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Tax reform could help Halliburton more than its competitors, but risks persist

While U.S. tax reform has brought Halliburton's margins in line with global competitors, the company still faces logistical risks given its exposure to the North American oil and natural gas market.

Among oilfield service companies Halliburton Co. has typically taken a back seat to its behemoth competitor Schlumberger, which has three times the market capitalization. But following what Halliburton President and CEO Jeff Miller described as a "dynamic year for the oil and gas sector in 2017," Halliburton is becoming a favorite for some Wall Street pundits focused on the sector.

Its diverse businesses along with the changes to the U.S. tax structure will tighten its income margins against industry giants like Schlumberger, and since Halliburton's fourth-quarter 2017 earnings call on Jan. 22, Halliburton has been described by analysts and ratings agencies as a "favorite" and "top pick."

In December 2017, President Donald Trump signed a comprehensive tax reform bill that, among other things, lowered the corporate income tax rate from 35% to 21% and moved the country towards a territorial tax system.

Behind the optimism for a successful 2018 for Halliburton, the U.S. tax reform is seen leveling the playing field for the company with the majority of its interests in the U.S. The company reported 55% of revenue from North America operations that helped fourth-quarter 2017 earnings increase 7% sequentially to $3.4 billion.

In the past, Halliburton's higher exposure to the U.S. has created a structural disadvantage versus competitors like Schlumberger, Bernstein analysts said in a note following Halliburton's earnings call in January. As a non-U.S. company, Schlumberger largely pays taxes where it works and earns profits without having to incur additional layers of taxes, Schlumberger CFO Simon Ayat said. Given the company's structure, the primary impact of U.S. reform on Schlumberger is that the lower federal tax rate will be applied to income earned by its U.S. business.

By comparison, for Halliburton, the change in tax law is a big positive.

"We expect it to lower our effective tax rate percentage from the high 20s to the 21% to 23% range, reflecting the new U.S. corporate rate plus state and local taxes along with our geographic earnings mix. The lower effective tax rate will positively impact our future earnings and help level the playing field with our foreign-domiciled competitors," CFO Christopher Weber said.

Bringing the effective tax down to 23% in 2018 substantially levels the playing field and adds value, the Bernstein analysts said. "Halliburton is now almost at the same margin level as Schlumberger. Halliburton has experienced a faster recovery and margins are now similar to Schlumberger."

Both Schlumberger and Halliburton have sizable upsides if oil prices go to $80 a barrel but Halliburton is once again a top pick for analysts.

"Our top pick remains Halliburton," Bernstein analyst Colin Davies said in a client note in early February. "While we recognize that Schlumberger is a high-quality company and may protect better on the downside, we see a clearer path to higher industry activity and prices for Halliburton. With more exposure to North American activity, and less exposure to international/offshore, fewer things need to 'go right' for Halliburton to reach its upside target price."

But looking forward, there are many challenges that the oilfield service sector will likely need to meet, analysts with Deloitte Center for Energy Solutions said in a 2017 year-end report released Feb. 14. "First, as fracturing continues to drive US production growth, the demand for sand and water services will likely increase. And while pumping horsepower is front of mind, those auxiliary services could be critical," the analysts said, adding, "In the case of sand, geography might be as important as quality, since transportation costs can be significant with Texas-sourced sand displacing Northern White."

Frac sand transport issues plagued Halliburton in the current winter as extreme cold weather negatively impacted the efficiency of rail lines including those of Canadian National Railway Co., which on Feb. 8 advised customers including Halliburton that it would halt all new shipments across a wide section of Minnesota and Wisconsin for four weeks.

Similarly, sourcing water in West Texas can be a challenge, and disposal could prove problematic as volumes continue to grow, Deloitte analysts said. Further, the analysts said that despite significant improvements in drilling and completions costs, the oilfield service sector has borne the brunt of the cost cutting, and there appears to be substantial remaining overcapacity across the sector.

Weber said revenue from the pressure pumping business is expected to drive Halliburton's performance in 2018 but could present another problem for Halliburton going forward.

Bernstein analysts said key risks to oilfield service are pressure pumping overbuild that would hit the market late 2018. The analysts also said exploration and production capital discipline could pose a risk but they consider that a minor worry.

Halliburton will host a conference call on April 23 to discuss its first-quarter financial results.