Weatherford Burning Through Its Benefits Of The Doubt

Broadly speaking, there are two valid reasons to own Weatherford (NYSE:WFT). First, you believe that the company's position in markets like artificial lift, casing, and tool rental coupled with more disciplined management will lead to solid revenue and profit growth. Second, you believe that the company's process of getting its act together, including resolving tax/reporting issues, a FCPA investigation, and working capital management, will lift the penalty discount on the shares and/or prompt a buyout.

Judging by Weatherford's second quarter earnings, and the market's reaction, it seems like the second notion is in the lead. This wasn't a great quarter for the service sector, but Weatherford's quarter was pretty poor on an operating basis, and there's only just so much grace period that investors will give this management team. While I'm still content to own these shares on the basis of what I think is the underlying value to the business, the company needs to get its act together quickly.

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Weak Operating Results Dominate Q2 Results
This was a decidedly feeble quarter for Weatherford, and there was some competition for that title with the quarters reported by Halliburton (NYSE:HAL) and Baker Hughes (NYSE:BHI). While a lower tax rate helped to Nerf some of the damage, Weatherford was pretty weak on an operating basis relative to both its own prior guidance and Street expectations, and it sounds as though managed walked back from its targets for the second half of the year.

Revenue rose 3% from last year and 1% from the first quarter, good for a slight beat relative to expectations. North American revenue was particularly weak, down 8% and 10%, relative to Halliburton, Schlumberger, and Baker Hughes, as the company has above-average exposure to the weak Canadian market and below-average exposure to the healthier Gulf of Mexico market. International performance (up 12% and 9%) was more encouraging, both relative to analyst expectations and the performance of rivals.

Margins were pretty ugly. Gross margin declined both annually and sequentially (down four points and one point). Operating income rose 7% and fell 10% relative to last year and last quarter and missed the average estimate by about 13%. North American margin was down more than two points, much worse than the performance of the Big Three, while the half-point improvement in international margin was actually better than Baker Hughes.

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Even if you exclude items like severance and legacy contract costs, it was only a weaker tax rate that saved the quarter, and Weatherford missed by about 20% per-share on an adjusted basis.

What Now?
With Weatherford seemingly making something of a habit of operating misses, the notion of the company rebuilding its credibility with the Street could be getting a little strained. Still, it didn't seem like sell-side analysts on the conference call were that aggrieved by it. What's more, with management announcing an additional FCPA reserve of $153 million ($253 million in total) for a long-ago violation of Iraq sanctions, and that reserve being about $100 million to $150 million below some estimates, it seems like analysts are still willing to look past current difficulties and toward a better future.

Operationally, there is an expiration date on the bullish case for Weatherford, but I don't think we're there yet. Those companies that outperformed Weatherford seemed to do so on the basis of stronger performance in service areas like reservoir characterization and stimulation/pressure pumping – areas where Weatherford is well-known to be weak. That's not a perfect excuse, as Dover (NYSE:DOV) saw 6% year-on-year growth in its production business (which includes artificial lift), but I think there is a valid argument to be made that the "sweet spot" for Weatherford is still coming.

The Bottom Line
Weatherford has already been outperforming on the basis of the "clean-up trade", and I'm not sure that there's much juice left there. Consequently, operational performance will become increasingly important if Weatherford is going to head higher and earn a better multiple from the market.

I continue to value Weatherford at a discount to Halliburton and Schlumberger, and closer to on-par with Baker Hughes (an EV/EBITDA multiple of 7x for WFT as opposed to 6.5x for Baker Hughes). On that basis, fair value still looks to be around $18, making this stock one of the cheapest in the energy services space. That apparent cheapness comes at a cost, though, as this quarter demonstrates once again why there's serious doubt in some corners as to Weatherford's ability to execute and drive good financial results on a prolonged basis.

Disclosure: At the time of writing, the author owned shares of Weatherford.