.

But there's another important component to value stocks: debt. I like the long-term debt-to-capitalization ratio to be lower than 40%. Just as you don't want your personal debt to overwhelm your monthly budget, neither do we want a corporation's debt payments to strangle their ability to deploy cash where needed, e.g. hiring employees, building plants, launching new products.

Baker Hughes' long-term debt ratio has been consistently low for a decade at 17-18% per year.

Baker Hughes has not increased its dividend in quite a few years, currently yielding 0.93%. I'd prefer a rising dividend or a large dividend, but the lack of such is more neutral than risk-additive to the investment equation.

Standard & Poor's projects BHI's 2014 return on equity (ROE) at 9.5%; significantly higher than in the last three years. Increasing ROE indicates strong corporate management, and Wall Street agrees, because institutions own 89% of this large-cap growth stock.

Halliburton (NYSE: HAL ) operates in very similar size and scope to Baker Hughes, achieving a record $29.4 billion in sales in 2013, with 52% of revenue coming from North American operations.

Halliburton's fundamentals are very attractive, although none of these numbers are as outstanding as those of Baker Hughes. Wall Street expects earnings per share ( EPS ) to grow 26%, 27%, and 19% in 2014 through 2016 (December year-end). The PE is 15.0, quite low within a normal range of 8-26; and the dividend yield is 1.0%. The 2013 long-term debt ratio is fair at 36%.

For perspective, I'd be happy with any stock where EPS were growing at 15% or more per year, with a low PE and low debt. And the company is also buying back stock -- always a bullish sign indicating balance sheet health. Halliburton bought $4.4 billion of its stock in 2013, and has about $1.7 billion remaining in its repurchase authorization.

78% of the company's stock is owned by institutions.

The stock recently retraced its highs from August 2011, then rose further to the current range of $57 to just over $60. The chart is extremely bullish, with no overhead price resistance. The erratic year-to-year PE ranges make educated price target predictions difficult.

Schlumberger (NYSE: SLB ) is also experiencing margin pressure due to overcapacity within North America, and weakness in natural gas production. Schlumberger is addressing this problem by shifting to higher-end technologies, which afford higher margins.

The company is also more focused on international business than Halliburton and Baker Hughes, with only 31% of revenue coming from North American operations. Schlumberger's international businesses generated margins of 22.2% in 2013, a full 2.5 percentage points higher than its North American operations.

One significant effect of the worldwide economic downturn has been slow corporate revenue growth. In contrast, Schlumberger's revenue has been growing significantly, reaching $46.5 billion in 2013, and expected to continue growing in the low double-digits in 2014 & '15.

And while EPS fell at rivals Halliburton and Baker Hughes in 2012 & '13, Schlumberger's earnings grew aggressively, reaching a new high last year, and projected to continue on an upward trend.

Wall Street expects EPS to grow 19%, 19%, and 10% in 2014 through 2016 (December year-end). The PE is 17.4, within a normal range of 13-27. The dividend yield is 1.6%, with the latest increase taking place on April 11.

Institutions own 78% of SLB shares. The long-term debt ratio is 20.8%.

SLB shares broke past four-year price resistance around $94 on March 25. The chart is bullish, with some long-term resistance at $110.

The company has better international exposure than its rivals, and a higher dividend. The downside is that SLB has less spectacular projected earnings growth, which is why institutions are more bullish on Baker Hughes.

How high could SLB reasonably climb? The stock price reached a PE of 25 (and higher) during eight of the last ten years. A PE of 25 in 2014 would put the stock price at $141.75, based on consensus '14 EPS of $5.67. That would represent a 40% capital gain from today's share price.

Risks to Consider: The oversupply of oilfield services in North America could last for several years, putting ongoing pressure on pricing and profitability. In addition, oil and natural gas prices can be volatile, capital spending decisions by customers can change with a poor economy, and political risk can affect both domestic and international energy markets. In addition, Halliburton is still facing potential legal costs from the 2008 Deepwater Horizon incident. (My colleague Marshall Hargrave took a look recently at the company at the center of the Deepwater Horizon incident .)

Action to Take --> Now is a good time to buy these three stocks, as oilfield services stocks are on a distinct uptrend. Schlumberger represents the best opportunity within oilfield services for investors to maximize capital gains while minimizing risk. Baker Hughes has very aggressive earnings growth, a low P/E ratio and low debt levels. The biggest caveat is three-year upside price resistance near $80, because the stock could easily stop climbing for a while at that point. In light of Halliburton's potential legal liabilities, my suggestion is that only veteran traders invest in Halliburton, using stop-loss orders to protect their capital.





The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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This article appears in: Investing , Stocks

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