Schlumberger Suffers a Double Downgrade: What You Need to Know

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Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

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It was a rough day for oil investors today, with analysts at New York-based Guggenheim Securities downgrading more than a half dozen stocks in the oil services sector, including big names like Baker Hughes, Halliburton, and Schlumberger (NYSE: SLB). Things could get especially rough for investors in Schlumberger in particular, with StreetInsider.com (requires subscription) reporting that it received a second downgrade from Atlantic Equities this morning as well.

Here are three things you need to know.

1. Forecast calls for clouds

Let's start with the latest forecasts for oil prices. The U.S. Energy Information Administration published its latest update on oil prospects earlier this month, noting that Brent crude averaged just $50 per barrel in May. (U.S. West Texas Intermediate crude, more commonly used in the U.S., generally sold for about $2 a barrel cheaper here.)

Peering into its crystal ball, EIA suggested that oil might average $53 overall this year, and only $56 next year. This suggests a nice bounce back from recent price levels below $44 in the U.S. -- but muted growth next year.

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2. ...with a possibility of storms

And that's not the worst of it -- EIA estimates could even prove optimistic. A day after EIA's estimates came out, Goldman Sachs cut its estimate for this year's average oil price to under $53 for WTI, and perhaps $55 and change for Brent. JPMorgan went a step further, predicting that Brent prices might not rise a few dollars in 2018, but rather fall steeply -- to $42 per barrel for WTI and $45 for Brent.

3. What it means for Schlumberger

Thus the story shaping up for oil prices appears to range from slim prospects for prices rising to a real possibility of a plunge to prices even more deeply discounted than where they sit today. What does this mean for Schlumberger?

Guggenheim isn't 100% sure, but it seems certain the news isn't good. This morning Guggenheim cut its rating on Schlumberger from buy to neutral and withdrew its $90 price target entirely. Atlantic Securities is a bit more specific about its concerns. Cutting its rating from overweight to neutral, and its price target from $86 per share to $68, Atlantic warns that it sees only a "limited rebound in oil prices" forthcoming, and worries that this will result in "only modest activity growth across SLB's businesses."

Why is that? "For many Oilfield Services segments," explains Atlantic, "a slow recovery implies capacity utilization will take longer to tighten." This is probably because more oilfield services firms will survive (or at least take longer to die) in an environment of modestly growing oil prices.

The result of more competition hanging around for longer, though, is that it will keep more capacity open and make it harder for Schlumberger to raise its own prices (and profits). Customers will play oil-field service providers off against each other, continuing "to exert downward pressure on [their own] costs" at Schlumberger's expense.

The upshot for investors

Thus, an oil environment like today's, with oil prices low growing only modestly, is "inconsistent with strong pricing power for service providers," says Atlantic. The most the analyst thinks investors can expect out of the stock is for Schlumberger to trade at about the same 19 times forward earnings multiple that the stock has enjoyed since about 2005. Applied to 2019 earnings, Atlantic values says that works out to a target price of $68 a share. 

Of course, Atlantic didn't say exactly how much it expects Schlumberger to earn in 2019 -- but it's apparently not a lot. Data from S&P Global Market Intelligence show that most analysts believe Schlumberger stock will earn as much as $4.46 per share in fiscal 2019. Apply that to Atlantic's offered earnings multiple of 19, and it would work out to a target price closer to $85 than to $68. In sticking with a $68 target price, therefore, Atlantic seems to be implying that it expects Schlumberger to earn a lot less than everyone else on Wall Street is expecting -- as much as 20% less. 

If Atlantic is right about that, though, then maybe it should actually be downgrading Schlumberger more aggressively. Maybe it should even be downgrading to sell.

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Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.