briefing.com
Updated 05-May-98
Rotation, Rotation, Rotation (and the Oil Equip. &
Serv. Sector)
If the three keys to real estate are location, location, location, the three keys to
the bull market's longevity are rotation, rotation, rotation. Rotating corrections
have enabled the market to work off excesses in one or two areas, while
creating excesses in others. Once the chosen groups (which presently include
pharmaceuticals, search engine and financials) have run their course, money
managers rotate back to the beaten up areas and begin the process all over
again. This pattern has been particularly evident in the tech sector over the past
couple years, as the sector goes in and out of favor with alarming regularity.
Another group that has been caught up in this pattern is the energy sector. Our
focus today is on the Oil Drilling Equipment and Services industries.
The Fall From Grace
After leading the market higher for nearly two years, the group fell on hard times
with the advent of the Asian contagion. Portfolio managers and momentum
investors (getting tough to tell the difference these days) were quick to jump off
the bandwagon for fear that Asian crisis had changed the earnings equation at a
time when the group's valuations left little room for error. Losses accelerated as
OPEC foolishly upped production quotas by 10%, the UN and Iraq reached an
agreement allowing the latter to bolster production and the major industrial
powers signed on the Kyoto accord. Fears of oversupply sent crude prices
tumbling to below $14 per bbl.
First Sign of Relief
One of the first signs that the group was preparing to turn the corner occurred at
the oddest of times - when crude prices fell to their lowest level in years. Logic
would dictate that as the price of crude fell to $13.21 on March 7th, the stocks in
the oil drilling equipment and services industries would be collectively setting
new 52-wk lows given that lower crude prices suggest less spending by the
major oil companies on exploration. But such was the case with only a few
stocks. Most of the component issues followed by Briefing (of which their are
12), simply remained confined to their months long trading ranges. When stocks
fail to fall on bad news it is an early signal that the bad news is already priced in.
Consequently, surprises are now more likely to be positive than negative, and
positive surprises are one of the main forces that drive stock prices higher.
Reclaiming "Favored" Status
In just the past few weeks, the group has slowly began to reclaim its "favored"
status. A number of factors have contributed to the group's resurrection. They
include:
Stabilization of crude prices in the $15-$16 range.
Realization that Asian contagion will be a relatively limited and short-lived
problem.
Surprising strength in US and European economies.
OPEC's decision to cut back quotas by 10%, and speculation that further
reductions could be forthcoming.
Muted impact on supply from Iraqi production.
Firm pricing conditions within industry despite weak crude prices.
On balance, major oil companies have not reduced exploration budgets,
confirming Briefing position that as long as crude didn't stay below the $15
bbl area for a sustained period, exploration budgets would remain intact.
This is one reason why we maintained our long-term outperform rating on
our Sector Ratings page throughout the pullback.
Continued strong revenue/earnings growth.
Discounted valuations.
Earnings, Earnings, Earnings
If the key to the market's success has been rotation, rotation, rotation, the key
to the sector's recovery can be found in its earnings, earnings, earnings. The
current earnings period has been outstanding - providing one of those positive
surprises which has triggered renewed buying interest. Of the 12 companies we
follow, 9 have already reported earnings. The average year-over-year
revenue gain for the period was 30.4%, with an average jump in
earnings of 56.7%. Meanwhile, the S&P 500 is struggling to post double-digit
gains.
Valuations
In light of the much better than market growth rates, you might expect the
sector to trade at multiples in line with or above the overall market. Not yet.
Though the group is emerging from a 5-month long basing formation, the sector
continues to trade at a steep discount to the market. At present, the sector
trades at 18.7x estimated FY98 earnings (with most companies having completed
at least half the fiscal year) and only 13.9x projected FY99 results. Considering
the strong numbers posted this quarter and the improving fundamental backdrop
it wouldn't be a surprise to see the street start upping its earnings estimates for
FY99. If it does, the already discounted valuations will become even more
compelling.
Conclusion
Though conditions in the sector are improving from both fundamental and
technical perspectives, good values can still be found as doubt continues to hover
over the group. Briefing maintains that these concerns are largely groundless, as
the reality remains: rising day rates, near 100% fleet utilization and slightly
higher exploration budgets. The end result will be continued strong revenue and
earnings growth. The street is beginning to take notice, as money is slowly
rotating back into the sector. Before too long, expect the trickle to become a
flood and for the Oil Drilling Equipment and Services sector to reclaim its status
as a market leader.
Component Issues: Baker Hughes (BHI), Camco (CAM), Cliffs Drilling (CDG), R&B
Falcon (FLC), Global Marine (GLM), Halliburton (HAL), McDermott International
(MDR), Schlumberger (SLB), Smith International (SII), Tidewater (TDW), Transocean
Offshore (RIG) and Unifab (UFAB).
c Copyright 1998 E*TRADE Securities, Inc. All Rights Reserved.
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