During the quarter, we exited our investments in National Oilwell Varco (NYSE:NOV) (Varco). Varco continues to dominate the market for supplying offshore rigs with comprehensive drilling packages and equipment. However, over the past few years we have seen dual industry headwinds hit Varco's customers particularly hard in the form of prohibitively high offshore development costs, combined with a continuous flood of OPEC’s low-cost oil supply. We concluded that the Company's customers - offshore drilling contractors, national oil companies and international oil companies - were systematically shifting their budgets away from offshore, towards onshore development, increasing the risk of another three to maybe even five years of low or negative earnings growth. In addition, while the company continues to have dominant market share, particularly in providing new and aftermarket equipment to offshore drilling rigs, we think this addressable market has the potential to contract for several years as cheap oil from OPEC countries crowds out higher-cost sources of marginal production, especially for non-OPEC offshore producers.
Varco's stock is no doubt cheap, at least based on the previous cycle’s earnings power, but we think the secular shift away from offshore exploration and development continues for a few more years, which makes the previous cycle difficult to use as a comparable. Further, Varco's exceptional financial strength affords them ample leverage to buy distressed assets, but in our view there are not many opportunities for them to grow their lucrative rig-tech businesses, where they have dominant market share. While Varco's long-term competitive strategy is heavily contingent on M&A, we have yet to see a material slow down in the availability of cheap capital to the sector, which has conspired to keep target asking prices above where Varco is willing to bid. In the meantime, management has signaled a less aggressive stance on share buybacks, despite what we think is a particularly attractive historical valuation, as they bide their time and husband capital for M&A. If the Company manages to close in on an attractive target to offset the long -term risk of offshore rig technology business, we will likely revisit Varco as an investment idea. However, we are skeptical that attractive returns are available, given the abundance of competing capital and the Company's already dominant position in rig technology. Continue Reading »