I first noticed National Oilwell Varco, Inc. (NOV, Financial) when Warren Buffett's Berkshire Hathaway reported a stake in the company in August 2012. I was also intrigued to learn that National Oilwell Varco's CEO since 2001, Merrill (Pete) Miller was selected “Morningstar's 2012 CEO of the Year”. Given that NOV stock is down to the $65 level, I decided to take a closer look at the company. National Oilwell Varco operates in the cyclical business of oil and gas equipment and services, but due to the astute strategy of its management, with continuous innovation and improvements that benefit its clients and intelligent capital allocation, the company has built up a strong economic moat.
I) The RecordNational Oilwell Varco (NOV, Financial) under Pete Miller has grown book value per share from $8.50 to $50 from 2003 to 2013. EPS has increased from $0.45 in 2003 to $5.83 in 2012. Cash flow per share has increased from $0.75 in 2003 to $7.25 in 2012. Share price has increased from $10 in 2003 to $65 in 2013. In spite of numerous acquisitions over the last decade (some with shares) the shares outstanding has increased only from 330 million to 427 million. What has been most impressive is the widening of the economic moat of the company due to the diligent strategy by Pete Miller and recently elevated Chief Operating Officer Clay Williams. National Oilwell Varco initiated a modest dividend in 2009 which currently stands at $0.52 per year, and I expect this to grow substantially over the next five years if the company does not find opportunities for value creation. A dollar invested with Pete Miller in 2003 would now be worth $7 in 2013.
NOV 10-Year Chart from Google Finance:
II) Business and History
National Oilwell Varco is a worldwide leader in the design, manufacture and sale of equipment and components used in oil and gas drilling and production, the provision of oilfield inspection and other services, and supply chain integration services to the upstream oil and gas industry.
Since 1841, National Oilwell Varco has been dedicated to ensuring that customers receive the highest quality oilfield products and services. Leveraging over 800 worldwide manufacturing, sales and service centers, National Oilwell Varco supplies customer-focused solutions that best meet the quality, productivity, and environmental requirements of the energy industry. National Oilwell Varco is a worldwide leader in providing major mechanical components for land and offshore drilling rigs, complete land drilling and well servicing rigs, tubular inspection and internal tubular coatings, drill string equipment, extensive lifting and handling equipment, and a broad offering of downhole drilling motors, bits and tools. National Oilwell Varco also provides supply chain services through its network of distribution service centers located near major drilling and production activity worldwide.
III) Operations and Competitive Advantages
Morningstar Analyst Stephen Ellis puts it well when he writes ”National Oilwell Varco remains at the center of several major industry trends, collecting large and growing economic rents. For offshore drillers, the firm represents the best and only source of rig equipment and the deep-water technology needed for new rigs to economically drill far more and deeper wells. For onshore drillers, National Oilwell Varco plays a similar role in providing the needed technology to properly exploit more demanding tight oil and gas reservoirs. The firm supplies nearly all of the equipment needed for a land rig and much of the downhole equipment and consumables. National Oilwell Varco's latest foray into subsea equipment positions the firm to lay claim to an increasing share of the economic rents as floating production storage and offloading and subsea development efforts accelerate over the next decade.”
NOV Products and Services:
National Oilwell Varco organizes its operations in three business segments:
1. Rig Technology: The Rig Technology segment (accounted for 57% of the company's 2012 operating profit) designs and manufactures integrated drilling systems and components for land and offshore drilling rigs.
2. Petroleum Services & Supplies: The Petroleum Services & Supplies segment (37%) consists of a number of the company's services and consumables, including inspection and quality assurance services for tubular goods, solids controls and rig instrumentation.
3. Distribution & Transmission: The Distribution & Transmission segment (6%) sells and rents technical equipment used in the drilling process.
NOV 2012 Operating Profit by Segment:
These are some of the competitive advantages:
1. National Oilwell Varco dominates in rig equipment particularly in deep-water rigs, which is a wide-moat business. Its equipment is on 90% of the world's rigs. The large market share gives economies of scale advantages.
2. National Oilwell Varco has built out a large product portfolio through acquisitions over the years leading to a shift toward a more standard rig design. This allows improvements in rig up-time, as well as lower training, maintenance, and installation costs which are major competitive advantages and a strong barrier to entry for competitors. Customers would rather choose a one-stop shop than deal with multiple suppliers. It saves on labor and increases efficiency.
3. National Oilwell Varco also provides a wide range of services and extensive support which are an advantage over other smaller competitors.
4. National Oilwell Varco is an innovative force in the industry, constantly inventing and manufacturing products that improve the safety and productivity of drilling and well-servicing processes.
5. National Oilwell Varco offers rig operating companies innovative and time-saving products make their rigs safer and more comfortable places to work - a big plus in recruiting and retaining valuable employees.
6. National Oilwell Varco offers education and training for its more complex products, increasing switching costs for customers. Once a company has invested time and money training for and implementing a system, it becomes a burden to move to competing products.
7. National Oilwell Varco has operations in the United States, Canada, Norway, Denmark, the United Kingdom, Brazil, China, Belarus, India, Russia, the Netherlands, Singapore, South Korea, South Africa and Angola. This global presence is a major competitive advantage.
8. National Oilwell Varco has numerous patents which can serve as a barrier to entry.
9. National Oilwell Varco has a service backlog of $12.9 billion as of April 2013. Maintenance and replacements services for existing deliveries assure a stream of revenue for years to come.
IV) Balance Sheet and Profitability
National Oilwell Varco, Inc. has one of the best balance sheets in the energy sector and also compares favorably when compared with businesses in the manufacturing and industrial sector.
At December 31, 2012, the company had cash and cash equivalents of $3,319 million, and total debt of $3,149 million. At December 31, 2011, cash and cash equivalents were $3,535 million and total debt was $510 million. The $2,855 million reduction in the net cash (cash less debt) balance in 2012 was due primarily to $2,880 million in cash paid for 2012 acquisitions. A significant portion of the consolidated cash balances are maintained in accounts in various foreign subsidiaries and, if such amounts were transferred among countries or repatriated to the U.S., such amounts may be subject to additional tax obligations. Of the $3,319 million of cash and cash equivalents at December 31, 2012, approximately $1,994 million is held outside the U.S. Of this amount, approximately $1,785 million is considered permanently reinvested and is available to fund operations and other growth of foreign subsidiaries including, but not limited to, capital expenditures, acquisitions and working capital needs. If opportunities to invest in the U.S. are greater than available cash balances, rather than repatriating this cash, the company may choose to borrow against its revolving credit facility.
On February 20, 2013, the company completed its previously announced acquisition of Robbins & Myers, Inc. for approximately $2.5 billion in cash. The company borrowed approximately $1.4 billion under the $3.5 billion revolving credit facility and used approximately $1.1 billion of cash on hand to fund the acquisition.
Balance Sheet Information:
Statement of Operations:
2012 Result of Operations by Segment:
V) Management
CEO Merrill (Pete) Miller, Jr. has led National Oilwell Varco since 2001 and is Morningstar's 2012 CEO of the Year. In late 2012, Miller stepped back from the day-to-day operations of NOV in preparation for his eventual retirement, after orchestrating numerous acquisitions that have largely consolidated the equipment market to the firm's benefit. The company also consistently offers some of the best industry commentary on its quarterly calls. Miller and recently elevated Chief Operating Officer Clay Williams, who now manages more of the day-to-day operations, are shrewd judges of value and very good capital allocators. Overall National Oilwell Varco is a very well-run company with a thoughtful management team that is focused on creating shareholder value.
Management Holdings:
Here are some excerpts from the first quarter 2013 conference call that give insight on how management thinks about capital allocation:
Clay C. Williams - President, Chief Operating Officer
“Since the beginning of 2009, we had generated $6.9 billion in cash from operations, and raised $3.4 billion in debt financing totaling $10.3 billion in capital generated were raised. We have paid $1.1 billion or 11% to our shareholders in dividends, invested $1.7 billion or 17% internally in capital expenditures and invested $7.4 billion or 72% in acquisitions.”
“The largest of our acquisitions since 2009 is Robbins & Myers which finally closed in the first quarter; it’s strengthened our position in a number of key technologies - progressing cavity pumps, flow line, artificial lift and downhole drilling motors, just to name of few. This acquisition makes NOV the largest provider worldwide of enabling required for the drilling and completion of horizontal wells and has a very busy four year period as far as closed 51 acquisitions. We are excited about this aggregate addition of new businesses to NOV including the talented teams that have joined our own.”
The verdict on the performance of Clay Williams after he takes over as CEO will be out in next three to five years, but I am optimistic about the prospects of National Oilwell Varco under his management since he has played an integral part of strategy and execution over the last four years and has been groomed for this role by Pete Miller.
VI) Value and Price
National Oilwell Varco (NOV, Financial) is currently trading in the $63 to $72 range. Value Line projects an earnings growth rate of 15%, book value growth rate of 11% and dividend growth rate of 25% over the next five years. Due to the cyclical nature of the business and assuming a conservative YOY growth rate of 9% over the next five years gives us a 2017 EPS of $9.00. Assuming a normalized terminal PE of 13 gives us a 2017 price target of $117. This equates to a 16.75% annualized return, assuming a 1% dividend.
Diligent capital allocation of cash flow over the next few years offers further upside potential. Below is also an example of the capital allocation record of the company's 2012 cash flow. The dividend is very low at less than 1% currently but payout is likely to grow in the future, assuming better avenues for value creation are not available for management.
NOV 2017 Mritik Capital Projection:
2012 Acquisitions and Investments:
National Oilwell Varco paid an aggregate purchase price of $2,880 million, net of cash acquired for acquisitions in 2012. On February 20, 2013 the company completed its previously announced acquisition of Robbins & Myers, Inc. for approximately $2.5 billion in cash. The company borrowed approximately $1.4 billion under the $3.5 billion revolving credit facility and used approximately $1.1 billion of cash on hand to fund the acquisition.
VII) Catalysts
The market is focused on the short term which allows us to own this wonderful business which will be successful and growing decades from now. Shares of National Oilwell Varco will be volatile in the next five years but as Warren Buffet says, it is better to have a bumpy 15% return than a smooth 8%. Although there may not be any immediate catalysts in next few months, I can think of the following catalysts over the next three years.
1. Increased delivery of deep water rigs in the coming years could boost earnings and surprise to the upside.
2. The synergies from $2.8 billion worth of acquisitions in 2012 and $2.5 billion Robbins & Myers in 2013 could increase earnings above initial expectations.
3. Increase in growth in international sales, especially to Brazil and Asia, may be a positive. Onshore drilling activity in North America which has been in a downturn for the last year may pick up in late 2013.
4. Continued innovation could lead to new products and services, and boost earnings.
5. Diligent capital allocation and annual dividend increases and prudent deployment of cash flow ($3 billion to $4 billion per year) over the next three years will increase the intrinsic value of the company. If share price drops further, the company could execute opportune share buybacks.
VIII) Specific Risk
As in any investment there are some risks associated with an investment in National Oilwell Varco:
1. National Oilwell Varco results are heavily levered to changes in the overall energy price environment, which are inherently volatile and subject to complex market forces. A prolonged downturn may affect the company revenues, earnings and cash flows.
2. The recent weakness in the North American onshore drilling has been a negative for National Oilwell Varco, which derives a substantial portion of its revenues/earnings from the region.
3.The One-Subsea joint venture combining Cameron's equipment design, manufacturing and installation expertise with Schlumberger's reservoir knowledge and well completion expertise could affect prospects of NOV's subsea ambitions.
4. There are certain environmental and regulatory risks. Terrorism and security-related risk factors exist.
5. Depreciation of foreign currencies against USD may reduce reported earnings.
6. There is execution risk with acquisitions not turning out to be accretive to earnings.
IX) Why Is This Cheap?
These are some reasons why we think the shares are cheap:
1. The market is overly pessimistic and as always focused on the near-term factors while ignoring the high- quality nature of the underlying business.
2. The market is under-appreciating the growth potential of business while focusing on the near-term weakness in the North America onshore drilling activity.
3. The market is taking a wait and watch approach due to global macro uncertainty.
4. The market is waiting to see if the acquisitions over the last year will be accretive to earnings.
5. When the price of oil drops, the share price of National Oilwell Varco also drops.
Disclosure
I own shares of National Oilwell Varco. I have also sold January 2015 puts on National Oilwell Varco at $ $65.
Comments and questions welcome.
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Note:
I have used information from NOV investor relations website, investor presentation and financial statements. I have referenced information from Morningstar.
