An Oil Service Bargain

I’ve been on the wrong side of the market, thinking that it would hold up well in early summer and then fade at the end. That was wrong.

Part of my forecast from the beginning of the year, however, was for an end of year recovery. It’s looks to me like the recovery has already begun, and I’m putting more money to work immediately. Note that Kelly Letter subscribers already hold a number of positions, some picked up at lower prices in early summer, that have appreciated handsomely thus far. I simply want more exposure to the rising market.

Oil is now some 20% off its July highs. The correction has created bargains in the energy complex, and I’ve picked through the wreckage to find what I think is the best play on an eventual recovery. I’ll get to that below. First, let’s take a look at last week’s market.

Economic data showing a soft landing gave hope that the Fed is finished, and sent the market higher last week:

Dow ……………. 11,561 +1.5%
Nasdaq …………. 2,236 +3.2%
Nasdaq 100 ……… 1,632 +3.6%
S&P; 500 ………… 1,320 +1.6%
S&P; Midcap 400 ….. 752 +1.8%
S&P; Smallcap 600 … 374 +2.8%

Monday saw oil prices fall for the sixth day in a row, something we haven’t seen in three years. Gold plunged to its June levels below $600 an ounce. The general pullback in commodities recently has served to ease inflation fears, which in turn eases fears of further Fed rate hikes.

The other part of easing inflation is a slowdown in economic activity, which brings its own risks. What we want is the economy to slow just enough to let inflation drain a little, but not so much that we stagnate. That’s the Fed’s soft landing scenario.

So, when St. Louis Fed President Bill Poole said that the economy is not fragile but “robust,” people took heart.

The Dow ended the day flat while the Nasdaq tacked on 0.3%.

Tuesday saw oil prices drop yet again, this time -2.8% to less than $64 per barrel, the same price we paid last March. The industry is forecasting lower demand and we’ve recently had news of increasing supply from both Prudhoe Bay, the Gulf of Mexico, and other regions.

Goldman Sachs (GS) beat analysts’ estimates and announced a 60-million-share buyback, which amounts to 15% of its outstanding stock.

The technology sector was boosted by an analyst upgrade on Advanced Micro Devices (AMD), new product announcements from Apple (AAPL), and the sense that Hewlett-Packard (HPQ) is putting its recent boardroom scandal behind it now that CEO Mark Hurd will succeed Patricia Dunn as chairman.

The Dow gained 0.9% and the Nasdaq gained 2%.

Wednesday extended the appeal of stocks that we’ve seen since the end of July. A sense that all is well was enough to overcome a slight rebound in the price of oil.

Lehman Brothers (LEH) followed on Goldman’s heels by beating estimates and saying that its pipeline of new deals is at record levels.

Investors took advantage of beaten-down prices in the oil sector to pick up shares. The energy sector rose 1.7% led by drillers (+3.1%) and explorers (+2.4%).

The Dow gained 0.4% and the Nasdaq gained 0.5%.

Thursday morning brought the retail sales report for August. They unexpectedly rose 0.2% in the wake of a 1.4% rise in July. Sales are up 6.7% year-over-year, up from 4.8% in July. Economists had expected a decline of 0.2% in August, so the news was good. It showed that consumers are alive and well, and that perhaps the death of the economy was widely overstated.

Also, jobless claims fell 5,000 to a seven-week low of 308,000. Such steady labor conditions provided further reassurance that the economy’s doing fine.

There was a whisper of concern over another drop in oil prices, this time -1.2% to $63.38 a barrel. Natural gas futures dropped a whopping 10% to two-year lows. While these readings are good for the economy, they will crimp the earnings of energy companies, which have been driving the double-digit earnings of the overall S&P; 500.

The Dow lost 0.1% but the Nasdaq gained 0.1%.

Friday brought the much-anticipated August consumer price index report. It came in at 0.2% in both the overall CPI and the core CPI, which removes volatile food and energy costs. That was slightly below expectations of 0.3% for the overall and in-line with expectations for the core. A tame reading was just what the Fed and the market wanted, and it’s what they got. It cooled inflation fears and lowered the chances of another interest rate increase.

Kansas City Fed President Thomas Hoenig told the annual convention of the Independent Bankers of Colorado that the CPI data for August was good news. He said the economy is still doing well, but that the rate of growth was slowing to less than the long-term trend.

Technology did well when Adobe (ADBE) beat estimates and gained 10%, and Microsoft (MSFT) went 2% higher on the announcement of its new Zune to rival Apple’s iPod.

Ford (F) fell 12% when it announced that as part of its “Way Forward” restructuring plan it would stop paying a dividend, and that its North American unit will not see a profit until 2009. Merrill Lynch promptly downgraded the stock.

The Dow and the Nasdaq each gained 0.3%.

Where to next? Expert opinions are mixed.

Peter Morici, a professor at the University of Maryland’s Robert H. Smith School of Business, says that Friday’s data will “ignite investor confidence.” He predicts that, “Portfolio investment will shift to stocks and conditions are ripe for a long-awaited bull run on Wall Street.”

On the other hand, Tim Wood of Cycles News & Views, who accurately called both the May top and the July bottom, writes, “I no longer trust this advance. . . . This is a time for caution and skepticism rather than complacency.”

The market itself is unenthusiastic. The Dow is now within 1% of a six-year high, yet call-buying remained languid at the International Securities Exchange last week. On Friday, the ratio of new calls to new puts came near 0.7, one of its lowest readings in the last 12 months.

John McClure at Equitrend wrote in his Sunday note to clients:

It is at times like this that investors and traders are severely tested. We have been in bear mode for a number of weeks while indexes have continued to drift higher. With the relatively strong performance this week, bears were tested and some no doubt bailed out. But markets are even more overbought than they were last week increasing the probability for a correction. If you go back to 1900 and compared the August high to the market’s value on the last day of September, the market has only closed higher than the August high twice in 106 years. Will this be one of those exceptions?

In my opinion, yes. That’s why I’m putting more money to work.

The popular story on oil is that it’s going lower. Peter Beutel said in Barron’s that prices could sink below $20 in the next several years. Philip Verleger in the Seattle Times called for $15 oil. Keep in mind, that’s the same Mr. Verleger who called for $100 oil on July 24, so his forecast is subject to change at any time. All these falling oil stories have created a case of falling energy company stocks, and I’ve put a great one on The Kelly Letter watch list as a result. More on that below.

With inflation looking all but deleted from the list of market concerns, the Fed is rapidly disappearing as well. Futures not only put the chances of another rate increase at Wednesday’s FOMC meeting at nearly zero, they’re starting to look ahead to the first rate DEcreases.

Great news for sto
cks? Maybe. Sometimes decreases happen because something is wrong and the system needs liquidity, as happened with the 2000 Nasdaq implosion. This time around, some fear that decreases could come as a result of housing’s hard times hitting bank assets. About 43% of bank assets are in real estate these days — the highest that figure has ever been.

Oil Service Bargain
What I do at times like this, when the market is at an inflection point, is look for bargains that I want to buy should a fantastic price present itself. I don’t like pure speculation, so I stick with companies that sport solid fundamentals that can allow me to relax even in the face of further declines after I’ve bought, which come rather regularly in this business. Show me a guy who gets the buy price right every time and I’ll show you a professional ad copy writer.

I was tickled pink last week as an oil service company that I’ve wanted to own for some time became very cheap on oil’s relentless decline. I sent an alert to Kelly Letter subscribers putting this company on our watch list.

This company is the oil services stock that most interests me, particularly now that it’s 32% below its May 10 close at $54.50. It began August at $46 and September at $43. In the last six weeks, it dropped 19% and in the last two weeks, it dropped 13%. The simple reason is that oil has dropped 20% from its July peak.

That, however, won’t affect the fundamentals of this company. From its headquarters in Houston, it sells services and equipment to the oil and gas industry through three segments: Drilling Products and Services, Drill Bits, and Tubular Technology and Services.

No matter what happens to the price of oil in the short term, companies will keep looking for more of it and they’ll need this firm’s products to do so. That trend shows up in the firm’s recent earnings pattern.

So far this fiscal year, it has revised its earnings-per-share forecasts upward. They started at $2.50, then went to $2.80, and then to $3.20 in July. Let’s focus on that last one since it’s the most recent.

On July 24, the company reported earnings of $105.6 million, or 79 cents a share, up from $25.8 million, or 21 cents a share, last year. Revenue rose to $431.8 million from $316.9 million. Analysts had expected earnings of 69 cents a share on revenue of $428.3 million. Analysts were looking for earnings of $2.90 a share for the year, which the company topped by pegging its own estimate at the $3.20 mentioned above.

Why the continued high expectations? The company gives credit to strong international demand, faster than expected capacity expansion, and better prices. All of that will remain intact regardless of short-term oil price volatility.

The fundamentals are sound: forward P/E below 10, 20% profit margin, 33% return on equity, 0.17 debt/equity, positive cash flow.

Now, let’s look at some technicals.

In the past year, this stock has not fallen more than 21% below its 50-day exponential moving average before recovering back to and/or beyond the average. To wit:

2/08: crosses EMA of 46.28
3/09: bottoms at 36.57, 21% below the 2/8 EMA
4/13: closes at 47.22, a 29% gain to back above the 2/8 EMA

5/15: crosses EMA of 48.15
5/24: bottoms at 42.78, 11% below the 5/15 EMA
6/02: closes at 48.65, a 14% gain to back above the 5/15 EMA

6/05: crosses EMA of 47.09
6/13: bottoms at 40.55, 14% below the 6/05 EMA
7/03: closes at 45.88, a 13% gain to back above the 6/5 EMA

7/13: crosses EMA of 45.06
7/21: bottoms at 37.74, 16% below the 7/13 EMA
7/31: closes at 45.51, a 21% gain to back above the 7/13 EMA

8/04: crosses EMA of 44.10
9/15: closed at 37.22, 16% below the 8/4 EMA

As you can see, the stock is currently right in the area of where we should expect a reversion upward. Just getting back to the Aug. 4 EMA would provide an 18% gain. Getting back to the May 10 peak would provide a 46% gain. The latter is not a crazy notion given the company’s healthy fundamentals and long-term prospects.

I’ve placed this stock on the Kelly Letter watch list to buy at $35, almost 21% below the Aug. 4 EMA. Remember that watch list target prices often change. I’ll be sure to let subscribers know by email if and when I place an active order to buy.

I’d like to let you know as well. If you want to follow this stock along with us, come aboard The Kelly Letter for a month. It’s just a penny to try. If you don’t like it, you’ll at least have one great stock to watch for a fine recovery down the road. Consider it my compliments for trying the letter. If you decide to continue your subscription to the letter, it’ll cost you just $5.48 a month. You can cancel at any time and the monthly payments stop immediately. That’s a reasonable risk, don’t you think? If you get my letter from now until the end of the year, your grand total paid would be only $16.44, and even that will paid in three installments of $5.48 — one in mid-October, one in mid-November, and one in mid-December.

What do you say? I hope to welcome you soon. You can learn more and sign up for your one-cent, one-month trial here.

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