Following the completion of the Smith International Inc. (SII) merger, we maintain our Neutral recommendation for Schlumberger Limited (SLB) shares as we believe that the investment case has not changed to that tune. While the merger diversifies the company’s offerings, the gap with its competitors have been reducing significantly in recent times.
Schlumberger’s closest competitor, Halliburton Company (HAL), has been actively engaged in international expansion and Baker Hughes’ (BHI) acquisition of BJ Services is commendable.
We believe Schlumberger will continue to benefit from its strong international market position, current uptrend in oil prices that will likely compel operators to maintain their spending levels, as well as from its dominant position in the Middle East/Far East. Assuming continued improvements in worldwide economic conditions, we also expect the company’s international activity levels to accelerate later in the year and in 2011.
The company’s extensive product base and leading technology portfolio will also continue to add value for customers by improving their drilling time through downhole information and efficiencies. Further, the Smith acquisition will augment Schlumberger’s product portfolio and strengthen its technological capabilities required to optimize customers’ drilling plans.
Schlumberger maintains a strong balance sheet with cash balance of $3.1 billion and debt-to-capitalization ratio of 18.4% as of the end of the second quarter. We expect the combined company to generate an excess of $2 billion in free cash flows in 2010 and even more beyond that.
However, given the company’s large international leverage, earnings volatility associated with operations in politically unstable regions (such as Nigeria and Venezuela) could negatively weigh on the stock. Moreover, we remain skeptical on natural gas activity as we believe the market remains oversupplied, with capacity increasing in 2010.
Although the Smith acquisition will benefit the combined company from a product portfolio perspective, the deal will not be accretive before 2012. Additionally, a renewed downturn in oil prices could negatively affect exploration spending, on which the company largely depends.
Considering all these, we expect the stock to perform in line with its peers and the broader U.S. market in the upcoming quarters.