Calculating Super normal profit

Question

The case study of an economic analysis is done for Schlumberger, oilfield Service Company.  They are No. 1 in terms of market caps, revenue and employees globally. When any references are used/outside sources (except for Schlumberger's annual reports and financial statements), they should be evidently stated. Now answer the following Question?

1. Calculate Super Normal profit: calculate exactly the % of super normal profit Schlumberger is making. Use 5 year average, as well as 2009 data separately, and Q 3 2010 (it was announced on Fri). Plot 3 simple graphs to show, or this three in one graph is also okay.

2. Effects of inflation on revenue: Do that either using GDP calculator or industry indices (e.g. Dow Jones.) To calculate real versus nominal value. The industry they should look for is oilfield equipment and services. If they can't fine then oil and gas. Also, if they could draw a generic conclusion on exchange rates. (There are no specific breakdowns detailed enough. they operate globally, generate revenue in dollars, and oil is traded in dollars. I just need a generic conclusion on how exchange rates affect their revenue and not specific data for them to look at. Note: it should not be a conclusion on how oil trade is affected by exchange rates fluctuations.

3. Price Elasticity of Demand (PED) for Schlumberger (i.e. oilfield service): I am not sure how they can do it. One way is to compare average change in rig rates (info available on site www.rigzone.com) to average change in SLB stock price? They must note that the stock price was split in 2006 when it crossed a 100$. I think that the site that have historic stock price have already considered that in calculation. Or they can use any other way.

4. Wealth generating potential: A few generic strategic sentences/one short paragraph, based on their balance sheet and net dept vs. equity or cash flow. Treat it as part of investment appraisal exercise.

Below is Schlumberger's revenue from 2009 - 2004 (backwards), in $ US Billions:

2009    2008    2007    2006    2005    2004
22.7    27.16    23.28    19.23    14.31    11.5

Below is RONA from one of the websites for 5 year average (need to check that figure):
Please note: this was as of Q 2 2010. For a 12 month period ending Q 2 2010 they had the following figure for RONA (all is $ US billion)

Below is also an explanation on GDP deflator and how to convert nominal to real values:

Nominal Sales/Output of UK based company 'X' (£m) = TR

2000    2001    2002    2003    2004    2005    2006    2007
1000    1027    1015    1034    1086    1210    1450    1520

GDP deflator = P    92.071    94.099    97.03    100    102.564
Real Sales/Output    1086    1091    1046    1034    1058    1153    1346    1369
(Q = TR / P)'

At the business level the simplest solution to this problem is to deflate current total revenue (i.e. the money value of output = P x Q) by an appropriate index of prices .The GDP deflator can be viewed as a measure of aggregate prices in the domestic economy. The deflator is usually expressed in terms of an index, i.e. a time series of index numbers The GDP deflator reflects movements of hundreds of separate deflators for the individual expenditure/output components of GDP.

GDP deflator for specific economy should be used The IMF is the first port of call for this data but local sources can also be used. In the example 2003 is the base year so when TR (the money value of output) is deflated before 2003 the real value is higher i.e. at 2003 prices TR is higher in 2000 when it is valued at 2000 prices. After 2003 the opposite happens so the real value (‘volume’) is less than the current value. Government statisticians use this method to value company level real output which they can they aggregate to obtain a macro level measure i.e. GDP

GDP deflator is an average measure of prices In general, it is better when calculating real output at the company level to use either a company or sector specific price index.  When this is not available the GDP deflator is a good alternative

Answer 1

I. Super normal profit:

That would require to  compare ROCE ( return on capital employed) or RONA ( return on net assets)- preferably ROCE, with long term government bond/interest rate/ rate of return in financial markets. It is OK to use US rate as benchmark - they are international and report everything in $, plus there is no currency-specific regional breakdown in the financial reports.

The 10 year bond yield (the long bond yield) is the rate that should be used for the calculation of normal and supernormal profit. This is built into the LRATC curve as an implicit cost of being in that business- any profits earned above that yield are classed within economic theory as supernormal.A firm makes normal profits if the rate of return equals the opportunity cost of the business activity. The simplest indicator of that is the rate of return in the financial markets on a low risk financial asset. If ROCE exceed that rate the firm makes 'supernormal profits'
 
The way  ROCE should be calculated
Operating  Profit/(ave total assets - current  liabilities) x 100
Or
Profit before tax/ (total assets - current liabilities) x 100
 
-need to use operating profit margin to determine  rate of return
-based on that need to conclude whether a company is in ' strategic hell' ( presumably not based on calculation) - conclude that by assessing the performance of a firm in terms of its ability to escape strategic hell

If they can't calculate ROCE they can use RONA. Some websites provide RONA, they are somewhat different but if they pick off one of the websites ( eg forbes etc) they need to specify which one and stick to the same one.

Super normal profit for Schlumberger is about – 7.92%

II. Inflation and revenue:

It has been noticed that a major decrease in revenue of oilfields services is mainly because of the deterioration of the local currencies as compared to the US dollar. This year’s drastic rise of oil prices and decline in the dollar has hit the US economy very badly. Moreover, an increase in the oil prices resulted in higher trade deficits and leading to a lower dollar price. As the demand of oil is more than the supplied amount therefore the price of a barrel of oil in the U.S. crossed a noticeable price per barrel during this year. Further, because of increment in the cost of U.S. oil and gas, imports have also increased. Every dollar increment in the price of a barrel of imported oil rises the extent of the U.S. trade deficit, which puts more weight on the worth of the U.S. dollar, which results in the value depreciation of the dollar, therefore OPEC countries will wish to lift the dollar-denominated price per barrel of oil to cope up with the decrease in dollar price.

III. Price elasticity of demand for Schlumberger:

The recent statistics reveal that rig count has come down during the year 2010. It has reached about $310,000 but previously it was around $368,000 per day in the year 2007 and $52,000 per day in the year 2000. To begin with, due the inadequate provision of rigs obtainable, there can be a serious slow down in the hiring due to the fact that high spec supply becomes more fully absorbed. With demand being doubtful to completely drop down because of technical needs, few of the more marginal rigs are expected to carry on. Therefore, it can said that the speed of rig add-ons in this recovery fairly represent an inverse association with high spec rig exploitation. The spot market land rig pricing is likely to enhance several areas of the lower 48. It is also suggested that the land rig demand can be  reasonably price inelastic at the time of up cycles therefore it can lead to decrease in the speed of hiring due to the fact that contractors attempt to increase prices. Considering the present market deployment to be anywhere between 65-75%, the divergence in demand for high vs. low spec units is expected to increase the  day rates which have been noticed for the higher spec fleet. Besides this, scarcity and commodity price outlook play a major part in widening US economic issues to large extend. Moreover, control in the speed of employment can be eliminated if the commodity prices witness a higher move or the operators choose to enhance their budget for 2010 or operators become more inclined towards lower spec rates.

IV. Wealth generating potential:

Taking into account the balance sheet and cash flow one can clearly notice a noticeable change in the revenue that was recorded in the third quarter of the year 2009 i.e. $5.43 to that which has been recorded in the year 2010 i.e. $6.85. The main reason behind this increase in revenue is the large augmentation in US land. Moving ahead, earning per share has also increased to $1.38 which was previously $0.68 in the second quarter of the year 2010 and $0.65 in the year 2009. Additionally, Schlumberger also recorded a profit of $0.98 per share in the third quarter of the year 2010 on its investment in M-I SWACO mainly because of its amalgamation with Smith international, Inc. It is highly expected by the management team of Schlumberger that the forth quarter of 2010 will represent powerful outcome in North America. The chances of rapid return to deepwater drilling in the US Gulf of Mexico are unseen. The keenness of the workforce of all our operating organizations is quite evident and has proved to be very productive. Further, the company is striving hard to increase its profit margins in coming years.  Finally, the integration team is speedily categorizing revenue as well as cost prospects that promise well for the coming year 2011.