Schlumberger Ltd (NYSE: SLB) Energy. SLB: High ROIC, Great Value. Krause Fund Research Fall November 17, Recommendation: BUY

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1 Krause Fund Research Fall 2015 Energy Recommendation: BUY Schlumberger Ltd (NYSE: SLB) November 17, 2015 Analysts Edward Bellay edward Alexander Pang alexander Company Overview Schlumberger LTD (SLB) is the global leader in the Oilfield Services Industry within the Energy Sector. The company provides various project management, information technology, and equipment manufacturing to various upstream companies of the Energy Sector. Schlumberger operates through three business segments: Reservoir Characterization, Drilling, and Production Groups. After the Cameron International acquisition, Schlumberger will have three new segments: Surface, Subsea, and Valve & Measurements. Stock Performance Highlights 52 week High $ week Low $66.57 Beta Value Average Daily Volume 9.35 MM Share Highlights Market Capitalization $96.02 B Shares Outstanding 1.43 B Book Value per share $30.09 EPS $2.65 P/E Ratio Dividend Yield 2.63% Dividend Payout Ratio 75.47% Company Performance Highlights ROA 5.21% ROE 8.96% Sales $40.37 B Current Price $76.14 Target Price $95.98 SLB: High ROIC, Great Value Schlumberger s technological edge and industry leadership within the Oilfield Services Industry will assist in positioning Schlumberger in reaping market share gains in the next 3 5 years as it undergoes strategic acquisitions. After the Cameron International acquisition is completed in early first quarter 2016, Schlumberger will become the first full service Oilfield Services Company that will provide every aspect of production and technological services to the Energy Sector. With our moderate forecasts in oil price increases over the next 5 years, Schlumberger will see double digit revenue growth in the next 3 5 years as it recovers from the recent downturn gripping the Energy Sector. Schlumberger s leadership in Research and Development spending as a percentage of sales will remain a strong competitive advantage against rivals Haliburton and Baker Hughes in the next 5 years. We have forecasted superb return on invested capital rates for Schlumberger, especially towards the end of our forecast period in which Schlumberger will continue to create extraordinary value for shareholders. One Year Stock Performance Financial Ratios Current Ratio 1.64 Debt to Equity 34.11% 1 P age

2 Economic Outlook Overview There are many economic factors that drive the energy sector, chief among them are crude oil prices and interest rates. However, within the drivers of crude oil prices are still more factors such as demand for oil and supply of oil. For our economic outlook, we have broken down the indicators that drive crude oil prices and have extensively covered these subdrivers since the energy sector is essentially commodity based. Oil Demand from OECD and Non-OECD Countries Demand for oil is driven by global economic growth in both developed countries (OECD) and developing and emerging countries (Non-OECD). Consequently, world oil demand has been fairly correlated with Real GDP growth, rising between 1-2% annually. i Source: EIA ii Above is a graph charting the consumption of all liquid fuels (i.e. oil, LNG, gasoline, etc.) against WTI prices and world GDP growth. Between Non-OECD and OECD countries, growth in oil demand is strongest in developing and emerging countries (Non-OECD). These countries tend to rely extensively on manufacturing versus services and thus demand more energy for consumption. According to the Energy Information Administration (EIA), OECD demand for oil actually declined between 2000 and ii However, growth in oil demand in countries such as China, India, and Saudi Arabia, as well as other Non-OECD nations increased by 40% over that period of time. ii 2 P age Future growth in world oil demand will likely stem from these developing nations and have a larger influence on oil prices over the next few decades. However, when taking into account China s lackluster growth and projected growth rates, oil demand will have to stem from either a pickup in Chinese growth and/or a shift towards Indochina countries in the near future. In addition, oil prices will likely recover at a slower pace for 2015 and 2016 as evidenced by the EIA estimates provided below. World oil prices are likely to recover from $41.55 bbl to $49 bbl by the end of 2015 and $51 bbl by ii We estimate 2017 and 2018 oil per barrel prices to be $60 and $70 bbl, respectively, eventually stabilizing around $75-80 bbl by 2019, with marginal growth in our CV year of This recovery will be driven by a combination of higher demand from these developing countries and a weakening of supply output in North America, which will be discussed in the Supply of OECD and Non-OECD Countries section. OECD and Non-OECD GDP Growth OECD GDP growth rates have been forecasted at 2%, 2.2%, and 2.3% for 2015, 2016, and 2017, respectively. iii The United States has forecasted GDP growth rates of 2.4%, 2.5%, and 2.4% for the same time period above. iii We believe these estimates are reasonable considering the mature economies of most OECD participants as well as troubling indicators in regards to deflationary pressure in Europe and general lackluster growth. For these reasons, we do not foresee a return to 3.5% GDP growth for at least the next 5 years, and instead forecast stable GDP growth at 2.75% for our CV year. We focused on China, India, and Indonesia s GDP growth rates since we believe the main sources of oil demand growth will be derived by these three nations and their general geographic areas. China s GDP growth estimates are 6.8%, 6.5%, and 6.2%, for 2015, 2016, and 2017, respectively. iii However, these GDP growth estimates are in line with the Chinese governments reported forecasts and we believe that these growth estimates are over-inflated. Capital Economics, Citibank, Conference Board, and Lombard Street have put the forward growth rates at about 3.8% to 4.9% for the next 5 years. iv The declining forecasted GDP growth rates provide insight into China s sluggish demand and is partly responsible for the decline in oil prices since 2014.

3 India s GDP growth rates are forecasted at 7.2%, 7.3%, and 7.4% for the corresponding period above. Indonesia s GDP growth rates are estimated at 4.7%, 5.2%, and 5.5% for the same period. iv Considering India s reliance on services over manufacturing as opposed to China s economic makeup favoring manufacturing, India is positioning itself as a service economy with services making up 57.9% of its current GDP growth. v Thus, we agree with the estimates provided. In regards to Indonesia, their resilient manufacturing growth will be tested by the coming interest rate rise by the United States Federal Reserve, but we believe that the estimates provided have accounted for this uncertainty in its growth rates. The much higher growth rates provided by Non- OECD countries, if realized, will be the main source of world oil consumption growth moving forward and will likely result in a tightening of oil prices since oil prices rise with higher demand, assuming constant supply. fracking revolution in North America. Once uneconomical, shale and oil plays have now become accessible through technological advances that allow unconventional drilling (fracking and oil shale drilling) to be profitable at estimates averaging at or above $65 bbl. The massive growth in North American production has acted as a catalyst for the 43% decline in oil prices since viii We believe that higher-cost producing sub-industries, such as unconventional companies along with offshore drilling companies will either slow down production or go bankrupt due to lack of free cash flows and high long-term debt payments maturing within the next 2-3 years. In the short-term, however, many of the North American onshore high-cost producers have shut down 60% of their drilling rigs year to date, and have transitioned to low-cost, highproducing oil plays. ix Due to this transition, rig usage declines have yet to cause a significant decrease in oil production. Thus, we believe oil supplies will largely stay bloated for the next 2 years, until these firms run into free cash flow problems. x Oil Output of Non-OPEC and OPEC Countries Non-OPEC countries can roughly be seen as OECD countries with the main exceptions being that Russia and Brazil are not participants in OPEC. Non-OPEC countries are currently responsible for producing 60% of the world s oil production, whereas OPEC is responsible for 40% of production. vi Source: EIA ii Source: EIA ii Above is a graph charting the production of liquid fuels by Non-OPEC countries against the WTI price of oil. As can be witnessed by the graph, Non-OPEC production has increased dramatically in the last 5 years. US field production from increased by 59.11%. vii The main cause of increase has been the 3 Page OPEC oil production is a different story all together. From 2005 to 2015, OPEC has consistently lost market share to North American, Latin American, and Russian oil companies, seeing a decline of 7% from 40% to 33% over that period. xixii In an effort to sustain their current market share, they have decided on a strategy of stable production growth which is contrary to the usual production cuts that OPEC would have taken to prop up oil prices in the world market. This strategy has contributed to the further

4 erosion of oil prices. We believe that OPEC will continue this strategy until it is adequately satisfied that high-cost North American companies will not pose a medium-term threat to its market share in the future. Crude Inventories Crude inventories are an excellent indicator for viewing and forecasting oil demand and supply in the world. When oil inventories build up, either a lack of demand or uneconomical oil prices are usually to blame. In either event, the market tends to react negatively to upward trends in crude inventories whereas a decrease in inventories usually corresponds with growing demand, resulting in higher oil prices. Unfortunately, for the 2015 year, crude inventories have been steadily building up. Since 2014, crude inventories have increased by 108.6%. xiii However, since we have forecasted oil prices to recover largely by 2019, although not to their peak 2014 levels, crude inventories should start to decrease moving forward. Source: FRED xiv We believe that the Federal Reserve, in light of recent positive economic data, will more than likely raise interest rates in late December 2015 from a low of.25%. xv We project the Fed Funds Rate will rise to 1% by the end of 2016, Janet Yellen s goal, and then about 1% increases per year to settle at 4% in xvi The main effect this rate rise will have on the energy sector is to make refinancing and further debt issuances costlier for borrowers. As we have stated, we believe that higher-cost oil producers such as fracking and tar sand companies will likely go out of business with higher debt and interest repayments, but an interest rate rise will act as a catalyst for this event to happen. When interest rates rise, these companies will have trouble financing their operations and will subsequently either have to issue equity, sell off assets, or file for bankruptcy. In any event, oil production should decrease as more players leave the industry which further justifies our view that oil prices will rise when supply tightens in the next 2-3 years. Conclusion Source: EIA ii Interest Rates Interest rates can be a positive or a negative for almost every sector, especially for the high-capital intensive energy sector. Most energy companies borrow heavily to both magnify returns and help fund operations. When interest rates are low, borrowing costs, or corporate bond yields, generally drop as a response. Thus, there is a positive correlation between interest rates and corporate bond yields as demonstrated by the graph below. After taking into account the demand and supply equations that are so prominent in understanding what drives crude prices, and thus, the energy sector, we have concluded that currently, the market is awash in oil supply and demand from China is weak. The result: low oil prices. However, when adjusting our view out 2-3 years, we forecast a pickup in Chinese and Indochina demand as well as a decline in oil production, largely stemming from North American output, to put upward pressure on prices. We believe that these forecasts and assumptions are reasonable and are generally in line with the EIA and other analyst estimates. 4 P age

5 Industry Outlook Overview We define the industry Schlumberger operates in as the Oilfield Services Industry. Oilfield Service companies primarily own and operate the equipment, excluding rigs, for exploration and production activities. Customers range from public E&P firms to Integrated Oil Companies. Key Industry Trends Decline in Upstream Capital Spending Due to the 43% decline in oil prices from mid-2014 levels, Exploration & Production companies, which represent Schlumberger s largest customer segment have effectively slashed capital spending for the 2015 FYE. viii Capital spending cuts for 2016 FYE have largely not been factored in due to E&P companies not yet developing their budgets for 2016, according to Paul Kibsgaard in Schlumberger s Q3 earnings call. xvii Capital spending has historically lagged oil prices by six months, so even though we project oil prices to increase marginally in 2016 and then increase upwards of 15% in both 2017 and 2018, E&P Capex will probably not grow as fast or at the same level of price increases. However, we do foresee eventual Capex increases in the near term (2-3 years) and then tapering off to consistent growth rates in line with our model s CV growth rate of 3.5% for revenue. Rising Research & Development Expenditures In order to stay competitive in the Oilfield Services Industry, companies must rely on cutting edge technology. Naturally, R&D expenditures have risen consistently and continue to remain constant even in the cyclical downturn currently experienced by the energy industry as a whole. We believe that this trend will continue, since Oilfield Services companies largely offer the same products and services with few companies offering any value that cannot be easily recreated, except for Schlumberger, who is the perceived technological leader in this industry. Therefore, Oilfield Services companies will have to continue to make large 5 P age investments in R&D to remain competitive against their peers. Consolidation The decline in oil prices has largely spawned yet another round of mergers & acquisitions, much like the spat of buying in the late 1990 s during the last downturn in the energy industry. For instance, Shell is currently undergoing the acquisition of BG Group, Haliburton is merging with Baker Hughes, and Schlumberger is acquiring Cameron International (which has significantly affected our model, as will be discussed later). We believe that this trend will continue in the shortterm as oil prices remain low, and various oil companies either start looking for acquisition targets, or become targets themselves. As mentioned, highcost production companies are the likeliest candidates for acquisitions since the majority will likely face cash flow problems in 1-2 years. Schlumberger has repeatedly affirmed that it remains opportunistic in pursuing acquisition targets, although Shell and Haliburton, who are both undergoing mega-cap mergers, will likely not undergo further acquisitions until their current deals go through and they have satisfied anti-trust regulators. xvii Comparable Company Analysis Due to Schlumberger s sizeable revenues and leadership status, it has very few direct competitors. Among those close competitors, in terms of size and product offerings, are Haliburton and Baker Hughes. Second tier comparable companies consist of National Oilwell Varco and Weatherford International since they do not compete with all of Schlumberger s segments. Furthermore, there are many other players in the Oilfield Services Industry that compete with Schlumberger in niche markets that have fairly sizable revenues that we have also compared with Schlumberger. A brief description of these competitors is as follows: Haliburton: Operates through its completion & production and drilling & evaluation segments.

6 Provides almost all the same services Schlumberger provides, but has a specific focus on well cementing. Baker Hughes: Provides drilling evaluation products and various geological exploration services. As with Haliburton, Baker Hughes is a close competitor with Schlumberger in many of its segments. National Oilwell Varco: Manufacturers and sells oil and gas drilling equipment. NOV does not focus on providing E&P services, such as reservoir mapping. We do not see NOV as close as a competitor to Schlumberger compared to Haliburton and Baker Hughes. Weatherford International: Provides energy equipment and rig leasing and operation services. As with NOV, Weatherford is not as comparable to Schlumberger. Cameron International: Provides flow equipment for onshore and offshore drilling rigs. Cameron is the acquisition target of Schlumberger and will fill the valve & manufacturing and production role of the combined entity. Helmerich & Payne: Operates as a contract drilling service provider outside of the United States, primarily serving Latin America, Africa, and the Middle East. H&P is a small competitor to Schlumberger s total business offerings and is thus not a preferable comparable peer. Transocean: Provides offshore contract drilling services. Even more so than Helmerich & Payne, Transocean operates as a niche competitor against Schlumberger and is not a preferable comparable candidate. Source: Factset xviii In terms of sales, Schlumberger is the clear leader with $48.58 billion in 2014 sales. When the Cameron 6 P age International acquisition goes through, which we believe is a certainty, then Schlumberger s sales would be upwards of $58 billion. In our model, we have amalgamated Schlumberger s and Cameron International s financial statements assuming they have operated as a single entity for the past 10 years in order to make forecasting easier. However, for the purposes of this comparable analysis, we will analyze Schlumberger and Cameron separately, as well as separately analyze Haliburton and Baker Hughes. Schlumberger has a global presence in terms of geographic revenue segmentation. Schlumberger currently receives 6.4%, 49.4%, 21.2%, and 22.9% from Africa/Middle East, The Americas, Asia/Pacific, and Europe sectors, respectively, for the 2014 FYE. Both Haliburton and Baker Hughes have less of an international presence, having less than 34.4% and 38.4% in international revenues outside of North and South America, respectively, but both focus more on the US than Schlumberger. xviii Haliburton has a minor lead in market share in the United States. National Oilwell Varco, Transocean, and Helmerich & Payne have a larger presence in the international arena compared to Schlumberger. xviii However, NOV, Transocean, and H&P, fail to compete with Schlumberger on every aspect of the Oilfield Services Industry, whereas after the Schlumberger and Cameron International acquisition goes through, Schlumberger will operate the first Oilfield Services Company that encompasses all sub-industries and segments within Oilfield Services. Their combined international presence will be an interesting advantage in terms of scale and offerings moving into 2015 and beyond. Operating Margin Performance 40% 30% 20% 10% 0% Source: Factset xviii EBITDA Margin Percent Average of Competition Schlumberger

7 As well as leading in sales revenues, Schlumberger has superior EBITDA margin performance compared to Haliburton and Baker Hughes. Schlumberger, Haliburton, and Baker Hughes EBITDA margins are 28.16%, 21.83%, and 19.97%, respectively for the FYE xviii However, compared with Transocean and Helmerich & Payne, who have EBITDA margins of 41.98% and 41.91%, respectively, Schlumberger falls flat. xviii Transocean mainly provides offshore contract drilling services and Helmerich & Payne operates as an international (ex-us) onshore and offshore drilling services contractor. We believe that both Transocean and Helmerich & Payne operate in niche segments of the Oilfield Services Industry and therefore are not major competitors to Schlumberger s wide swath of segments. Thus, their margin superiority should be discounted and the focus should shift towards Haliburton and Baker Hughes. xix Cameron International s EBITDA margin was 16.11% for the 2014 FYE. Since we believe that Schlumberger will acquire Cameron, and have assumed that Schlumberger and Cameron have operated as a single entity in our model, Schlumberger s EBITDA margin should be lower than the reported 28.16% moving forward into 2015 and beyond to adjust for Cameron s lower EBITDA margins. xviii The reason behind this drop in EBITDA margin is the fact that Cameron operates as more of a valve and equipment manufacturing company which has higher fixed expenses than Schlumberger s information technology focused segments. We foresee a shift towards the production versus geological mapping aspect of Schlumberger s business segments moving into Currently, however, we believe that Schlumberger s superior margin performance is a testament to its economies of scale and its focus on high margin, low cost services such as the Reservoir Characterization Group. Research & Development Investment 4.00% 3.00% 2.00% 1.00% 0.00% Source: Factset xviii As the recognized technological leader in the Oilfield Services Industry, it is fitting that Schlumberger should have the largest percentage of research & development to sales. Although the trend has been decreasing/flat for Schlumberger, the fact remains that a 2014 FYE R&D percent of Sales ratio of 2.51% versus Haliburton s and Baker Hughes 1.83% and 1.75%, respectively, clearly indicates that Schlumberger has committed more resources to gaining and keeping its edge on the technological systems required to generate value for its clients. xviii We believe that Schlumberger s higher spending in R&D will largely continue and has added to Schlumberger s perceived market leadership and stock premium. Capital Expenditures Trends 80.00% 60.00% 40.00% 20.00% 0.00% % Research and Development % Sales Average of Competition Capex Growth Rates Schlumberger Average of Competition Schlumberger Source: Factset xviii 7 P age Schlumberger s competitors appear to be growing their property, plant, and equipment at a faster rate over this five-year trend graph. Schlumberger s 2014

8 FYE capex growth rate was -.92% compared with Haliburton s and Baker Hughes 11.90% and %, respectively. xviii Compared to Schlumberger s smaller competitors, the capex growth rate spread becomes even more pronounced as NOV, H&P, and Weatherford International grow their businesses faster. Due to Schlumberger s much larger size than these competitors, its capital expenditure growth rates will naturally be smaller as the company has been at maturity for many years now. If Schlumberger s smaller rivals, and even some of its larger ones such as Haliburton and Baker Hughes, continue to grow capex at faster rates than Schlumberger, then we could potentially see Schlumberger lose some of its economies of scale and overall market edge. However, we have not forecasted this trend to have any material affect for the next 5 years due to the current downturn in the energy industry and the subsequent capex cuts that many of Schlumberger s rivals have already put in place and will most likely continue to do so in the near 1-2 years. Debt to Assets Comparison 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% Source: Factset xviii Schlumberger generally operates with less debt to assets than its competitors. Although lower debt does not assist Schlumberger in magnifying returns during good economic times, having lower debt during economic downturns, does assist Schlumberger s in riding out the energy downturn currently besieging the market. We believe that Schlumberger s debt to assets ratio of 19.92% for the 2014 FYE is a strategic advantage 8 P age Debt to Assets Average of Competition Schlumberger during this energy crisis. xviii Compared with Weatherford International and Transocean, which have a 39.84% and 35.52% 2014 FYE debt to assets ratio, respectively, Schlumberger is better positioned to withstand the current low oil price environment and also pursue acquisitions, which it has already undergone in the past 6 months. xviii Weatherford International and Transocean on the other hand will likely face increased hardship moving into 2016 and will be pressured to sell off assets or cut capex or other expenses in order to remain free cash flow positive. We believe that Schlumberger, as well as some of its more direct peers such as Haliburton and Baker Hughes, which have debt to assets ratios of 24.36% and 13.98%, respectively, will continue to have larger operating cash flows due to lower interest expenses and may pursue further consolidation and acquisition strategies after their merger. xviii Porter s Five Forces Supplier Power Supplies are based on raw materials to produce services equipment. Many producers of raw materials exist, so their bargaining power is limited. Buyer Power The power of buyers is high in this industry. E&P companies need high-tech energy equipment to drill for oil and natural gas and many Oilfield Services companies compete for E&P business. Even though Schlumberger, Haliburton, and Baker Hughes are leaders in market share, they still need to remain competitive on price and product offerings in order to retain customers. Competitive Rivalry Oilfield Services firms have to compete on price and service quality, as well as create new innovative product offerings, because the services and products offered in this industry are relatively the same. Threat of Substitution Threat of substitution is moderate since products and services are relatively the same, but certain companies have perceived technological offerings

9 assumed to be better and more cost effective. One determinant that would offset the threat of substitution is long-term client relationships and product innovation. Considering the high capital intensity inherent in the industry, E&P firms like to work with companies that have a track record of completed contracts. Threat of New Entrants The threat of new entrants into the Oilfield Services Industry is low due to the high working capital requirements. Large scale equipment is often needed and, firms need to fund their own projects for a period of time before they collect day rates. Oil is a global industry that requires Oilfield Services companies to have a large presence in foreign countries and be able to drill anywhere at a moment s notice. xx Conclusion The Oilfield Services Industry is intensely competitive and requires larger expenditures in R&D to find new technological competitive advantages as many current product offerings become standardized. This industry also has many competitive advantages since new competitors are unlikely to enter a high-capital intensive industry and long-term client relationships prove a strategic advantage to those older more established companies. Valuation Analysis Overview We are issuing a BUY recommendation for Schlumberger given our model s DCF/EP stock price of $95.97 and Schlumberger s consistently stellar ROIC over historical and forecasted periods as well. Furthermore, Schlumberger s technological leadership, scale, and strategic acquisition of Cameron International in the Oilfield Services Industry will prove an enormous benefit to riding out this current market downturn and positioning the company for the long-term. Analysis of Valuation Methods Discounted Cash Flow and Economic Profit Model 9 P age Our DCF/EP valuation model yielded a partially adjusted present value stock price of $ As of 11/15/2015, Schlumberger s stock price was $ The resulting premium over Schlumberger s current stock price is 19.84%. The premium is largely due to Schlumberger s high forecasted ROIC, CV Growth rate of 3.5%, and increasing margins into 2020 as it recovers from the market downturn. Although the DCF/EP model is likely the most accurate indicator of Schlumberger s true intrinsic value, we believe that this model has some inherent flaws. Chief among them are the estimated revenue growth rates and assumption that Schlumberger s growth of NOPLAT will increase forever at a 3.5% rate. The fact that the Oilfield Services Industry is highly cyclical discounts our DCF/EP model more so than other non-cyclical industries would. However, we do believe that the DCF/EP model has picked up on Schlumberger s ability to generate high returns on its invested capital and the technological innovation that is inherent in the company s growth. Therefore, it is our model of choice in finding Schlumberger s target price. Dividend Discount Model (DDM) Our DDM came up with a partially adjusted intrinsic value per share of $ This per-share estimate represents a.1838% premium to the current share price of Schlumberger. The DDM price is on par with the current price mostly due to the low fundamental P/E ratio used in the model. We believe that the DDM intrinsic value price is grossly undervalued compared to Schlumberger s actual value, since the DDM cannot theoretically account for higher dividend growth rates than the expected return. Schlumberger has historically grown dividends at high double-digit rates, but we have had to lower the growth rates in order for the DDM to calculate an intrinsic value. However, Schlumberger will more than likely increase its dividends at higher rates compared to its expected return in the short to medium term. Thus, the DDM is unduly conservative in its valuation of Schlumberger. Due to the DDM s inherent limitations in valuing all of Schlumberger s options in boosting shareholder returns and value, we have chosen to disregard the

10 DDM intrinsic value per share price and instead focus on the DCF/EP model. Relative Valuation Model We chose to compare Schlumberger with its more direct and indirect competitors on a relative P/E and EV/EBITDA scale. Schlumberger s direct competitors relative P/E valuations for forward years 2015 and 2016 were $78.81 and $117.1, respectively. Schlumberger s total competitor relative P/E valuations for the same time period were $65.26 and $108.13, respectively. We believe that the relative P/E valuation is of little use when trying to derive a per share value for Schlumberger. Schlumberger trades at a premium to the majority of its competitors, and so, will typically have a lower relative valuation. Furthermore, both relative P/E analysis have very few peer comparisons with positive P/E ratios for both 2015 and 2016, and so the analysis has been distorted, particularly in the 2016 FYE. Our other relative valuation analysis involved using EV/EBITDA, which we believe is a better valuation indicator since it focuses on profitability of operations. Schlumberger s direct competitors relative EV/EBITDA valuation for 2015 and 2016 were $79.46 and $82.42, respectively. Schlumberger s total competitor relative EV/EBITDA valuation for 2015 and 2016 were $55.02 and $69.63, respectively. The relative EV/EBITDA valuation is less variable than the relative P/E valuation and more reasonable in terms of the direct competitor valuation. However, the total competitor relative valuation was distorted since Helmerich & Payne and Transocean had lower EV/EBITDA multiples due to being particularly beaten up in this market trough. Although we would still prefer to focus on the DCF/EP analysis, the direct competitor EV/EBITDA valuation would be our second model of choice even though Schlumberger still trades at a premium EV/EBITDA multiple and would command a higher valuation than the $79-81 per share price produced by the relative EV/EBITDA valuation. Key Assumptions Revenue Growth and Decomposition In accordance with our economic and industry analysis, we believe that Schlumberger, as well as most Oilfield Services companies, will experience sharp revenue declines in the short term (1-2 years) eventually transitioning to larger double digit revenue growth in the medium term (3-5 years). Since we have chosen to combine Schlumberger s and Cameron International s financial statements, Schlumberger will have 3 new segments within its company. We have forecasted revenue growth for those segments along with Schlumberger s original segments We forecasted revenues using managerial guidance, reported 10-Qs, analyst reports on both Schlumberger and Cameron International, and in accordance with our oil price forecasts. Since we believe that capital expenditures lag oil prices, the recovery we have forecasted for oil prices over the next 5 years will have larger percentage increases compared with revenues and will generally follow into the next year to account for lag. Thus, are forecasted revenue percentage increases (decreases) are -23%, -6.7%, 12.7%, 12.4%, 9.8%, and 4.5% for the FYE 2015, 2016, 2017, 2018, 2019, and 2020, respectively. These estimates are generally less optimistic than the consensus estimates among sell-side analysts. We have also assumed that Schlumberger will adjust more of its sales towards equipment production through its V&M and Production segments to account for Cameron International s segment focuses. Our segment revenue growth rates were largely based on historical growth rates mixed with recent quarterly reports and managerial guidance. All segments were forecasted to decline for the 2015 and 2016 FYE. Reservoir Characterization and V&M were projected to decline the most in 2015 through As the current surplus in oil puts downward pressure on oil prices, E&P companies have pulled back on exploration of new reservoir sources, thus hurting Schlumberger s RC segment. V&M is projected to decline due to the higher costs associated with production, especially for offshore projects that have been the hardest hit in capex cuts. 10 P age

11 Moving forward into , all segments will experience revenue growth in line with oil price recoveries, with the production segment experiencing the largest growth as Schlumberger shifts towards production, in order to capitalize on Cameron s equipment manufacturing expertise. For our CV 2020 revenue growth assumptions, Production will continue to expand at the fastest rate (5.75%), followed by Surface and V&M (4.60%) and then OneSubsea and Reservoir Characterization as more offshore drilling and exploration picks back up. Capital Expenditures Growth Rates We grew capex by Schlumberger s historical growth rate (8.98%) while taking into account managements most recent guidance and quarterly reports for Schlumberger has repeatedly stated their intention to take advantage of this oil price downturn to grow their business and position themselves strategically within the next few years. Taking this strategy into account, we believe a continual growth of capex rates at 8.98% is fair. WACC Estimation We calculated Schlumberger s WACC to be %. The WACC estimate included total debt, equity, and operating leases. In order to calculate the pre-tax cost of debt for Schlumberger, we averaged Haliburton s and Baker Hughes 30-year debt yields and Schlumberger s current 10-year debt yield to derive the 4.51% pretax cost of debt. We believe this number is fair since it captures the increased riskiness of the energy industry at this time. After adjusting the pre-tax cost of debt with Schlumberger s and Cameron s weighted average 2014 marginal tax rate of 24.86%, we derived an after-tax cost of debt of %. In calculating the cost of equity, we averaged Schlumberger s 1, 2, 3, 4, and 5 year weekly and monthly raw betas to derive the beta we used in our model. We wanted to use fairly recent data to account for the increased volatility in the energy industry, but since we believe the industry will stabilize in 5 years, we also wanted to include beta estimates of how Schlumberger would operate in a more stable environment, and so, included a mixture of short and medium term betas. For the risk free rate, we used the most recent month s (11/01/15) 30-year Treasury Bond yield of 2.95%. For the equity risk premium we used Aswath Damadoran s implied ERP. We adjusted his number to reflect the use of the 30-year risk free rate. Our ERP was 5.37% after the adjustment. Our cost of equity came to 9.71%. In calculating the WACC we assumed that operating leases had an interest tax shield based on the same marginal tax rate of Schlumberger s debt. Furthermore, since Schlumberger is acquiring Cameron with a mixture of cash and stock, Schlumberger s new capital structure will shift dramatically to 83.56% equity and 14.73% debt. Even though Schlumberger may want to increase debt later on to return to its historic 70/30 split between equity and debt, respectively, we do not foresee this happening within the next 5 years due to the current downturn in the oil market. We believe Schlumberger will want to issue as little debt as possible in order to avoid downgrades to its credit rating and avoid additional interest expense. CV Growth Rate We developed our CV growth rate with the United States GDP growth forecasts and international GDP growth rates in mind. The US will likely grow between 2.5-3%. Internationally, China, India, and Indonesia, will likely see growth rates ranging from 3.8-7% into the future. We think a CV growth rate of 3.5% is fair considering Schlumberger s maturity as well. Sensitivity Analysis BETA $ % $ $ $ $ $ $ $ % $ $ $ $ $ $ $ % $ $ $ $ $ $ $ Equity Risk Premium 5.00% $ $ $ $ $ $ $ % $ $ $ $ $ $ $ % $ $ $ $ $ $ $ % $ $ $ $ $ $ $ The Beta and Equity Risk Premium used in our model is important in determining variations in Schlumberger s intrinsic per share value. Since the Oilfield Services Industry is highly cyclical, beta 11 P age

12 numbers will deviate wildly over the years, generally resulting in lower betas during stable times and higher betas during market downturns and recoveries. Minor adjustments in our beta assumption would have wide effects on our stock price. The ERP is probably more controversial in that minor.25% adjustments would change Schlumberger s stock price by $7-10. CV Growth of NOPLAT $ % 2.50% 2.75% 3.00% 3.25% 3.50% 3.75% 3.25% $ $ $ $ $ $ $ % $ $ $ $ $ $ $ % $ $ $ $ $ $ $ Pre-Tax Cost of Debt 4.00% $ $ $ $ $ $ $ % $ $ $ $ $ $ $ % $ $ $ $ $ $ $ % $ $ $ $ $ $ $ CV growth of NOPLAT is also an important determinant in our model since it acts as the steady state growth rate, assuming consistent growth into perpetuity. Although changes in our CV growth of NOPLAT compared with the pre-tax cost of debt, does not have as pronounced variation compared with the above sensitivity analysis, it is still an important variable due to its large percentage makeup in our DCF analysis. CV ROIC $ % 25.50% 26.00% 26.50% 27.00% 27.51% 28.00% 7.50% $ $ $ $ $ $ $ % $ $ $ $ $ $ $ % $ $ $ $ $ $ $ WACC 8.25% $ $ $ $ $ $ $ % $ $ $ $ $ $ $ % $ $ $ $ $ $ $ % $ $ $ $ $ $ $ For much of the same reason that CV growth of NOPLAT is vital to our model, CV ROIC is just as important since it also acts as the value driver into perpetuity. Very little.5% changes along with changes in WACC could be the difference between a $126 intrinsic value and an $83 per share value. Changes in the CV ROIC and WACC could also have wide changes to our Economic Profit, and subsequently, per share intrinsic value price. percentage of sales. A.5% change in SG&A leads to a.4% change in stock price. This lack of significant change shows us that Schlumberger s DCF stock price is driven more by non-operational factors like beta, ERP, risk free rate, etc. than certain operational metrics. Although we believe that Schlumberger will (and has) cut its labor force due to the current slump in oil prices, SG&A as a percent of Sales will likely increase as the market recovers and Schlumberger hires back workers. We have pegged SG&A to Sales for that reason, even though under normal circumstances, SG&A would most likely be fixed since Schlumberger has more fixed expenses than other non-capital intensive industries would have. Company Analysis General Information and Financial Summary Schlumberger is the world s leading supplier of technology, project management, and information services in the Oilfield Services Industry with principle offices in Paris, Houston, London, and The Hague. xxi Schlumberger s segments consist of Reservoir Characterization, Drilling, and Production Groups. Since we have included Cameron International into our model, we have also added their Subsea, Surface, and V&M segments. These various segments help Schlumberger cover most of the service needs of the oil and gas industry. Reservoir Characterization Group: Includes technologies involved in finding hydrocarbon resources through their WesternGeco and Wireline services. Drilling Group: Includes technologies involved in positioning and drilling gas and oil wells through their M-1 SWACO segment. COGs % Sales $ % 63.00% 64.00% 65.00% 66.46% 67.00% 68.00% 4.00% $ $ $ $ $ $ $ % $ $ $ $ $ $ $ % $ $ $ $ $ $ $ SGA % Sales 4.75% $ $ $ $ $ $ $ % $ $ $ $ $ $ $ % $ $ $ $ $ $ $ % $ $ $ $ $ $ $ Testing the operational margins of our company, we compared COGs as a percentage of sales to SG&A as a 12 P age

13 MM, The Surface Group with 1,499 MM, and the V&M Group with 1,185 MM. Although revenues for all groups have declined by 22%, 23%, 24%, 7%, 14%, and 26%, respectively, the revenue breakup percentage among these groups has remained relatively unchanged. xxiv The Reservoir Characterization Group has declined by 1% and Drilling has increased by 1% as a result of a shift away from exploration to production as customers seek to develop the reservoirs that they have rather than seeking new reservoirs during this low oil-price environment. xxiv Source: slb.com xxii Geographic Revenues Production Group: Consists of the technologies involved in the production of oil and gas reservoirs through their Well Services platform. Subsea: Provides products, services, and technologies to the subsea oil and gas industry. Surface: Involved in the design and manufacture of wellheads for onshore and offshore drilling. V&M: Provides valve and measurement systems to measure the flow of oil and gas from wellheads. Segment Revenues Source: Schlumberger 10-Q xxiv The Drilling Group made up the largest percentage of 2015 nine-months ended September 30 th revenue with $10,729 MM, followed by The Production Group with $9,827 MM, The Reservoir Characterization Group with $7,278 MM, The SubSea Group with 2, P age Source: Schlumberger 10-Q xxiv North America is Schlumberger s largest geographic segment by revenues with 29% of total revenues. Followed by the Middle East & Asia, Europe/CIS/Africa, and Latin America with 28%, 26%, and 17% of revenues, respectively. xxiv What is evident in both the product and geographic segments is the double-digit decline in revenues from the prior year s Nine months ended Septmber 30 th 10-Q. North America, Latin America, Europe/CIS/Africa, and The Middle East & Asia revenues all declined by 34%, 18%, 31%, and 13%, respectively. xxiv We believe that North America has declined at a much larger percentage due to the highcost nature of the shale revolution that has spurred much of the growth in capital expenditures over the past decade and is now tightening in response to low oil prices. Schlumberger s corporate strategy consists of creating innovative technology, serving clients in a timely and reliable manner, and restructuring and

14 resizing itself to face low commodity prices in 2015 and beyond. These strategies ultimately point towards Schlumberger s goal to strive for more market share and consolidation, as particularly evidenced with the Cameron International acquisition. The company is in a mature, yet evolving industry due to the emergence of the shale revolution in 2006 and the subsequent increase in oil production, which ultimately led to the increase in capital expenditures and demand for pressure pumping services that fueled double digit growth in certain business segments such as The Production Group which grew 14% in 2014 to $18.1 Billion. xxi We project year over year growth to decrease by 23% in Products and Markets Product Market The main product markets are the integrated oil and gas companies, land and offshore drilling companies, specifically conventional and unconventional, in North America. Overseas markets include national oil companies in the Middle East, Asia, and Europe. New Products New technology sales composed of more than 27% of Schlumberger s total sales. The New Technologies include: Wireline Quanta Geo formation imaging devices -, Drilling and Measurements GeoSphere reservoir mapping technology -, Well Services Broadband Sequence and Broadband Precision pressure pumping stimulation services. xxiii Customers No one customer represents more than 10% of their sales revenue. We believe that Schlumberger is fairly diversified in this aspect. Recent Earnings and Managerial Guidance For the nine months ended September 30, 2015, product segments have seen declines across the board as compared to the same time period in Revenues for the Reservoir Characterization, Drilling, Production, Subsea, Surface, and V&M groups have 14 P age declined 24%, 20%, 23%, 7%, 14%, and 26% respectively. For the third quarter, Schlumberger beat the consensus estimate by $.01 with a reported EPS of $.78 against the consensus of $.77 xxiv Schlumberger has indicated that oil prices will remain relatively weak in the near future but is firmly of the belief that as production slows the world market for oil will tighten and prices will subsequently recover though they have not given a time line of when that will be. Until then, they have continued to highlight their restructuring and consolidation efforts to position themselves strategically for a continual low oil price environment. xxiii Catalysts for Growth and Change Environment Regulation The Oilfield Services industry is subject to many regulations at the local, state, and federal levels. Hydraulic fracturing in particular has come under intense scrutiny lately due to its increased use in natural gas extraction and the negative effects it produces. The main concern of fracking is the increased seismic volatility in extraction sites and the leakage of propping agents and chemical additives into ground water supplies. Oilfield Service companies must create new technologies to improve leakage while they face increased environmental regulation pressure by lawmakers moving forward. xx Research and Development As oil and gas production companies are coming to terms with $40 oil for the foreseeable future, they are looking for ways to cut costs and increase efficiency. Schlumberger saw 32% growth in its research and development from 2010 to 2014, producing technologies to extract oil from old wells and get the most petroleum from existing resources and will likely continue to do so in the current commodity environment. xxi Consolidation As indicated by the competition in the Oilfield Services Industry, size is key to lowering operating costs and therefore, acquisitions are vital to

15 successfully utilizing economies of scale. With the recent downturn in oil prices, smaller service companies are being bought up by the major players to hedge risk and provide a wider scope of services to their clients. From late August to early September alone, Schlumberger acquired or planned to acquire three companies: Cameron International, Novatek Inc, and BAUER Maschinen-Drilling Bus and will likely continue to acquire companies in the near future. xxv Schlumberger has offered to buy Cameron International at $14.8 Billion in an all cash and stock deal. The deal is slated to close in the first quarter of Schlumberger has already acquired Novatek and BAUER Maschinen-Drilling Bus at undisclosed (immaterial) amounts. xxvi S.W.O.T Analysis Strengths Schlumberger s main strengths include its size, technological and research advantage, and diversified revenue streams. As indicated in various sections, Schlumberger is the largest Oilfield Services Company and therefore is positioned to take advantage of their economies of scale. It has continuously increased research and development spending while introducing new and improved technologies and software which has bolstered its revenue-generation capabilities. All the while deriving revenues from four main geographic areas, with no one area representing more than 30% of total revenues. xxv Weaknesses Schlumberger faces a host of weaknesses inherent in its industry and capital structure, mainly currency exposure and dependence on capital expenditures for revenue. In regards to Schlumberger s Europe/CIS/Africa geographic sector, a large portion of their revenue decline was attributed to a weakened Russian Ruble in relation to the US Dollar. A stronger US dollar negatively impacts revenue for a US based firm. Considering Brazil, China, and various other nations currencies have weakened against the dollar, Schlumberger s international revenue will continue to face pressure even though Schlumberger has a foreign currency risk management strategy that hedges against currency risk. Schlumberger derives the majority of their revenues from their customers capital expenditures budgets. When the energy sector is doing well, more projects get approved and vice-versa. With the current state of affairs in the energy sector, capital expenditures have been estimated to decrease 49% in Schlumberger s over-reliance on Capex will hurt their earnings in the short-term without any signs of revenue generation beyond Capex. Opportunities Schlumberger s largest opportunities lie in its consolidation efforts and new software and product development capabilities. Schlumberger has quite recently undergone a string of acquisitions and as new opportunities present themselves, Schlumberger will continue to pursue strategic acquisitions that complement their wide ranging products and services. Schlumberger has already released new software pertaining to their reservoir characterization group, however, we believe that Schlumberger will continue to produce new and improved technologies so long as R&D continues to increase as well. xxvii Threats Consolidation from other firms is a major threat to Schlumberger. Schlumberger leverages its size and diverse service offerings to customers. When companies like Halliburton acquire Baker Hughes, they narrow the gap between them and Schlumberger, creating more competition. Furthermore, Schlumberger faces threats from large legal proceedings. In the last calendar year, Schlumberger has faced penalties from violating U.S. sanctions with Iran and unfair competitive practices in hydraulic fracturing. Although they have discontinued their Iranian operations, hydraulic fracturing legislation remains a medium to long-term legal issue. xxvii Important Disclaimer This report was created by students enrolled in the Security Analysis (6F:112) class at the University of 15 P age