Halliburton Company (HAL) — Q3 2016 Earnings Call Transcript

Good morning, and welcome to the Halliburton third quarter 2016 conference call. Today’s call is being webcast and a replay will be available on Halliburton’s website for seven days. Joining me today are Dave Lesar, CEO; Mark McCollum, CFO; and Jeff Miller, President. Some of our comments today may include forward-looking statements, reflecting Halliburton’s views about future events. These matters involve risks and uncertainties that could cause our actual results to materially differ from our forward-looking statements. These risks are discussed in Halliburton’s Form 10-K for the year ended December 31, 2015, Form 10-Q for the quarter ended June 30, 2016, recent current reports on Form 8-K and other securities and exchange commission filings. We undertake no obligation to revise or update publicly any forward-looking statements for any reason. Our comments today also may include non-GAAP financial measures. Additional details and reconciliation to the most directly comparable GAAP financial measures are included in our third quarter press release, which can be found on our website. Now, I’ll turn the call over to Dave.

Thank you, Lance and good morning to everyone. Let me start by saying that I am very pleased with our results. I never thought I would be so satisfied by barely making a profit. But given where this market is, I certainly am. Through hard work and determination, we have returned to positive territory for our earnings. Now, this has been a historic down cycle for the industry and it’s had its fair share of challenges. Our organization is meeting those challenges head-on and fighting through them. I am very proud of our leadership and all of our employees. We are the execution Company and I believe this quarter we out-executed even the very high expectations we placed on our organization. Let’s take a minute and talk about what transpired over the quarter. Our North America revenue grew 9% for the period, representing the first revenue increase in seven quarters. Our results improved as we took advantage of the rig count growth by focusing on increasing utilization and working our surface efficiency model. Our customers’ animal spirits remain alive and well in North America even though for some they may feel a bit constrained by cash flow limitations in the short term. The average U.S. rig count increased 14% over the quarter, driven primarily by rig additions to smaller operators where we saw a trend of less service intensive wells, which is not activity typically worth chasing at today’s pricing. This quarter was also impacted by the natural lag time between drilling and completion activity. However, we are now seeing completion activities starting to pick up as we start the fourth quarter. We continue to aggressively implement our structural cost reductions announced in our first quarter call, and we have met our goal. On a monthly basis, we have already achieved the run rate of $1 billion of cost savings annually. We also generated over $1 billion in cash flow from operating activities this quarter. As you all know, as we executed our playbook, we gained significant market share globally through the downturn. As the markets stabilize, our primary focus will now switch to improving our margins while maintaining that market share. In the U.S., we believe we now have the highest market share we’ve ever had. And at this point, if we have to give some of it back to move margins up, we might take that approach. In North America, we achieved a 41% incremental margin. This is a strong step in the right direction as we work to regain profitability there. We remain steadfast in our belief that significant activity increases from our customers starts with sustainable commodity prices over $50 per barrel, which we haven’t seen in any meaningful way yet since the rig count activity bottomed out. Operators have had time to reflect on our future drilling plans, and I believe they will approach the recovery with a rational, methodical response in activity based on commodity price fluctuations. Now, looking ahead to the fourth quarter on North America land, activity levels are difficult to call at this point. Based on current customer feedback, we remain cautious around customer activity due to holiday and seasonal weather related downturns. Our customers may take extended breaks, starting as early as Thanksgiving and push additional work to the first quarter of 2017. As one customer told me, "It doesn’t make any sense for me to rent an efficient high-spec rig if I have to start and stop all the time for the holidays or the last five weeks of the year. I just can’t get the efficiencies I’m paying for in the rig. I would rather just wait till next year to start drilling." And I believe we will see a lot of that mentality in the fourth quarter. But that being said, it does not change our view that things are getting better for us and our customers. Now, let’s turn internationally. I like where our market share is today in the international markets, and I believe we continue to outperform our peers. I expect the international markets to slowly grind downward due to the lower commodity price environment. We experienced activity and pricing headwinds during the quarter, but in anticipation of those forces, we aggressively managed our cost. Although we have had to concede some on pricing, we have worked closely with our customers during the past year to improve their project economics to technology and operating efficiency. We expect to see a bottoming of the international rig count in the first half of 2017. Land-based mature field activity should lead the international recovery, while we expect the deepwater complex to remain so severely challenged for the foreseeable future. Even though the light at the end of the tunnel is getting brighter, there is no question we remain in a very challenging market. However, we’re confident in our ability to navigate through this cycle and in our continued focus on unconventional mature fields in deepwater markets. As we have said before, unconventional, particularly those in North America are leading their recovery in activity, providing the optimal combination of short cycle returns and the fastest incremental barrel to market. Mature fields continue to be resilient given their relatively low lifting cost. And finally, deepwater remains structurally challenged with higher costs and long duration project characteristics. While each faces a different set of circumstances today, you can be sure we’re looking at our business closely to ensure that we accelerate our growth in each sector as the industry begins to heal. As we have said for some time, North America has assumed its role as the swing producer in global oil production. Because of this shift away from production discipline, which was historically created by OPEC, our industry will likely experience shorter commodity price cycles going forward. So, we see the future market as a combination of shorter cycles and range-bound commodity prices. In that environment, it is imperative that returns-focused companies like Halliburton be more asset-light. Having an organization structured in a way that is flexible, nimble, and efficient and that can adapt to these new quick-moving cycles will be critical to drive the returns that our shareholders have come to expect. Our philosophy is then in prioritizing returns over margins and revenue, and that philosophy will continue. Now don’t get me wrong. We are always focused on improving margins. But keep in mind, the last cycle of $100 oil covered up terrible inefficiencies across the industry. In today’s environment, asset utilization will be just as critical to improving margins. And I have full confidence we’re taking the necessary steps to achieve that. Positioning us for success while navigating through this deep cyclical downturn was one of the most intellectually stimulating management challenges we have ever had. And I am confident that Halliburton's management team has and will continue to successfully meet each and every challenge. With that let me turn the call over to Mark and Jeff to cover our financial and operational results. Mark?

Thanks, Dave. Good morning, everyone. Let’s start with the summary of our third-quarter results compared to our second-quarter results on an adjusted basis. Total company revenue for the quarter was flat at $3.8 billion, while our operating income doubled to $128 million. These results were primarily driven by increased activity in North America and the continued impact of our global cost savings initiatives. Moving to our regional results, North America revenue increased 9% with a $58 million increase in operating results or 47% sequentially. The higher U.S. land rig count coupled with better equipment utilization and our ongoing cost management efforts drove this improvement. In Latin America, revenue and operating income declined by 13% and 50% respectively. These results primarily reflect reduced activity levels in Mexico, Argentina, and Venezuela as we’ve now experienced a 15-year low in the regional rig count. Turning to Europe/Africa/CIS, revenue declined 6% as a result of lower drilling activity in West Africa and Continental Europe. Operating income increased 19%, primarily related to our cost savings initiatives and improved pressure pumping and pipeline service profitability throughout the region. In Middle East/Asia, revenue declined 3% with a decline in operating income of 4%. The decrease through the quarter was primarily driven by reduced activity across Asia Pacific, including Australia and Indonesia, as well as pricing pressure across the entire region. Our corporate and other expense for the third quarter totaled approximately $47 million, which was positively impacted by a true-up of some of our insurance reserves. For the fourth quarter, we expect our corporate expense to return to our previous run rate of approximately $60 million. Interest expense for the quarter was $141 million and was positively impacted by the interest income we’re now earning on the Venezuelan promissory notes we accepted in exchange for some of our trade receivables last quarter. We expect that this level of net interest expense will be our new run rate for the next several quarters. Our effective tax rate for the third quarter was a 114% benefit, well above the already unusual 50% rate we anticipated on our last call. As we’ve discussed before, these unusual effective tax rates are primarily the result of having tax losses in the U.S. that are offset by taxable income in foreign jurisdictions with lower statutory rates. However, the difference this quarter from the rate we anticipated was largely due to an adjustment reflecting the beneficial use of an Argentinean tax treaty that limits the taxation of royalty payments for intellectual property and will allow for more efficient movement of our foreign cash in the future. Based on our current outlook, we anticipate that our effective tax rate for the fourth quarter will be approximately 65%. Turning to cash flow, we improved our cash position during the third quarter, ending the period with $3.3 billion in cash and equivalents even after paying off $600 million of senior notes. This increase in cash flow was primarily due to working capital improvements which included a seven-plus-day reduction of our day sales outstanding and the receipt of a series of tax refunds. Capital expenditures for the year are still expected to be approximately $850 million. Now, turning to our short-term operational outlook, let me provide you with our thoughts on the fourth quarter. In North America, the uncertainty surrounding customer activity around the holiday season makes the quarter difficult to predict. Based on what our customers are collectively telling us, we anticipate our revenue to perform in line with the rig count and we expect our sequential incremental margins to be 35% to 40%. In our international business, we believe the typical seasonal uptick in year-end software and products sales will be minimal this year as customer budgets are exhausted and may not fully offset continued pricing and activity pressures. As such, we expect fourth-quarter revenue and margins to come in flat compared to the third quarter. Now, I’ll turn the call over to Jeff for the operational update. Jeff?

Thank you, Mark and good morning everyone. I’d like to thank and congratulate all of our employees for their fantastic execution throughout the cycle. It’s been a tough two years and our organization has delivered on service quality, has delivered on cost savings and has absolutely executed on our value proposition, collaborating and engineering solutions to maximize asset value for our customers. The result of this execution was improved margins and repeat business. So, let’s start with North America. While the supply and demand balance for U.S. onshore services is heading in the right direction, we are still in an oversupplied equipment market. Our customers remain focused on cost and producing more barrels. I believe this puts us in an excellent position. No one is better at collaborating with customers to engineer solutions that deliver the lowest cost per barrel of oil equivalent than Halliburton. In fact, the more I talk to customers, the more I’m convinced this is the winning formula. In pressure pumping, we estimate that the U.S. active fleet, I emphasize 'active', grew to over $7 million horsepower and the utilization of that active marketed fleet is about 70%. This is a long way from full capacity, but it represents substantial tightening during the third quarter. And as I said last quarter, this is the first step towards a balanced market for the industry’s available fleet. And while we know the industry has additional horsepower on the sidelines that could come into the market, we also know that this additional equipment requires substantial maintenance to be put back to work, and will require adequate price increases to justify its return. So, as we look ahead, we expect pricing to work its way through a couple of predictable steps. The first step which we’re starting to see now is a tightening of active capacity. This will have a modest price impact but more importantly, it allows increased utilization to have a positive contribution to earnings. Step two is when we see equipment requiring significant investment returning to the market. I expect that this will require a significantly higher pricing to justify the investment. This is by no means traditional pricing power; instead, it’s the industry recognizing the relationship between investments and returns plateau. Market share is valuable and that’s why we build it in the downturn. I think Dave was crystal clear that our target is leading returns, and we have not forgotten that. High market share gives us choice in the recovery to work with the most efficient customers and value what we do and who ultimately reward us for helping them make better wells. There is no doubt that in this environment our clients are planning work based on commodity prices. The stakes have never been higher for us to help maximize the value of their assets. And this is exactly what we’re doing. So, let me take you through some examples of how we’re doing this today. Last quarter, we worked with a Permian operator who wanted to step outside of their core assets and find a way to optimize the value of their acreage. With the robust drilling and completion plan in place, the customer started to minimize completion damage during flowback and maximize overall recovery. Through the use of our CALIBR Engineered Flowback service, we were able to prevent damage and achieve a 15% higher cumulative production on this well than on wells nearby with similar completions. The well is now the best producer in the customer’s portfolio despite it being in the geology that had been originally considered marginal. There has been a lot of talk about drilling in core reservoir rock recently. I believe it’s now our job to help our customers extend the definition of core. This is a great example of how we listen to our customers' drivers and work with them to develop a unique solution to meet their goals. CALIBR has not been used before in the Permian but thanks to this success, it’s gained traction in that basin. In the Middle East, we recently engaged in a highly collaborative project where the customer’s drivers were to improve delivery time and production. We developed a solution that stimulated a well in less time and in a more cost-effective manner. Using our surgi-squeeze technique, where coiled tubing is used to deliver more focused stimulation to selective areas, we were able to use fewer chemicals and reduce pumping time by 40%. This highlights how Halliburton systematically collaborates with the customer, the engineered solution that maximizes our asset value. In Brazil, we worked to maximize our customer’s asset value through intelligent completions. These are essential in the pre-salt area to improve reservoir management and production, while reducing the overall well cost. In the quarter, we completed a multiyear campaign of 40 successful intelligent completions, which lowered the lifting cost dramatically. This is what clients appreciate about Halliburton. We collaborate, meaning listen and respond to our customers. We focus on creating and maintaining strong client relationships. It’s why we win and keep work. It’s why we get things done and why we are the execution Company. To sum up, I’ve walked through our value proposition and action, and it’s equally effective in all of our strategic markets: unconventionals, mature fields, and deepwater. The takeaway is that Halliburton is well-positioned to win the recovery in each of these markets. Now, I’ll turn the call over to Dave for closing comments. Dave?

Thanks Jeff, and let me summarize. As we predicted, the North America unconventional market has responded the quickest demonstrated by the increase in recent rig count activity. However, we continue to believe meaningful activity increases from our customers will not start until we see sustainable commodity prices above $50 per barrel. And while the international markets will take a little more time to rebound, we are maintaining our integrated global services footprint, managing costs and continuing to fight for market share. We expect to see the bottom for activity in this market occurring in the first half of 2017. In this global recovery, we expect cycle times to accelerate. I believe successful companies will be characterized by a lighter asset base, faster asset velocity, and job site execution, all geared to respond quickly to deliver returns. So, to me, no matter what market is handed to us, Halliburton is well-positioned, and our dedication to execution gives me confidence that we will continue to outperform our peers. With that, let’s open it up for questions.

I wanted to dig in, Dave or Jeff, on the pricing question around North American pressure pumping. At this point, I know you’ve indicated you’ve got the market share, so you’ll give up some in order to get profitability up. Are you starting to see the early signs of some pricing gains in certain basins, and maybe it’s not in the Permian but maybe some of the basins where equipment has migrated out of?

Pricing is still, yes, I’ll describe it overall as a brawl. As I said, we’re always pushing on pricing. We’re seeing small increases in different basins, but where we’re most focused is around those customers with whom we collaborate the best. And I’ve always said that the tightening of utilization was a critical first step and we are beginning to see that. We’re also moving away in some cases from work where we don’t see a similar clear path to returns.

And then maybe a follow-up on that, so I guess your strategy for unstacking equipment at this point, you suggested it’s more of a conversation about returns on the assets. That would assume that you need at least some level of price increase to bring stacked equipment, even if it’s in great shape back to work?

Spot on James. I mean the equipment’s got to make returns. In my view this does require a step up in price. And so for that reason, we don’t have current plans to restart the market. I would expect the next round of investment broadly to drive better discipline related to returns.

I have a question for Dave or Jeff. Dave, could you elaborate on your prepared comments regarding the need to be asset light? You mentioned a shorter cycle; does this indicate a shift in how you will operate the business or your strategy, and how does it influence your investment approach?

We are concentrated on all the factors that contribute to returns. In my opinion, shorter cycles align closely with our value proposition, which emphasizes execution and the final stages of delivery. This means we are not pursuing vertical integration merely for its own sake; instead, we are focusing on making aspects of our business more flexible wherever it makes sense. As a result, we are enhancing our margins through improved utilization and pricing strategies. As we move forward, maintaining speed will be more crucial than ever, and we are actively implementing measures to boost that speed across all areas of our business. We firmly believe that this approach will lead to superior industry returns.

My follow-up question is about the guidance for North America in the fourth quarter, which seems clear. I'm curious about your visibility regarding the calendar for the first quarter of early 2017. This will likely depend on the fluctuations in oil prices and OPEC's decisions. It appears that some customers are beginning to schedule work for 2017, and I would appreciate any insights you could share on that.

At this point, the board is full, but it’s unclear if that indicates customer flexibility. Historically, we see a slowdown during the holidays, which could result in more work being pushed into the early part of next year. However, that segment of the market is not clear right now. Therefore, we will focus on managing our costs and operations to maintain structural cost savings, positioning ourselves for when recovery occurs.

This is Mark. I believe our overall perspective is that Q1 will be an improvement. Customers are engaging, but the extent of that improvement will heavily rely on the commodity prices as we enter the early part of next year. Therefore, we feel confident that we are on a clear path to recovery.

So, I was down in the Permian about a month ago and met with a collection of operators, and everyone just was discussing more sand per well and longer laterals, two trends that everyone has been discussing for a while. The trend that stuck out to me and which appears less well appreciated is the trend towards more frack stages per well. A couple of operators were discussing shifting towards fully 40, 50-stage wells and one was actually discussing pushing towards 90-stage wells. Are you seeing this trend in the Permian? And if so, can you discuss the impact on the requisite pump time to complete these wells?

Look, we are seeing a move towards shorter spacing on the stages which ultimately drives more stages, and this will drive more service intensity for us. More stages means more plugs, means more perfs, earns more sand. So, you get the point but just don’t forget that the most important thing is making a better well, ultimately which involves stimulating more rock. And so, I would say that the precise placement of the sand is probably the most important thing. And that’s where we spend our time, is optimal frac design and placement and really how to make a better well.

And just generally, are you seeing operators outside of the Permian squeeze the spacing as well or is this just a Permian phenomenon?

I would say that what’s right is what’s right for the rock. And I think you’re seeing that moving into the Permian basin, probably less so in other places, so constantly trying new ways to again get more sand in the right place as opposed to just more sand.

I want to congratulate everyone on a strong quarter despite challenging market conditions. I also appreciate your realistic view of shorter cycles and fluctuating oil prices. Regarding the question for Mark, do you still see opportunities to reduce other structural costs in North America and internationally as we move into 2017 with this asset-light model?

I think that we’ve never finished in terms of reviewing our overall structural costs. Jeff made the comment earlier about variablizing costs. And I think there are some things that we haven’t necessarily always thought of as structural. They would be variable in a definition of how we would typically look at them. But when we talk about variablizing those, we’re talking about possibly looking at do lease versus buy; do we turn the depreciation charge into a lease charge; do we rent versus own; what can we do to continue to try to increasingly create optionality in our business, so that we can flex with the market overall but more importantly flex with our customers, to making sure as they continue to evaluate, how they want to do their wells or where they want to do their wells that we can move with them and be as nimble as possible. So, I think that we’re going to go into next year. Jeff alluded to this; even though we believe the year will be better, we’re going to plan very aggressively flat in terms of our structural cost. And even planning flat requires the organization to continue to really focus on what can we do from a continuous improvement standpoint to continue to drive that cost. I believe you’re never done, and we’re going to continue to go forward.

So going back to North America pressure pumping, you’ve made comments in the past on what you thought the margin outlook would be, if you have your fully deployed fleets at full utilization. Can you give us your updated thoughts there? The currently deployed fleet at full utilization.

Yes. What I would do is let’s go back to kind of a margin progression for the business and in my view it’s a path back rather than a dramatic move up. And so, as we said, certain things have to happen around equipment tightening and attrition and it starts with making positive operating income, then returning the cost to capital, and then pushing for industry-leading returns. Clearly, we’re starting from a lower base, but the formula is very much the same and it’s the formula that we know.

We’re definitely going to need some price to back toward the historic margins that we’ve had in the past and historic returns. But the first order of business is to get capacity tightened up in the market. We believe the activity levels in the Permian and others are serving to work equipment harder, it’s going to tighten up equipment faster and we’re starting to see price against the edges and we’ll continue to drive that forward as we hold the line on cost and we’re going to get there. The model is the same and we’ve just got to execute.

Thank you, guys. I had a follow-up question on the margin front from earlier. I guess my question is, is with the lean cost structure you talked about, variabalizing cost where you can underutilized existing asset base, why would incremental margins only be in the 35% to 40% range; why shouldn’t we be able to expect to see something higher than that?

At some point, they will go higher. It’s usually a progression. Right now, coming off the bottom, we are still fighting every day for some level of pricing and trying to get crews above water. When crews are below water, it creates stress on your incrementals, and it's not consistent. A crew might perform well one month but could struggle the next month due to customer decisions about working, downtime, maintenance, or other factors. Until we consistently have everybody above water, the incrementals will remain a bit erratic, but they have improved from our expectations. As a result of the utilization we’re achieving, we are now seeing increments in the 35% to 40% range and are aiming to increase from there.

Historically, we would see a trough following, the trough in rigs was followed by a trough in margins. And so in my view, we’ve actually accelerated that and a lot of that on the back of the cost reductions and the structural cost moves that we’ve made, which we’ve always said, we wouldn’t see the real benefit of those until we saw some sort of bottom. And so, we’re seeing that. And so in some ways, we’re moving more quickly than we would expect it.

You guided the flattish margins next quarter for international, given the minimal seasonal benefit. Thinking about the first half of ‘17, how much of that bottoming comes from the seasonal drop-off in the first quarter versus ongoing budget challenges in some markets, maybe like Latin America? Just trying to think about does that guidance imply 2017 budgets likely flatter or say flat to lower year-over-year but with that sequential improvement in the back half?

The international business traditionally lags North America by six to nine months. So, that’s just sort of broadly across all of the markets in terms of activity. And we’re continuing to see, and if you look at sort of geographically outside of the resilience in the Middle East business, there’s been a substantial decline in activity commensurate with the commodities. And certainly, Latin America’s at historical lows; Asia Pacific is down in some ways as much as 50% in terms of rig count that we see in the marketplace. And so, and I think that continues into kind of the first part of next year and there are obviously the resetting budgets with the national oil companies and a lot of things that conspire to slow that down. So certainly not clear but we expect consistent with sort of our outlook that the middle of next year is where we start to see that repairing.

I believe we currently lack significant visibility from customers. The first quarter will typically see a seasonal decline, particularly in the North Sea and Russia, which have the most substantial impacts. There will also be some delays in Latin America as national oil companies adjust their budgets and begin operations. However, once we reach the lowest point in international markets early next year, the strength of any recovery will depend on the commodity price outlook at that time.

Okay, I’ll leave it there. Thank you.

I’d like to follow up on one of the questions earlier from Jim. And as you think about your logistical network and the infrastructure, I think that’s something we all view as one of the key competitive advantages of Halliburton. Can you maybe give us an update on where your infrastructure currently stands, maybe how much capital was invested in that business, and would you consider different structures to get that off of your book in the future?

So, we’re not going to give specifics on the total capital invested or anything like that. But I would tell you that we’ve got transloading capabilities in all of the major basins that we feel like that we’ve got sufficient capital and resources to make sure that we can service our own business. It was purposely designed in a way that doesn’t meet 100% of our needs. That’s I’m talking about how you variablize your business. One of those things has been that we have tried to construct that in a manner that meets a significant portion of our transloading needs that allows us to also be able to flex with the market, should the need arise. And so, we believe right now that it’s an important strategic asset. We’re going to continue to hold that but, I can’t tell you where or if. It’s just one of those things that like any other portion of our business, we will continually look at that, look at the returns that we earn off of that business, its relative importance to customers in the market and make evaluations as we get there.

I don’t currently see any limitations. There are always aspects of that process that we’re looking to improve, but we are able to address those challenges consistently. As we've shown in the past, we have led in resolving those kinds of market opportunities. If the Permian continues to strengthen, we will make the necessary investments.

Thank you, guys. I appreciate it.

Thank you, Shannon. And I’d like to wrap up the call with just a couple of key points. First, the North America unconventional market has a predicted recovery, first, and should continue to strengthen in a plus $50 oil price environment. Secondly, Halliburton's strategy is directly pointed at the most important part of the market and collaborating and engineering solutions to maximize asset value for our customers. This along with our customer relationships, geographic footprint, and service quality positions Halliburton to outperform in the recovery. Now, thank you and I look forward to speaking with you next quarter.