Over the past twelve months, Halliburton (NYSE: HAL) was on a tear, giving a total yield of 78%. This outperformed Schlumberger (SLB) by around 2,500 basis points and Helmerich & Payne (HP) of about 1000 bps. For context, the S&P 500 has “only” gained about 12% during this period. In fgeneral, the company‘s capitalization on digital upscaling (it is a leading software provider in oilfield services), capital efficiency and breadth of product lifecycle of the well have borne fruit. With 58% of its revenue generated internationally, Halliburton also benefited from improved margins. Strong operational execution and improving economics drove outperformance.
According to data from Seeking Alpha, the street is very bullish on the stock. 13 out of 27 analysts rate the stock as a “strong buy” and 8 rate it as a “buy”. Even as the stock plummets, the Street has grown increasingly optimistic about its prospects. At the start of last year, the street was roughly split, with 50 per cent rating Halliburton as a ‘take’. At 16.9x forward earnings, the stock is trading at a premium to industry leader Schlumberger (16.3x). Halliburton has slightly weaker operating margins of 11.8% (compared to SLB’s 12.1%) but has a healthy balance, as evidenced by the 1.8 quick ratio. All things considered, the PEG ratio at 0.39 suggests activity is heavily discounted for all the macro uncertainty in Oil & Gas.
DCF analysis indicates fair valuation
To get an idea of the intrinsic value of the company, I performed a DCF analysis. No DCF analysis can provide a perfect picture of future shareholder returns; however, they can provide an illustrative “story” of the likelihood of different scenarios. I projected 20% growth in 2022, in line with Street’s forecast, decreasing to 5% by 2026. I assumed margins would grow at a minimum of 200 basis points in 2026 to 13.5% . Capital expenditures, increase in net working capital, depreciation and taxes have been stabilized for simplicity. By 2026, I have an EBITDA of just under $5.0 billion.
Assuming a terminal EBITDA multiple of 9x and a discount rate of 7%, the stock is more or less correctly valued. Over the past 15 years, the stock has generally traded in the 7-12x range, so I think my estimate is reasonable. For context, Schlumberger has generally traded in the 10-12x region, so there is material room for upside if Halliburton continues to widen towards its larger counterpart.
Looking at the sensitivity analysis, it’s a mixed bag. Unfortunately, Halliburton has a high beta of 2.43, which reflects its greater volatility against the broader macro environment as upstream producers cut and ramp up production. Don’t just think that the price of oil over the past two years is an aberration; this commodity swings unpredictably, and both stock traders and would-be commodity traders have been mistaken in their predictions of the future. With that in mind, I would look at a wide range of multiples to get a sense of valuation returns. With an exit multiple of 7x, the stock is about 19% down vs. 21% up if it nears Schlumberger’s historical range. In light of the 7% annualized returns implied in my discount rate, I think this makes the risk/reward ratio, at first glance, at least favourable.
There are several factors that I believe will cause Halliburton to continue to outperform. Beyond the continuous earnings beats, the company is playing a huge role in upgrading its technology. The launch of Halliburton 4.0, with subsurface, well construction, reservoir recovery and enterprise technology, will allow operators to optimize capacity and automate drilling. With many shale plays maturing, operators are under increasing pressure to actually generate positive free cash flow. By leveraging its strength throughout the life cycle of the well and translating it from drills and pressure pumping into technology, Halliburton could justify multiple expansion. In 2021, the company brought more than 50 new technologies to market, including the iStar smart training assessment platform.
The company must also improve its free cash flow conversion and demonstrate its ability to increase its margins in a competitive environment. Management aims to reduce capital expenditure to 5-6% of revenue by changing portfolio composition and increasing asset velocity, but that remains to be seen. In the fourth quarter, the company increased operating margins in its flagship Completion and Production division to 15% as business improved to offset inflationary pressures.
Finally, I am also optimistic about the company’s international potential. Drilling activity is ramping up overseas and Halliburton has unique potential in specialty chemicals and artificial ancestry. The pipeline of opportunities in this segment is a longer cycle and comes with a further increase in improved margins. These should help broaden Halliburton’s multiples further.
With a sky-high beta of 2.43, Halliburton is not for the faint-hearted. This is a stock that lost 75% of its value in the first month of the pandemic in March 2020. Yes, that’s ancient history, and the stock has grown eightfold since then, but the geopolitical environment remains very precarious.
This is particularly concerning given the company’s indebtedness. The company has total debt of $10.3 billion for a debt to EBITDA ratio of approximately 4.0x. Add to that low operating margins and a general oversupply of pressure pumping technology, and the company has significant headroom for downside. the previous company investments in deepwater equipment in the early 2010s proved poorly timed, and a stark reminder to investors of that round.
Halliburton is a risky stock, but with today’s highly exploitable international growth catalysts, technology expansion and margin expansion, I believe it is more upside-positioned. I wouldn’t recommend Halliburton to investors looking for a quick win or a great ‘value play’, but I think it could be a good long-term winner for those willing to weather the storm in the over the next ten years. Performance will continue to be volatile, but the secular tailwinds are there for Halliburton to continue to broaden its portfolio mix and steal shares from Schlumberger. In the process, I think he is able to expand the multiples further and bring some back on the fence who have been spooked over the past two years.