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In a bear market environment where all three major benchmarks are in negative single-digit and double-digit territory so far this year, Schlumberger Limited (NYSE: SLB) is one of the best stocks to buy and hold for high returns both in the form of price appreciation and dividends. Shares of SLB have appreciated more than 20% since the start of the year, and the company has announced a 40% increase in the dividend for 2022. I am convinced that the shares and cash returns of the main company oilfield services will continue to grow due to three key drivers, including robust upstream spending, pricing power and cash flow growth. To assess the yields of SLB, let’s take a look at these catalysts.

1. Aggressive Upstream Spending

As oil and gas prices are expected expected to remain at double their normal level for the next few years due to a growing gap between supply and demand, the industry is responding to supply constraints by increasing short-cycle investments in exploration and production. Upstream investment is expected to rebound in the second quarter and expand more strongly in the second half, driven by North America, the Middle East and other key international offshore basins. In 2022 alone, international upstream spending is expected to increase at an average rate, while investments in North America could exceed 20%.

The impact of aggressive spending has already begun to bolster Schlumberger’s financial numbers. Its first-quarter revenue jumped 14% year-over-year to $5.96 billion, driven by 31% growth in North American revenue and a 10% increase in international markets. The well construction segment, the largest revenue-generating segment for Schlumberger, posted 24% year-over-year revenue growth in the March quarter. As noted above, with the investment cycle accelerating in the second quarter and further intensifying in the second half, Schlumberger is poised to deliver double-digit revenue growth in 2022.

2. Schlumberger Pricing Power

As oil and gas prices have been at high levels for several years and producers seek to maximize opportunities, concerns are growing over a shortage of oil services. Ongoing equipment shortages and widespread bottlenecks mean that oil service players have significant pricing power. Schlumberger’s large global footprints as well as a portfolio of industry-leading products and technologies such as basin-specific technologies, transition technologies and emissions solutions strengthen its pricing power.

In fact, pricing power has already started to show up in the earnings reports of oil service companies. Schlumberger’s pretax segment operating margins increased 229 basis points (bps) in the first quarter of 2022, while its Adjusted EBITDA margins of 21% increased 94 basis points. Schlumberger expects its adjusted EBITDA margins to end the year at least 200 basis points higher than in the fourth quarter of 2021. Higher margins mean higher profits and cash flow for the business.

In addition, the ramp-up of upstream production activities in the second half of the year will further expand the scope and magnitude of net price impacts in long-cycle development projects.

3. Cash flow

The company’s cash generation potential has improved significantly over the past year and is expected to further accelerate in the coming quarters. The improvement is not only attributed to increased revenues and profits. The improvement is mainly due to the efforts made by SLB over the last two years regarding the good rating of its portfolio. It expects to generate a double-digit return on capital employed in the short to medium term.

This means that the improvement in cash generation is supported by a real change in the structure of return on capital rather than fluctuations in income and earnings. This is also reflected in its free cash flow performance in 2021, when the company generated $0.3 billion more free cash flow than in 2019 despite a 30% decline in revenue. The company now expects to generate double-digit free cash flow margin growth for 2022 over the prior year. The 40% increase in the dividend also indicates management’s confidence in future cash generation.

How high can Schlumberger shares go?

Schlumberger stock price is currently trading around $37, up 21% year-to-date, and up 46% in the last twelve months. Market analysts also seem optimistic about the extension of the bullish momentum in Schlumberger stock price. For example, Piper Sandler raised Schlumberger’s rating from Neutral to Overweight with a price target of $55.

‘Shortages of rigs and other supplies today are ’emblematic of the scar tissue and atrophy of the wider industry that resulted from abrupt downsizing for several years prior to the current crisis energy supply,” said Ian Macpherson of Piper. wrote.

In my view, the company’s stock will likely follow broader energy market trends, while substantial growth in revenue and earnings will bolster investor sentiment. To find the upside potential and its fair value, I used a discounted cash flow model. I assumed that its leveraged free cash flow would grow 15% over the next five years, which is in line with the company’s projections. The company’s weighted average cost of capital is 8%, while I used an average 5-year government bond yield of 3.75% to estimate future growth. The model is composed of two stages. In step 1, I discounted the 5 year cash flow forecast to present value while step 2 deals with present value of terminal value to determine stock price.

Step 1:

Figures in billions

Year

2022

2023

2024

2025

2026

leveraged free cash flow

$2.00

$2.3

$2.64

$3.04

$3.5

WACC

8%

8%

8%

8%

8%

Current value

$1.85

$2.13

$2.45

$2.82

$3.24

Present value of cash flows over 5 years = $12.5 billion

2nd step :

Terminal value = FCF2026 * (1+g)/(rg)

Terminal value = $3.5 billion * (1+3.75%)/(7%-3.75%)

Terminal value = $85.5 million

Net present value of terminal value = TV / (1 + r)5

Net present value of terminal value = 85.5 billion/ (1 + 7%)5

Net present value of the terminal value = $58 billion

Common shares outstanding = 1.2 billion

Net value = $48

SLB stock looks over 20% undervalued, trading around $37 versus fair equity value of $48.

Risk factors

Schlumberger’s performance is directly linked to exploration and production expenditures. In 2022, upstream spending is expected to remain strong due to supply shortages, which is favorable for oil service companies. The company’s strategy of reducing its operations in Russia would also have a negative impact of 5% on its revenues. The company, however, is optimistic that its revenue from other parts of the world will make up for this loss.

In conclusion

In today’s volatile and unpredictable market conditions, Schlumberger appears to be one of the best stocks to buy and hold due to its strong market fundamentals. Its actions are expected to extend the bullish momentum due to robust upstream spending expectations and near-to-long-term pricing power. Strong cash flow would also allow it to deliver healthy cash returns to shareholders.