Ladies and gentlemen, thank you for standing by, and welcome to the Schlumberger Earnings Conference Call for the conference. All the participant lines are in a listen-only mode. There will be an opportunity for your questions. Instructions will be given at that time. If you should require any assistance during the call, please press star then zero. As a reminder, today's call is being recorded. I'll turn the conference now to the Vice President of Investor Relations, Mr. Simon Farrant. Please go ahead, sir.
Thank you. Good morning, and welcome to the Schlumberger Limited Second Quarter 2015 Results Conference Call. Today's call is being hosted from London, where the Schlumberger Limited board meeting took place yesterday. Joining us on the call are Paal Kibsgaard, Chairman and Chief Executive Officer, and Simon Ayat, Chief Financial Officer. Our prepared comments will be provided by Simon and Paal. Simon will first review the financial results. Paal will discuss the operational and technical highlights. However, before we begin with the opening remarks, I would like to remind the participants that some of the information in today's call may include forward-looking statements as well as non-GAAP financial measures. A detailed disclaimer and other important information is included in the earnings press release on our website. We welcome your questions after the prepared statements. I will now turn the call over to Simon.
Thank you, Simon. Ladies and gentlemen, thank you for participating in this conference call. Second quarter earnings per share from continuing operations, excluding charges and credits, was $0.88. This represents decreases of $0.18 sequentially and $0.49 when compared to the same quarter last year. Our second quarter revenue of $9 billion decreased 12% sequentially. Despite the very challenging environment, pre-tax operating margins only declined by 49 basis points sequentially. This resulted in decremental margins of just 23%, which is a result of continued strong and proactive cost management across the entire organization. Sequential highlights by product group were as follows. Second quarter reservoir characterization revenue of $2.4 billion decreased 5% sequentially. This decrease was largely driven by wireline and testing as a result of lower exploration spending.
Pre-tax operating margins decreased 84 basis points to 26.5%. The impact of the lower exploration activities was offset by increased higher-margin software sales. Drilling group revenue of $3.5 billion decreased 11%, primarily due to the further significant drop in the North America rig count. Margins remained resilient at 19.5% as strong cost management limited the margin decline to only 44 basis points. Production group revenue of $3.1 billion decreased 18% sequentially as both activity and pricing for pressure pumping services in North America fell dramatically. Despite the severe revenue decline, margins only fell by 179 basis points to 12.8%. Now turning to Schlumberger as a whole, the effective tax rate, excluding charges and credits, was 21.1% in the second quarter. This was essentially flat when compared to the previous quarter. Our cash flow generation continues to be very strong.
During the second quarter, we generated $2.3 billion of cash flow from operations. During the first half of 2015, we have generated $4.1 billion of cash flow from operations. This is all despite making severance payments of approximately $200 million during the second quarter and almost half a billion during the first six months of the year. Net debt increased $111 million during the quarter to $5.6 billion. During the quarter, we spent $520 million to repurchase 5.8 million shares at an average price of $90 per share. We spent $587 million on CapEx during the second quarter. Full year 2015 CapEx, excluding multi-client and SPM investments, is still expected to be approximately $2.5 billion. Now I will turn the conference call over to Paal.
Thank you, Simon, good morning, everyone. Schlumberger revenue decreased 12% sequentially in the second quarter, driven by a significant reduction in land activity in the U.S. as the rig count decline accelerated and by further pricing erosion in both North America and the international areas. North America revenue fell 27% sequentially, while international revenue was 5% lower as customer budget cuts and pricing concessions impacted results for a full quarter. Despite the challenging market conditions, overall pre-tax operating margins were maintained well above the levels of previous downturns as we continued to proactively manage costs and resources, carefully navigate the commercial landscape, and further accelerate our transformation program throughout the organization. The success of this approach can be seen in a double-digit pre-tax operating margin in North America and an international margin of 24.5%, which is 35 basis points up sequentially
44 basis points up year-over-year. In the first half of 2015, year-over-year revenue has now dropped 26% in North America and 14% internationally. These levels exceed those of the 2009 downturn in both pace and size. Still, we have delivered first-half decremental margins of 37% in North America and just 18% in the international area. These decremental margins represent a marked improvement over the equivalent figures from the last downturn, which were in excess of 70%, particularly as we begin to approach what we believe is the market bottom. While the market remains tough, we also believe we have been successful in adapting to a rapidly changing situation as far as the size of our workforce is concerned. The absence of charges in the second quarter is evidence of this, as the adjustments made in the second quarter were absorbed in our normal operating costs.
In terms of corporate financial performance, we also generated almost $1.5 billion in free cash flow in the second quarter. This figure, which represents a conversion rate of 132% of the quarter's earnings into free cash flow, demonstrates our ability to generate free cash even in these market conditions. Looking at our results on a geographical basis, North American revenue decreased 27% sequentially, a figure greater than the 25% sequential decrease seen in the first quarter. Again, significantly lower than the fall in the land rig count, which was down 40% sequentially in North America land. In spite of this drop, operating margins in North America decreased by only 268 basis points sequentially, leaving our margins 465 basis points higher than the same period of the 2009 downturn.
The strength of this performance was underpinned by our proactive approach to cost and resource management, the growing impact of our transformation program, strong new technology sales, and efficient supply chain management, altogether limiting the sequential decremental margins to 20%. In U.S. Land, activity was down in all basins in the second quarter, with the rig count dropping below 860 for most of the month of June. In addition to the significant reduction in rig count, poor weather conditions with floods in Texas, Arkansas, and Alaska also drove activity lower in the second quarter. The dramatic reduction in activity in U.S. Land has created a massive capacity oversupply in the service industry, with pricing quickly plummeting to unsustainable levels, in particular for pressure pumping, where many companies now are desperately fighting to survive.
Our approach to the market remained unchanged in the second quarter, where we concentrate our activity in core areas and for key customers, and where we, beyond this, proceed with stacking of equipment rather than operating with large losses. We continue to maintain our overall infrastructure and long-term service capacity, and we are working closely with our customers to help reduce cost per barrel through better operational efficiency and reliability, and through the application of new technology, workflows, and business models. Based on this approach, we will ramp up our activity for opportunities that bring the required returns. The strength of our technology portfolio, the range of our workflow solutions, and the depth of our shale understanding also enables us to pursue performance-based contracts where we initially underwrite the incremental cost of our technology and where we recover this cost plus the performance upside from incremental well production.
In Western Canada, activity was also down significantly in the second quarter, with the rig count falling by 66% sequentially, impacted by the early spring breakup, and with the recovery expected to be limited during the summer months. Offshore in the U.S. Gulf of Mexico, deepwater rig activity was down in the second quarter, and activity was also impacted by loop currents, while pack ice off Eastern Canada also impacted our drilling and seismic operations in the second quarter. Offshore revenue was further impacted by the expected shift in service mix from exploration to development and completions, as well as increasing pricing pressure. The primary driver for offshore success continues to be risk reduction and project performance, and we are therefore fully engaged with our customers to help reduce overall AFE costs through better project planning and execution.
In the international markets, revenue declined by 5% sequentially, driven by further budget cuts from our customers as well as further pricing concessions. For the first half of the year, revenue has now dropped 14% compared to last year, a figure that is more than double the 5% fall experienced over the same time frame in the 2009 downturn. Second quarter operating margins at 24.5% was up 35 basis points sequentially and 44 basis points year-over-year as first half decremental margins were held to 18% compared to 73% over the same period in the 2009 downturn. These results fully demonstrate our leadership in the international markets, which is built on flawless execution from the entire organization, proactive cost and resource management, and the acceleration of our transformation program focused on workforce productivity, asset utilization, and reduction in unit support costs.
In this environment, we focus on carefully balancing market share growth with protection of operating margins and by negotiating pricing concessions in return for additional work, integration opportunities, or improved contract terms, knowing from experience that any permanent pricing concessions that we make will be very hard to recover even as market conditions improve. Within the international areas, Middle East and Asia revenue declined by 5% sequentially, while pre-tax operating margins improved 8 basis points to 28.7%. Activity remained robust in the GCC region. Strength in Saudi Arabia, United Arab Emirates, and Kuwait was not sufficient to offset weakness in the Asia Pacific region. Year-on-year revenue decreased by 13%, while margins expanded by 87 basis points. In the Middle East region, our lump sum turnkey project in Saudi Arabia continued to gain momentum during the quarter.
Our overall results were not immune to the customer pricing concessions we gave in the first quarter. In the United Arab Emirates, drilling and production-related activity increased as work on the Satah Al Razboot (SARB) North Island project ramped up, and with further rig additions expected over the coming quarters. Drilling activity was also stronger in Kuwait as the rig count increased in line with the country's strategic production targets, while unique land seismic activity grew with improved operational productivity. In Iraq, revenues in the north declined further in the second quarter, while activity in the south of the country remained flat sequentially, but is expected to increase in the second half of the year on the back of recent contract wins.
In Southeast Asia, activity fell in Australia as projects were completed both on land and offshore, while activity in Malaysia declined as customer budget reductions affected both OpEx and CapEx investments. In Latin America, revenue declined 7% sequentially, while pre-tax operating margins improved 81 basis points to 23.3%. Revenue was impacted once again by decreasing activity in Mexico, Brazil, and Colombia, however, somewhat offset by increased activity in Venezuela. Year-on-year revenue decreased 17% and margins grew by 111 basis points. In Mexico, revenue decreased significantly in the second quarter on further customer budget cuts that impacted both onshore and offshore activity. In spite of new contract wins for both seismic and integrated well construction, the outlook for the second half of the year remains challenging. At the same time, the energy reform continues to progress on plan, with the first major license award being announced in the third quarter.
Offshore activity in Brazil remained weak, with the deepwater rig count being down significantly versus the first quarter, while in Colombia, the activity slowdown continued and now affects all product lines. In the Venezuela, Trinidad, and Tobago geomarket, increased activity was driven by exploration work in Suriname and Guyana, while joint ventures in the Faja region of Venezuela continued to ramp up. Elsewhere in South America, revenue in Argentina remained resilient as growth in conventional activity partially offset pricing pressure for unconventional services. At the same time, SPM activity remained strong in Ecuador as the Shushufindi project continued to perform in line with expectations, and with activity and production starting up on the new Camana SPM project. In Europe, CIS, and Africa, revenue fell 5% sequentially, with margins edging off by 29 basis points to 21.3%. Year-on-year revenue decreased 26% and margins dropped by 85 basis points.
Within the area, revenue increased in Russia and Central Asia, driven by the seasonal recovery of conventional land activity and as the ruble strengthened somewhat. In the North Sea, the shift from exploration to development-related activity continued, while customer budget pressure both in the U.K. and Norway resulted in lower sales of new technology. In Sub-Sahara Africa, both development and exploration activity was down sequentially as customer budget pressure resulted in several active rigs being demobilized. In Algeria, activity was slightly up sequentially while work in Libya was limited as the security situation remained very challenging. One year ago, at our 2014 investor conference, we told you about our transformation program, which is designed to provide a new approach to how we run our business in order to enable fundamentally better performance.
Our transformation leverages the drivers of technology innovation, equipment reliability, process efficiency, and system integration, all together delivering better management of costs, better quality of products and service delivery, and better generation of free cash flow. While we set goals for new technologies and increasing elements of service integration, we also target a tenfold reduction in customer non-productive time, a doubling in asset utilization, a 25% reduction in inventory days, a 20% increase in workforce productivity, and a 10% lowering of unit support costs. I am very pleased with the progress we have made one year later. While the transformation was designed to deliver outperformance in any part of the cycle, the current market conditions have enabled us to increase customer dialogue and to accelerate the program throughout our global organization.
The strength of our international margin so far this year is one demonstration of the performance impact from our transformation, while the resilience in our North American margins is another proof point. In terms of costs, our figures show that we are managing all aspects very well, including both fixed and variable compensation, as well as the cost of product and service delivery. In terms of quality, the investments we have made in training, new technology, and enabling systems are now really starting to pay off, as can be seen by our second quarter quality results, where we set a new record low in terms of non-productive time incurred for our customers.
Last, in terms of cash, the reduction in CapEx intensity and the discipline we have shown with respect to managing working capital have delivered a very strong free cash flow in the first half of the year, with a cash conversion rate of 98%, including severance payment, which is well above our 75% target. Turning now to the overall outlook for the second half of the year. Visibility still remains limited. However, some tentative signs of change are emerging. On the supply side of the oil market, the global market share battle between OPEC and the high-cost producers is still playing out, with the first signs of flattening North America production starting to show.
Within OPEC, production in the second quarter was at the highest level for three years as marketed supply was again increased at the expense of lower core spare capacity, which in June dropped to 2.3 million barrels per day. In addition to this, non-NAM, non-OPEC production weakened in the first half of the year by 650,000 barrels per day, driven by Brazil and Mexico, with a further softening expected in the second half of the year as the lower investment levels in many regions start to take full effect. Against these supply figures, global oil demand growth continues to strengthen, with the IEA having revised its 2015 estimate up to 1.4 million barrels per day during the second quarter. These factors all point to a potential tightening in the global supply-demand balance in the coming quarters.
Turning to our industry, the largest drop in E&P investments is, as expected, occurring in North America, where 2015 spend will now likely be down by more than 35%, driven by both pricing and activity on land. We do believe that the North American rig count has now reached bottom, but that we will only see a slow increase in drilling and completion activity in the second half of the year, which will not make any material dent in the massive overcapacity that has been created. This again means that there will be little to no improvement in pricing levels, and hence the market will still remain very challenging for the foreseeable future.
In the international market, E&P spending is now expected to fall more than 15%, driven by lower activity in most regions and further amplified by a very strong dollar, in particular versus the Russian ruble and the Venezuelan bolívar. Given the nature of the business in the international markets, we do not expect any upward adjustment to existing customer budgets for the second half of 2015. Instead, we see a continuation of the trends from the first half, with very low exploration activity, tight management of development-related spend, and continued pricing pressure for our products and services. However, we do expect that any improvement in oil prices in the second half of the year will potentially lead to increased investment levels in 2016, both for exploration and development-related activity.
In the midst of the current market challenges, we remain focused on the things we can control, including our cost and resource base, the effective deployment of our technology and expertise, and the quality and integrity of the products and services we provide to our customers. The success of this approach is enabling us to maintain solid international margins despite a significant drop in activity and, at the same time, also allowing us to maximize our performance in North America. We remain very confident in our capacity to weather the current downturn better than our surroundings, and also significantly better than what we have done in previous downturns.
Our global strength, our technology differentiation, and our accelerated corporate transformation is creating a great platform for us to increase revenue market share, post lower earnings per share reductions than our peers, and continue to reduce working capital and CapEx intensity to deliver unmatched levels of free cash flow. At the same time, this financial strength positions us well to take advantage of increasing market opportunities resulting from the current market environment. Thank you very much. We will now open up for Q&A.
Ladies and gentlemen, if you would like to ask a question on the call, please press star then one. You'll hear a tone indicating you've been placed in a queue. To remove yourself from the queue at any time, please press the pound key. Again, star one if you have a question. First we have the line of Ole Slorer with Morgan Stanley. Please go ahead.
Thank you very much. I think you're going to make it a difficult weekend for some of your peers since they ponder what they're going to say next week.
Thank you.
I wonder whether we could revisit your macro view. Are you more confident or less confident that the oil markets are tightening than what you were a quarter ago, given the most recent IEA report and some of the resolutions around previously sanctioned countries?
I think our view on the macro and our confidence in the tightening, I think, is relatively unchanged. We've been saying now, I think, for a number of quarters that we see solid oil demand growth. Again, this was revised upwards again this year to 1.4 million barrels during the second quarter. We've also said that with a certain lag, the large cuts in E&P investments are going to show up in the supply numbers. We see it, in particular, in non-NAM, non-OPEC , which has showed a gradual weakening over the first six months of this year. U.S. monthly sequential production is flattening, and the core OPEC spare capacity was also down to only 2.3 million barrels per day in June.
I think the tightening that we've been foreshadowing, we are still relatively confident that that will happen in the second half of the year.
Okay, good. On the environment, you highlighted pricing is still tough. We're at a trough, but clearly, a trough means probably average pricing still rolling down. How do you see the second half pricing and macro headwinds relative to the momentum that you have created within the organization? It's very clear from what you're delivering here that some of the initiatives that you initiated maybe a year ago are really starting to deliver. How much more can we expect given what you're already doing?
Well, you're asking whether our results are sustainable, I guess, right?
Yeah. The headwinds relative to the internal momentum. How should we think about it?
Well, if we take the pricing part of the question first, I would agree with you that there's going to be a further impact on pricing in the second half of the year. We haven't seen the full impact of that. I would say that there's probably still more relative impact in North America than what it is in the international markets. There's going to be impact in both regions in Q3 beyond where we are in Q2, but I think that's relatively larger in North America. As to our ability to offset this, the transformation and the general way that we are managing the company and the focus we have on cost and resource management, through this, we are going to continue to create a financial leverage over the coming years. We are going to take that leverage out in two forms.
We will take it out through market share gains by being able to be even more competitive on price. Secondly, we'll take the other part out through very strong incrementals when we grow, or alternatively, very strong decrementals when we shrink. What we talked about in 2014 at the Investor Day in terms of what the transformation represents for the company, say, in the next five-year horizon, it is there. We are accelerating the impact from it, and we see this leverage as something that we will continuously take out in the coming years. Fundamentally, I think the performance that we are posting is sustainable. It's not going to be a straight line, but overall, what we are doing now is not a fluke.
Okay. Very impressive. Thank you very much. Simon, congratulations with the free cash conversion. I'll hand it back.
Thank you.
Thanks.
Our next question's from Jim Wicklund with Credit Suisse. Please go ahead.
Good morning, guys. Good morning. How do you see the performance-based work evolving in the U.S.? I know you won projects internationally in the quarter, in your SPM work in Ecuador and other places internationally. Can you talk about the issues with growing that business model in the U.S.?
I think I would mention two specific things here. Firstly, what is very positive at this stage is that customers are more and more starting to buy in to the fact that we have technologies and workflows that can create more value. That is what we've been investing in for the past five years, and that is how we wanted to try to create technical differentiation in the largely commoditized North American market. With the dialogues we have with customers both on geo-engineered completions, on refracturing, in terms of more sophisticated fracturing fluid systems like BroadBand, it is very clear that the appetite to use new technology and more sophisticated technology is growing.
Some of the customers would take on that technology on more of a standard type of contract where we will still get a premium over what basic commodity type of technologies will give, while other customers will also like to go into a more risk-based contract setup. We are fine either way. We are looking to create technology differentiation, and I'm very optimistic about our ability to continue to push that forward in the coming quarters, even in this business environment.
That's helpful. My follow-up, if I could, there's been a great deal made about the slowdown in deepwater project development, FID delays, and major oil companies moving to onshore. Yesterday, we saw Conoco break a contract on almost a new rig. Can you talk about what Schlumberger sees in terms of the progress in deepwater development and how that's changed, what you expect to see going forward, if you would, whatever, over the next couple of years?
The immediate thing we see is obviously an impact on deepwater drilling activity, and this is largely focused in on the exploration side of deepwater, and it's a pretty significant reduction in that. That is already incorporated or absorbed in our results where they stand today. In terms of the deepwater projects, yes, there are some projects that are being delayed and some projects being canceled, if possible. In general, these are long-term investments. Many of them are already deeply committed. We don't see any kind of dramatic impact at this stage on the projects that are in the pipeline.
Going forward, in terms of sanctioning new projects, I think it's going to be very important for the service industry, together with our customers, to be able to come up with technical solutions and field development plans that significantly reduces cost per barrel. If we can do that, which is the overall objective for the industry, I think we can make many of the pending deepwater projects also economically viable in the future.
Okay, gentlemen, thank you very much.
Thank you, Jim.
Our next question's from Angie Sedita with UBS. Please go ahead.
Thanks, guys. I echo, certainly a good quarter, particularly with the decremental margin. Paal, can you talk a little bit more about the decrementals, obviously strong in North America and International , but specific to North America. Can you talk about, at least for the Q2, the impact of the transformation efforts versus new technology versus the headcount? Are you seeing better uptake from the new technologies this cycle than in prior downturn?
Yes. I think, basically all the elements that you listed are the contributing factors to the lower decrementals. Obviously we have a clean quarter this quarter. There are no charges in it. This is basically straight line business performance in the second quarter. Like you said, the overall impact on transformation, which we started several years earlier in North America, is part of driving this. We started that transformation and reorganization back in 2010. I would say our North American organization has also been very proactive when it comes to cost and resource management. As we just talked about earlier on one of the questions there, the uptake of new technology, both in North America and International, the rate of uptake, given the downturn, is actually quite strong and actually much higher than what we have seen in any previous downturn.
I think that comes down to the fact that a lot of the new technologies we now have out have very clear cost and efficiency angles to them. Which means that they sell equally easy in the downturn as they do in the upturn.
Okay. That's helpful. Appreciate the clarity. You referenced it briefly in your remarks regarding the international outlook for 2016, which is obviously very preliminary, but based on your recent conversations and thinking through your viewpoints on supply-demand for crude, if we are in a $65 Brent world, what's your preliminary thoughts for color be on E&P CapEx on the international markets, and do you have any color on the region?
Well, I think it's too early to make any firm predictions on E&P CapEx investments internationally next year. I would just say that we are relatively confident in the tightening of the supply-demand balance of the second half of the year. That would, under normal circumstances, lead to some uptick in the oil price. If we see some improvement in the oil price in the second half of this year, I don't think there's going to be any huge impact on the current year budgets. I think it's a positive indicator that we might have some increase next year. I don't think the increase in 2016 is going to be large, but I think there is a good chance that E&P investment levels next year will be higher than what we've seen in 2015.
Great. Thanks. I'll turn it over.
Thank you.
We'll go to David Anderson with Barclays Capital. Please go ahead.
Yeah, thank you. Paal, I just want to ask about Iran. Obviously, assuming there's an Iran deal goes through, I just wanted to know if you could highlight a little bit about some of the service opportunities if that opens up over the next few years. Would you expect IOCs to start moving aggressively in there?
Well, I think what the IOCs are going to do, I think you're going to have to ask them. I don't know. Our position and our view on Iran is the following. We have fully exited Iran. When the sanctions are lifted and when it is permissible, we will evaluate going back in. Beyond that, I don't really have anything more to say about what we will do. It's coming down to firstly, that the sanction needs to be officially lifted, which they are not yet done.
Okay, just a quick follow-up on the offshore, just can I get a little bit more detail? You talked a few times about exploration spending coming down. I was just wondering if you could just help me understand how you see the exploration cycle playing out say over the next 12 months. Do you think exploration can bottom by the fourth quarter? If these costs, and you talked about risk reduction in some of these contracts, do you think you could start seeing some sort of impact, some sort of turnaround in there by mid 2016 or something along those lines?
I would say potentially. We see the exploration spend down potentially around 30% again this year. That's including seismic, probably around the same level. That is obviously a dramatic reduction if you look at what we already saw in 2014, right? Yes, we might not be too far away from bottom on exploration spend, but again, I don't see any dramatic turnaround immediately. We could potentially start seeing something towards the second half of 2016 if there is a kind of a gradual uptick of the oil price to at least ±70. Nothing on the horizon as we see it today. It's still a very tough market. We see this very, very clearly in some of our key high-tech product lines, where our exploration revenue over the past six quarters has actually dropped by 35%.
I don't think we're too far away from bottom because there's not that much left to cut. The comeback, I think, is still a little bit out in time. If you look at the level of spend today versus what is required for the industry to replace reserves and to find new oil field developments, we are obviously way under-investing. This is not a sustainable situation. The uptick will have to come. It's just that we don't see it on the immediate horizon.
Great. Thanks.
Thank you.
Our next question's from James West with Evercore ISI. Please go ahead.
Good morning, Paal. Or good afternoon, I guess, Paal, congratulations on a well-executed quarter. I had a question really related to the technology and technology uptake. It seems like this cycle is somewhat different than we've seen in previous cycles, where the technology uptake is actually greater. Last year, I think 27% of your revenues were from new technologies. Do you have a sense, or can you give us a number of what, in terms of revenues you're seeing in terms of new technology today or maybe the first half of this year?
Yeah. What we've seen so far this year, in terms of new technology as a percentage of our total technologies or total revenue is 22%. This is slightly lower than the 25% target that we laid out last year, but given where we are in the cycle, this is dramatically higher than what we have seen in any previous cycle, right? Yes, we are selling a significantly higher rate of new technology in this part of the cycle versus previous. As I said earlier, this is down to, I think, the fact that we have a very flush new technology portfolio and offering. I think we have been doing a better job in clearly demonstrating to our customers what these new technologies bring in terms of lower cost per barrel, in terms of efficiency, in terms of higher production.
This is, again, why I think the uptake, although it's slightly down from where it was in the second half of 2014, it is still holding up very, very well.
Okay, thanks. Then, kind of an unrelated follow-up here on the third quarter, in particular. Clearly, we're going to see continued declines in revenue internationally and probably some margin degradation. In North America, do you still expect to see a significant revenue degradation and margin degradation as well? Could you give us some clarity on kind of how we should think about three Q, is three Q the bottom?
Okay, well, let's start over at the beginning. In terms of revenue, we expect that the sequential drop is going to slow in Q3, and it could potentially represent bottom when it comes to revenue. If you look at Q1, we saw a 19% sequential decline. In Q2, we saw a 12% sequential decline in revenue. For the third quarter, we expect something in the range of 5%-6% further decline in sequential revenue.
Okay.
If you look at the two main parts of the world, in North America, we do expect a slight increase on activity on land. Again, we see this being offset by weakening also offshore activity and further pricing pressure both on land and offshore. Internationally, no major change. We think the overall weak activity is going to continue, and also there's going to be sustained pricing pressure. In addition, we have the slowing down of activity for part of Q3 in the Middle East and also the maintenance season in the North Sea. If you look at this cycle so far, we have proactively managed costs to protect margins, and I think we demonstrated that we are pretty quick on our feet, and we can manage this very, very well.
At this stage, our structural cost and our field capacity is really tailored to our Q2 activity level. For now, we have decided to preserve our current structure for Q3, and this is in order to be ready for increased activity as we go forward. Provided this is for a limited period of time, we are prepared to live with the temporary margin impact that carrying these slightly elevated levels of resources is going to have. It's not going to be a huge impact on margins, but it's going to be a little bit more than what we could have managed if we were to cut even deeper. If you look at EPS, it's going to come down in Q3, and I think the current consensus of $0.77 is a pretty realistic number.
Okay, perfect. Thanks, Paal.
Our next question from Bill Herbert with Simmons & Company. Please go ahead.
Good morning. Going back to an earlier question, I wanted to be more specific with regard to discussing the attempted improved alignment with customers, looking at three buckets. If you could talk specifically about refracking in terms of uptake, number of project wins, what have you, engineered completions in a similar vein, and also on the deep water front getting more aligned and paid on the AFE versus NPT.
Okay. If we start off with the land part, right?
On geo-engineered completions in North America, we have over the past quarter engaged and are in contract. Either we have signed contracts or in contract discussions with several customers on doing consistently geo-engineered completions for them. With refracturing, we are already engaged with eight different customers in North America land on doing refracturing for them. Both of these elements are picking up nicely. As I said earlier, some of the customers would like to go with traditional contracts where they just pay us a technology premium for what we bring. Others are still considering whether to go into a performance-based setup. Either way, we are fine. The main thing, as I said, we are looking to create technology differentiation. Again, this is going quite well.
If there is any resistance to your underwriting the cost of a refrac or an engineered completions, what is it exactly? What would be the resistance on the part of a customer from actually allowing you to do that?
Well, I think the only resistance will be the fact that when they see that we are prepared to do it. It must be a pretty good business proposition. I think when they look at this in more detail, they'll figure out that there is no need for us to carry the cost because they happily will carry the cost because it's a good investment. I think that's really the main. There's no resistance. It's just a reflection of, do they want to capture more of the value themselves, or would they like to outsource all the risk and potentially much more of the upside to us?
At this juncture, with regard to the uptake on the land front, is it an even split between standard contracts and more of the underwritten contracts?
I think at this stage, I would say it is probably more so standard contracts with a pricing premium rather than having to underwrite it. We offer underwriting to all of them, but most of them actually do take more of a standard type of contract.
Okay. Any comments on the deep water front?
Well, in terms of changing the business model on deep water and being, I would say more compensated on performance rather than standard type of contract, it is not that much movement on that front. We are discussing with some of our larger customers various types of framework. We haven't concluded any of these yet, I would say there have been good, productive discussions. It takes a bit more time. These are larger projects. It's a bit more complicated to do than the single well things we can do on land. I would say we have good discussions and a good dialogue, and I think there is openness from our customers to invite us to the table and basically have us participate more. Nothing really material in terms of new contracts signed yet.
Okay, last one from me. Your final comment or one of them with regard to your opening narrative, was referencing your balance sheet strength and your free cash flow generation, thus allowing you to take increased advantage of market opportunities. Can you elaborate on that? I assume in part that means acquisitions.
Simon, you want to comment on our use of free cash flow?
Our priority to cash is still as we always declared. We will fuel the growth of the business. You've seen a slowdown on the CapEx because of times. Obviously, we continue to invest in SPM and multi-client. As far as acquisition, we do small ones on regular basis, and this is also funded through cash. We don't borrow for that kind of acquisition. We will remain to be opportunistic on that front. As I said, smaller acquisition that regular as far as to our use of cash.
Okay, thank you.
Thank you very much.
Our next question's from Kurt Hallead with RBC Capital Markets. Please go ahead.
Hey, good morning, guys. Good afternoon where you guys are. Congratulations on a very well-executed run, Paal, over the last 12 months.
Thank you very much.
Welcome. You indicated here that you're carrying a cost structure that is sized for second quarter activity and willing to deal with some near-term margin dynamics related with that cost structure if activity comes in a little bit more. I don't want to be too presumptuous, I would assume that you wouldn't want to sit for too much longer than one quarter with some sort of a margin drag. Can we maybe infer from your comments you're expecting an increase in activity, generally speaking, in the fourth quarter? That'd be for North America and then maybe international as soon as the first quarter of next year?
Yeah, I think you can read into this that, first I think we're pleased with how we've handled the downturn so far. We decided to be rather decisive in right-sizing the workforce for the downturn we're facing, and that includes both right-sizing and streamlining support structure as well as the field capacity. I think what you can read into the comments on the fact that we are prepared to carry slightly more costs into Q3, and this is not a significant part, it's slightly more. That is that we are indeed looking to be ready for growth in activity. Now, I can't say 100% certain that it's going to come in Q4 or Q1. What we're saying is that we believe we are getting close to bottom. We believe that we have demonstrated very clearly our ability to manage cost and resources.
In the event the upturn is a couple of quarters away, we are prepared to carry the costs, and I think that would be a much better management of our resources to enable us to be well prepared and positioned for the growth. In the event it's pushed out a bit more, we can also do further adjustments. That's relatively easy. We've shown that we can do it. Yes, you can infer that we are looking and searching for the uptick and that we think that we are pretty close to bottom.
Okay. That's great color. Appreciate that. Now, in the context of the margin performance in the international markets for the second quarter, and we roll through into the third quarter. If I look from the outside in, I'd have to say to myself, if you did so well in the second quarter, I got to assume you're going to do probably equally as well in the third quarter, right? Because you're sized for it, you've been positioned for it. Why would margins come down internationally in the third quarter versus the second quarter?
Well, I can't say that they would or they wouldn't. Obviously, we would still like to maintain them where they are. We will internationally as well carry, I would say, slightly more resources than what is necessary for the third quarter. We see revenue coming down still a little bit from the second quarter level, and we could have shed some more resources to be prepared for that. I think the only reason why the margins would come down, I would say in general, would be that we are carrying slightly more resources. There is also a further pricing effect that comes into it, but obviously offsetting this is the continued impact from transformation. I would say if we decided to go forward and completely align resources to activity, we should be able to absorb a large part of the pricing.
I think the way we're going now, you could potentially see a little bit of margin drop in Q3, that will be more by design, the fact that we are willing to carry a bit more resources rather than not being able to effectively maintain it.
All right. That's great. If I just, on the pricing front, on the international dynamic, what area are you seeing the most pricing in terms of geographic, and what product lines are coming under the most pressure right now?
In the international market?
Yes.
Well, obviously the product line that has been the most affected so far is WesternGeco on the seismic side, which has been now going on for a good, what, six odd quarters, right? I think our team in WesternGeco has done a tremendous job in streamlining the cost structure, improving how we operate our fleet. We are very well positioned to maximize our performance on the marine seismic business the way it is today. That's probably where we have seen the most. In terms of geography, you see it more or less everywhere, both on land and offshore actually, but we've seen it in some of the large markets in Latin America, sub-Sahara Africa, the North Sea. Even on land in the Middle East, we have significant pricing pressures.
We are navigating the landscape, and we have to give concessions, but we try to trade the concessions for something in return, either better terms and conditions, more integration opportunities, higher market share. Whatever is left to be offset, we are trying to offset with the leverage we're creating from the transformation.
Hey, that's great, Paal. Appreciate it. Thank you.
Thank you.
We'll go to James Crandell with Cowen. Please go ahead.
Good morning, Paal. What impact is the pending merger of Halliburton and Baker Hughes having on the awarding of business outside of North America?
It's a bit difficult for me to say what the impact is. That's more of a customer question. I think it obviously creates a bit of uncertainty from our customers. Firstly, is the transaction going to go through? If it goes through, then it's from three to two players. If it doesn't go through, then obviously that warrants a different approach to how they potentially would like to award. I think it creates uncertainty from the customer side as to how they go about awarding in tender situation. It has probably also led to potentially slightly lower rate of tendering in this part of the cycle. This is the ideal time for most of our customers to tender, given the fact that activity is down. I think that is probably one impact that it has.
If you look at our performance, I'm actually very pleased with our tender win rate in the first half of the year. I think we have done very well. I'm pleased with some of the key wins that we have taken on. For me, that should bode well, I think, for market share evolution in the second half of this year and into 2016.
Do you think you've won market share year to date internationally in the areas that you compete with Halliburton and Baker?
Yeah. There's nothing in our revenue numbers in H1 as of yet. If you look at the amount of contract volume we won, I believe we have won a higher share of the contracts out for bid than what our current market share is, which means that over time, we should gain share.
Okay, good
as these contracts are implemented. Yeah.
Okay, good. As a follow-up question I have on the U.S. pressure pumping business, in this kind of environment that we're in today, are there many instances where customers are willing to differentiate and pay for technology?
Well, if you look at the total business volume in North America land, it is not a high percentage yet, but I would say it's a growing number of customers that are willing to have a much more open technologies discussion with us. They see the importance, I think, of moving away focus entirely from driving down the well cost to driving down the cost per barrel for the production that they have. The only way to do that now going forward, as we are nearing the asymptote of how cheaply you can drill and complete these wells, you're going to have to get more production out of them. I think it's very evident that the only way to get that done is through new technology and new workflows.
Okay. Thank you.
Thank you.
Our next question is from Doug Becker with Bank of America Merrill Lynch. Please go ahead.
Thanks. Paal, maybe sticking with the pressure pumping topic, you highlighted the unsustainability of where that business stands right now. How do you expect this to play out? Does the capacity simply shift to stronger hands, or do you see some meaningful capacity reductions?
I think what you find in any of these commoditized markets, if companies go under, there might be a temporary impact on capacity as the capacity shifts hands. Most likely, whatever capacity is in the market today will likely resurface with some other ownership once those type of transactions are sorted out. I don't think it's going to be a permanent capacity reduction from companies potentially going under. I think these assets will shift hands and resurface with different ownership.
That makes sense. Then maybe a quick one for Simon. In the past, you mentioned getting payback on severance costs within a year. Is that on track, and does this simplistically mean cost savings of something around $750 million in 2015? I'm just arriving at that number by summing up the severance cost from fourth quarter to second quarter.
It is on track. It is as we confirm, within one year. I'm not too sure about your number, your logic is correct. If you take what we have declared as far as the payments are concerned, this would be recovered less than a year.
Okay. Are the remaining headcount reductions more concentrated in North America or internationally?
We are almost completed with what we have done. There is no more reduction.
Got it. Has that skewed more in North America or internationally?
Well, North America percentage-wise was higher, but it was global, yes.
Understood.
All over.
Thank you very much.
Okay.
Thank you.
Ladies and gentlemen, due to time constraints, that'll be our last question. I'll turn it back to the presenters for any closing remarks.
All right. Thank you. Before we close, I'd like to summarize the three most important points that we have discussed this morning. First, the market evolution in the second quarter was the continuation of what we saw in the first quarter, with North America land rig count falling further, and with pricing pressure increasing in both North America and international markets. In response to this, we have proactively managed what remains under our control and subsequently delivered our best cost and cash performance so far in any downturn. Second, our strong performance has been amplified by the acceleration of our transformation program, which is being actively implemented throughout our global organization and which has enabled us to increase pre-tax operating margins in the international areas and maintain double-digit margins in North America.
Third, we believe that we now have seen the bottom of the rig count decline in North America, and that North America land activity will see a slow increase in the second half of this year, while service pricing is expected to decline further in the third quarter as the fight for market share continues to play out. In the international markets, we expect no upward revision to E&P CapEx spend for the remainder of 2015, as the trend of low exploration activity, tight management of development spend, and sustained pricing pressure is likely set to continue. Based on this, the third quarter could potentially represent the bottom of this cycle in terms of earnings per share, as the pace of the revenue drop is set to slow, and as we continue our steadfast efforts to maximize operating margins in both North America and international markets.
With the streamlining of our cost and resource base undertaken in the past nine months, together with the acceleration of our transformation program, we remain very optimistic about our ability to deliver unmatched incremental margins as soon as E&P investments start to show any signs of growth. That concludes today's call. Thank you very much for attending.
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