When it comes to the No. 4 energy services company Weatherford (NYSE:WFT), I have walked the line between supporter and apologist as I thought I saw a lot of potential value in running this business better. Unfortunately, while it is still true that Weatherford has an interesting under-valued business, it's also true that the company's management has to clean up a lot of messes. Consequently, there's value here, but its value that comes with a big asterisk.

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A Less Impressive Second Quarter
Weatherford's second quarter was OK relative to expectations, but the company didn't seem to perform as well (or ease the Street's worries) as Halliburton (NYSE:HAL) or Schlumberger (NYSE:SLB).

Revenue rose 5% from the first quarter, with a 14% growth in international markets outweighing a 4% sequential decline in North America. Interestingly, not only are Weatherford's reported international segments (Latin America, etc.) roughly similar in size, but all grew at a double-digit sequential clip.

Margins were a mixed bag. Operating income fell 2% from the first quarter, with a nearly one-point drop in margin. North American performance was worse, as income fell 25% on a four-point drop. International was strong, though, as income grew 37%.

Assessing this performance, it was a mixed bag. Again, Weatherford really didn't outperform and didn't show the better-than-expected North American performance that Halliburton and Baker Hughes (NYSE:BHI) did. On the other hand, growth and margin expansion in the international business was better than the average of the Big Three, even though Weatherford has less leverage to offshore business.

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Embarrassing Non-Operating Issues
Weatherford's "back office" problems continue to fester. The company has had tax problems for quite a while now, and yet the company still reports that its internal controls with respect to taxes are inadequate. And now there's more - the company took a $100 million charge for an anticipated settlement with the government over illegal dealings with countries under sanctions, and also wrote down goodwill tied to prior deals and investments.

Now, to be fair, the sanctions infractions occurred a while ago and the wheels of justice sometimes turn very slowly. What's more, goodwill write-downs are not uncommon or exclusive to Weatherford. It's also true that management is making some progress with its tax troubles, including hiring more senior management positions.

All of that said, it's hard for me to give management much credit for cleaning up problems (and seemingly doing so slowly) that should have never existed.

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Of Lift and Margins
Weatherford remains the leading player in artificial lift, with No. 1 share in rod lift, PCP, hydraulic, gas lift and plunger technologies. Weatherford plays in virtually every segment of artificial lift except electric submersible pumps, where Baker Hughes, Schlumberger and General Electric (NYSE:GE) have meaningful share.

As a refresher, artificial lift is a way for well owners to improve production, particularly oil production. While wells can often produce hydrocarbons just on the basis of the pressure in the ground, the abatement of that pressure often leaves as much as 80% of the oil sitting in the ground. Artificial lift, then, is a way of generating more valuable oil out of an already-drilled hole ((and that's essential to returns, as companies like Apache (NYSE:APA) know so well)).

What does worry me about Weatherford is its inherent margin structure. Across the spectrum of energy services, Schlumberger is strongest in the highest-margin services like wireline and production testing. Weatherford's strengths lie on the other end of the spectrum - in the lower-margin services like rentals, data logging and servicing rigs where the barriers to entry are lower. Likewise, Weatherford has a large overseas land exposure - where there tends to be more risk of price pressure from national oil companies and more emphasis on building up local service capabilities.

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The Bottom Line
I wonder if Weatherford would appeal to GE as an acquisition candidate, as there is little overlap between the companies today. Then again, if GE wants to expand its artificial lift capabilities, it could also just buy Lufkin (Nasdaq:LUFK), the No. 4 overall player in artificial lift and No. 2 in rod lift technology.

Right now, I'm imposing a discount on Weatherford's valuation due to "headline risk." Where I give a six times forward EBITDA multiple to Halliburton and Baker Hughes, I give a five times multiple for Weatherford. Doing so suggests a fair value of more than $17 and a respectable appreciation potential, but investors need to decide for themselves if the risks and market exposures are worth it.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.



Tickers in this Article: WFT, HAL, SLB, BHI

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