Halliburton HAL
December 26, 2006 - 5:54pm EST by
kitkat919
2006 2007
Price: 31.17 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 3,134 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Some conventional wisdom says that going forward, mergers between energy companies will begin to look more attractive than exploration and drilling. Some Wall Street analysts believe that the big companies plan to get bigger and increase proven reserves through acquisition because it will be cheaper than developing existing fields. Whether this is the reason the energy services sector is declining is unclear—but declining in price per share they are. What ever the proven reserves are for any given oil company and whether increases in reserves are acquired, the fact remains that those reserves will have to be drilled and existing wells serviced. Oil and gas services companies are not likely to suffer from lack of business.
 
Halliburton (HAL) is one of those companies. HAL is trading at a discount currently to its peers including Schlumberger, Baker Hughes and Weatherford.
 
Energy services companies are in the business of facilitating drilling and exploration operations. HAL supplies drill bits and downhole tools, directional (including horizontal) drilling support, cementing new boreholes and fluids. And it has a business segment providing software to interpret seismic data. HAL also offers services for existing wells that optimize production and enable recovery of hydrocarbons by secondary means. It involves fracturing and propping open gas and oil reservoirs that trap the hydrocarbons (tight) and acidization to remove solids blocking flow. It does sand control by ingenious filtration and pipeline maintenance. All services that will be in high demand to keep existing wells producing. The good news is that this particular segment accounted for 43% of revenues in 2005. And the remaining three segments make up the following percentages:
 
Fluid systems—28%
Drilling & formation evaluation—22%
Digital & consulting—7%
 
So while new exploration may decline (and I am not convinced), HAL is positioned to continue to grow its well optimization segment.
 
The big event in Halliburton’s life is its pending divorce from the extremely troublesome and very unprofitable KBR. The recent IPO of 19% of KBR did very well.  Shares were offered at $17 per share and now sit at $27. HAL shareholders will get the remaining shares spun off to them in the spring of 2007. The pending IPO and promised spin off sent shares of HAL from $27 in October to $32-$33 in November. But with the recent analyst downgrade of Schlumberger, most of the energy services sector is on the decline again, including HAL. While a few of the other companies perhaps deserved a correction for excessive valuation, HAL still falls into value territory. 
 
KBR has not been a great business for HAL. Halliburton merged with Brown & Root in 1962 and in 1998 acquired Dresser Inc, which brought Kellogg in to the company. The Dresser merger included asbestos litigation, which has been settled at the cost of billions. And KBR has been a never-ending source of alleged criminal activity government disputes. KBR has had continuous run-ins with the US government on a number of contracts and subsequent withholding of payment. This requires HAL to appeal the government actions. Currently there is:
 
$55 million withheld for containerized housing--Iraq
$95 million for dining facilities--Iraq
Much bad press regarding overcharging for services in Iraq
 
And there is an ongoing investigation into bribery allegedly committed by KBR regarding development of a Bonny Island gas liquefaction site. No money is involved yet but the fines could be substantial. Knowing something of the incredibly corrupt Nigerian government this is easy to believe. It will impact KBR I suspect ($2 million per criminal violation and $500K per civil violation)
 
Then there is the bad investment in a profitless overleveraged Australian railway--HAL owns 36.7% interest. HAL took a $26 million Q1 2006; $32 million writedown Q3; and most likely $10 million to be written off in the next few quarters, which takes care of the whole investment.
 
There are more--a faulty blower sold by Root to Newmont Mining, a class action suit regarding an Algerian transaction and overstatement of unapprovable accounts, more bribery to tax officials in Nigeria, some illegal dealings with Iran, a suit by employees in Iraq against KBR for failing to pay time and a half for overtime. Most of these are KBR related and are not likely to amount to significant liquidity crunching awards.
 
HAL has to indemnify the potential fines and charges KBR may incur, but KBR must repay HAL for any expenses. KBR has not been a good partner for Halliburton. Luckily for HAL, all these concerns and potential future expenses leave with KBR. And the bad business decisions and liabilities that have costs Halliburton so much in the past few years will quit draining profits from the company.
 
In spite of Halliburton’s determination to rid itself of KBR, the market does not seem to realize the weight of the stone that will be lifted from HAL’s back. The small gains in price realized when the IPO was announces are now reversing.
 
Besides the legal expense and potential fines accruing to KBR there is the issue of their extremely low profitability that has dragged Halliburton’s bottom line down for years.
 
                     2005  2004  2003
KBR
operating margins    4%    -3%   -1%  
net margins          2%    -3%   -1%
 
 
Halliburton
operating margins    12.7%  4.1%   4.4%
net margins          11.2%  1.9%   2.1%
 
In the most recent reported quarter, operating margins for the energy services segment were 27% and for KBR, 4%. When the spin off is complete, operating margins should nearly double and I am not sure Wall Street fully appreciates the improvement the new HAL will undergo. While KBR does provide nearly half of the combined revenue, it is only around 10% of operating income. The bottom line should not shrink much after the disposition.
 
One negative that weighs on HAL and possibly tips investors toward Schlumberger is the exposure to US natural gas production. There is no question HAL does a majority of its business in the US. Over 50% 0f business is US. But HAL is signing new contracts internationally in Russia and Saudi Arabia and realizes the need to expand its footprint there. They are taking steps to do so. And the North American natural gas market is not DOA. Supplies will inevitably tighten and prices will rise and the energy services sector will find favor again. Especially hot at present is the Barnett Shale play that requires exacting drilling and extraction techniques like fracturing, well-suited to US energy services companies. 
 
HAL’s energy services group has done well this year:
 
For the first 9 months in 2006:
 
ESG--9 mos
$9.4 billion revenue
$2.4 billion operating income
30% growth yoy revenue
25.7% margins
 
KBR--9 mos
$7.1 billion down $302 million
$119 million operating income down $226 million
Due to decreased military support
 
Third quarter results:
 
Energy Services revenue increased 9% sequentially over Q2 Revenue grew in all regions
 
North America +13%
Latin America  +10%
Europe/Africa +5%
Middle East/Asia  +2%
 
Energy Services operating income up 15% sequentially. Operating margins expanded to 26.7% from 25.4%
 
Production Optimization revenue grew 10% sequentially-- operating income advanced 14%. Operating margins were 28.6%
 
 Fluids revenue rose 7% sequentially. Fluids operating income
increased 9% sequentially. Operating margins were 22.7% Middle East.
 
Drilling and Formation Evaluation revenue increased 9% sequentially. Operating margin rose to 26.9% EQUITY RESEARCH
 
 
Digital and Consulting Solutions revenue climbed 12% sequentially. Operating income increased to $62 million from $52 million in the prior quarter Operating margin expanded to 30.8%
 
 
Where oil is concerned, investors and futures traders have a remarkably short horizon. The proof of capacity is not in the short-term storage capacity or in OPEC cuts and increases, it’s in the ground. Current overcapacity and high storage levels do not tell  the story of long-term demand for hydrocarbons. Despite declining oil prices and softening natural gas prices in the third quarter of 2006, prices still remain historically high when considering the past decade and proven reservoirs are declining. There is sufficient incentive even at third quarter prices to look for new oil and gas and invest in optimizing production from slowing wells. Cheap oil is now $55-$60 per barrel and gas even at recent lows in spot price on warm weather speculation is $6.43 per MMBtu for December contracts and  $6.769 per MMBtu for January. This level still supports the costs of E&P.
 
Worldwide demand for hydrocarbons continues to grow, and the reservoirs are becoming more and more complex. Demand for field services in North America continues to be strong. HAL believes they currently do not have enough capacity to serve all the customers seeking pressure-pumping services in North America. Even if they lose a job or a customer, there is enough work to keep employees and equipment highly utilized. HAL has a nearly $6 billion backlog. If natural gas drilling were to decrease with decline in prices (gas is the most volatile commodity), they expect to see customers shift their focus to drilling oil wells in the near term, rather than letting the rigs go unutilized.
 
 
Oil and gas will continue to be volatile due to the fluctuations of the futures market based on supply, weather and natural disasters. Over the long run, I expect we will see an unyielding trend of ever-upward prices due to
 
1) growth in worldwide petroleum demand remains robust, despite high oil prices
 
2) projected growth in non-OPEC supplies is not expected to accommodate worldwide demand growth
 
3) worldwide spare crude oil production capacity continues to remain low
 
4) fear of possible supply disruptions from OPEC, Iran, Iraq, Nigeria, and Venezuela due to political or social circumstances.
 
And as gas and oil prices move, so do oil and gas services companies.
 
The outlook for world oil demand continues to remain strong, with China, the Middle East, and North America accounting for approximately 72% of the expected demand growth in 2007. The International Energy Agency continues to forecast world petroleum demand growth in 2007 to increase nearly 2% over 2006.
 
 
Comparisons to competitors as follows based on December 18th prices
 
               PE    PS   PBV   FCF/share EV/EBIT  EV/FCF 
Schlumberger   24.7  4.2   7.9   $1.54    18.2     45.1  
Baker Hughes   22.2  2.5   4.7   $2.98    13.4     26.6 
Weatherford    18.3  2.6   2.7   $1.18    14.3     40.5   
BJ Services    12.0  2.1   4.2   $2.91     7.7     10.6    
Halliburton    12.1  1.5   4.6   $2.43     9.8     13.9
 
Valuation
 
The model includes a 5% growth rate for the 2006 loss of 20% of KBR revenue to be partially offset by organic ESG growth. From there, when the entire KBR revenue is lost, I modeled a -25% growth in revenue for year two. After that growth is estimated in a range between 15%-20% for most of the 10 years of high growth. Margins should increase--gave them 25% operating margins. The capex may be high per the company for two years but historically it has not exceeded growth in revenue but such extreme amounts. For the majority of the model, I have it grow with revenue.
Other inputs
Beta 1
WACC 9.9%
COE 10.5%
COD aftertax 4.55%
Stable growth 3%
 
The intrinsic value is $44 with this model

Catalyst

Separation from KBR eliminates litigation costs, future fines, and bad press for remaining ESG
Improved operating margins second half of 2007
Specialized sevices required in the Barnett Shale fields ongoing--very large hot field high production
Trading at a substantial discount to competitors
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    Description

    Some conventional wisdom says that going forward, mergers between energy companies will begin to look more attractive than exploration and drilling. Some Wall Street analysts believe that the big companies plan to get bigger and increase proven reserves through acquisition because it will be cheaper than developing existing fields. Whether this is the reason the energy services sector is declining is unclear—but declining in price per share they are. What ever the proven reserves are for any given oil company and whether increases in reserves are acquired, the fact remains that those reserves will have to be drilled and existing wells serviced. Oil and gas services companies are not likely to suffer from lack of business.
     
    Halliburton (HAL) is one of those companies. HAL is trading at a discount currently to its peers including Schlumberger, Baker Hughes and Weatherford.
     
    Energy services companies are in the business of facilitating drilling and exploration operations. HAL supplies drill bits and downhole tools, directional (including horizontal) drilling support, cementing new boreholes and fluids. And it has a business segment providing software to interpret seismic data. HAL also offers services for existing wells that optimize production and enable recovery of hydrocarbons by secondary means. It involves fracturing and propping open gas and oil reservoirs that trap the hydrocarbons (tight) and acidization to remove solids blocking flow. It does sand control by ingenious filtration and pipeline maintenance. All services that will be in high demand to keep existing wells producing. The good news is that this particular segment accounted for 43% of revenues in 2005. And the remaining three segments make up the following percentages:
     
    Fluid systems—28%
    Drilling & formation evaluation—22%
    Digital & consulting—7%
     
    So while new exploration may decline (and I am not convinced), HAL is positioned to continue to grow its well optimization segment.
     
    The big event in Halliburton’s life is its pending divorce from the extremely troublesome and very unprofitable KBR. The recent IPO of 19% of KBR did very well.  Shares were offered at $17 per share and now sit at $27. HAL shareholders will get the remaining shares spun off to them in the spring of 2007. The pending IPO and promised spin off sent shares of HAL from $27 in October to $32-$33 in November. But with the recent analyst downgrade of Schlumberger, most of the energy services sector is on the decline again, including HAL. While a few of the other companies perhaps deserved a correction for excessive valuation, HAL still falls into value territory. 
     
    KBR has not been a great business for HAL. Halliburton merged with Brown & Root in 1962 and in 1998 acquired Dresser Inc, which brought Kellogg in to the company. The Dresser merger included asbestos litigation, which has been settled at the cost of billions. And KBR has been a never-ending source of alleged criminal activity government disputes. KBR has had continuous run-ins with the US government on a number of contracts and subsequent withholding of payment. This requires HAL to appeal the government actions. Currently there is:
     
    $55 million withheld for containerized housing--Iraq
    $95 million for dining facilities--Iraq
    Much bad press regarding overcharging for services in Iraq
     
    And there is an ongoing investigation into bribery allegedly committed by KBR regarding development of a Bonny Island gas liquefaction site. No money is involved yet but the fines could be substantial. Knowing something of the incredibly corrupt Nigerian government this is easy to believe. It will impact KBR I suspect ($2 million per criminal violation and $500K per civil violation)
     
    Then there is the bad investment in a profitless overleveraged Australian railway--HAL owns 36.7% interest. HAL took a $26 million Q1 2006; $32 million writedown Q3; and most likely $10 million to be written off in the next few quarters, which takes care of the whole investment.
     
    There are more--a faulty blower sold by Root to Newmont Mining, a class action suit regarding an Algerian transaction and overstatement of unapprovable accounts, more bribery to tax officials in Nigeria, some illegal dealings with Iran, a suit by employees in Iraq against KBR for failing to pay time and a half for overtime. Most of these are KBR related and are not likely to amount to significant liquidity crunching awards.
     
    HAL has to indemnify the potential fines and charges KBR may incur, but KBR must repay HAL for any expenses. KBR has not been a good partner for Halliburton. Luckily for HAL, all these concerns and potential future expenses leave with KBR. And the bad business decisions and liabilities that have costs Halliburton so much in the past few years will quit draining profits from the company.
     
    In spite of Halliburton’s determination to rid itself of KBR, the market does not seem to realize the weight of the stone that will be lifted from HAL’s back. The small gains in price realized when the IPO was announces are now reversing.
     
    Besides the legal expense and potential fines accruing to KBR there is the issue of their extremely low profitability that has dragged Halliburton’s bottom line down for years.
     
                         2005  2004  2003
    KBR
    operating margins    4%    -3%   -1%  
    net margins          2%    -3%   -1%
     
     
    Halliburton
    operating margins    12.7%  4.1%   4.4%
    net margins          11.2%  1.9%   2.1%
     
    In the most recent reported quarter, operating margins for the energy services segment were 27% and for KBR, 4%. When the spin off is complete, operating margins should nearly double and I am not sure Wall Street fully appreciates the improvement the new HAL will undergo. While KBR does provide nearly half of the combined revenue, it is only around 10% of operating income. The bottom line should not shrink much after the disposition.
     
    One negative that weighs on HAL and possibly tips investors toward Schlumberger is the exposure to US natural gas production. There is no question HAL does a majority of its business in the US. Over 50% 0f business is US. But HAL is signing new contracts internationally in Russia and Saudi Arabia and realizes the need to expand its footprint there. They are taking steps to do so. And the North American natural gas market is not DOA. Supplies will inevitably tighten and prices will rise and the energy services sector will find favor again. Especially hot at present is the Barnett Shale play that requires exacting drilling and extraction techniques like fracturing, well-suited to US energy services companies. 
     
    HAL’s energy services group has done well this year:
     
    For the first 9 months in 2006:
     
    ESG--9 mos
    $9.4 billion revenue
    $2.4 billion operating income
    30% growth yoy revenue
    25.7% margins
     
    KBR--9 mos
    $7.1 billion down $302 million
    $119 million operating income down $226 million
    Due to decreased military support
     
    Third quarter results:
     
    Energy Services revenue increased 9% sequentially over Q2 Revenue grew in all regions
     
    North America +13%
    Latin America  +10%
    Europe/Africa +5%
    Middle East/Asia  +2%
     
    Energy Services operating income up 15% sequentially. Operating margins expanded to 26.7% from 25.4%
     
    Production Optimization revenue grew 10% sequentially-- operating income advanced 14%. Operating margins were 28.6%
     
     Fluids revenue rose 7% sequentially. Fluids operating income
    increased 9% sequentially. Operating margins were 22.7% Middle East.
     
    Drilling and Formation Evaluation revenue increased 9% sequentially. Operating margin rose to 26.9% EQUITY RESEARCH
     
     
    Digital and Consulting Solutions revenue climbed 12% sequentially. Operating income increased to $62 million from $52 million in the prior quarter Operating margin expanded to 30.8%
     
     
    Where oil is concerned, investors and futures traders have a remarkably short horizon. The proof of capacity is not in the short-term storage capacity or in OPEC cuts and increases, it’s in the ground. Current overcapacity and high storage levels do not tell  the story of long-term demand for hydrocarbons. Despite declining oil prices and softening natural gas prices in the third quarter of 2006, prices still remain historically high when considering the past decade and proven reservoirs are declining. There is sufficient incentive even at third quarter prices to look for new oil and gas and invest in optimizing production from slowing wells. Cheap oil is now $55-$60 per barrel and gas even at recent lows in spot price on warm weather speculation is $6.43 per MMBtu for December contracts and  $6.769 per MMBtu for January. This level still supports the costs of E&P.
     
    Worldwide demand for hydrocarbons continues to grow, and the reservoirs are becoming more and more complex. Demand for field services in North America continues to be strong. HAL believes they currently do not have enough capacity to serve all the customers seeking pressure-pumping services in North America. Even if they lose a job or a customer, there is enough work to keep employees and equipment highly utilized. HAL has a nearly $6 billion backlog. If natural gas drilling were to decrease with decline in prices (gas is the most volatile commodity), they expect to see customers shift their focus to drilling oil wells in the near term, rather than letting the rigs go unutilized.
     
     
    Oil and gas will continue to be volatile due to the fluctuations of the futures market based on supply, weather and natural disasters. Over the long run, I expect we will see an unyielding trend of ever-upward prices due to
     
    1) growth in worldwide petroleum demand remains robust, despite high oil prices
     
    2) projected growth in non-OPEC supplies is not expected to accommodate worldwide demand growth
     
    3) worldwide spare crude oil production capacity continues to remain low
     
    4) fear of possible supply disruptions from OPEC, Iran, Iraq, Nigeria, and Venezuela due to political or social circumstances.
     
    And as gas and oil prices move, so do oil and gas services companies.
     
    The outlook for world oil demand continues to remain strong, with China, the Middle East, and North America accounting for approximately 72% of the expected demand growth in 2007. The International Energy Agency continues to forecast world petroleum demand growth in 2007 to increase nearly 2% over 2006.
     
     
    Comparisons to competitors as follows based on December 18th prices
     
                   PE    PS   PBV   FCF/share EV/EBIT  EV/FCF 
    Schlumberger   24.7  4.2   7.9   $1.54    18.2     45.1  
    Baker Hughes   22.2  2.5   4.7   $2.98    13.4     26.6 
    Weatherford    18.3  2.6   2.7   $1.18    14.3     40.5   
    BJ Services    12.0  2.1   4.2   $2.91     7.7     10.6    
    Halliburton    12.1  1.5   4.6   $2.43     9.8     13.9
     
    Valuation
     
    The model includes a 5% growth rate for the 2006 loss of 20% of KBR revenue to be partially offset by organic ESG growth. From there, when the entire KBR revenue is lost, I modeled a -25% growth in revenue for year two. After that growth is estimated in a range between 15%-20% for most of the 10 years of high growth. Margins should increase--gave them 25% operating margins. The capex may be high per the company for two years but historically it has not exceeded growth in revenue but such extreme amounts. For the majority of the model, I have it grow with revenue.
    Other inputs
    Beta 1
    WACC 9.9%
    COE 10.5%
    COD aftertax 4.55%
    Stable growth 3%
     
    The intrinsic value is $44 with this model

    Catalyst

    Separation from KBR eliminates litigation costs, future fines, and bad press for remaining ESG
    Improved operating margins second half of 2007
    Specialized sevices required in the Barnett Shale fields ongoing--very large hot field high production
    Trading at a substantial discount to competitors
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