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NOV - A Good Time To Buy

April 28, 2013 | About:

I first noticed National Oilwell Varco, Inc. (NOV) 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) 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:

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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:

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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:

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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:

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Statement of Operations:

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2012 Result of Operations by Segment:

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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:

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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) 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:

1535812900.jpg

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.

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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.

Read more:

NOV 2012 Annual Report

Note:

I have used information from NOV investor relations website, investor presentation and financial statements. I have referenced information from Morningstar.

About the author:

MritikCapital
Mritik Capital Inc. is a financial advisory firm with focus on identifying quality businesses with durable competitive advantages that are undervalued. Our first goal is to preserve the capital of our clients and look for strategies for enhancing their net worth based on opportunities that present compelling risk adjusted reward.

Please note that investing offers both risks and rewards. Before investing do your own due diligence and consult your financial advisor.

Visit MritikCapital's Website


Rating: 4.5/5 (47 votes)

Comments

trinathdasari666
Trinathdasari666 - 1 year ago


Well done again .... Your articles are very simple to understand and detail as always

Trinath

MritikCapital
MritikCapital - 1 year ago
Hi Trinath,

Thanks for reviewing the article. I appreciate your feedback.
kartikey1
Kartikey1 - 1 year ago
Great read. Very concise with insights investor needs. Thank You.
MritikCapital
MritikCapital - 1 year ago
Hi Kartikey1,

Thanks for commenting on the article, I appreciate it. I used to avoid stocks like this with high beta but it took me some time to realize that large fluctuations in stock price is not necessarily a bad thing when the underlying business keeps executing and growing and management is diligent with capital allocation.

I am looking forward to seeing how NOV turns out in the next 3-5 year period.
vgm
Vgm - 1 year ago
Yes, another exceptional piece. Thanks for sharing your insights and analysis.

Regarding beta, Buffett tells us that volatility is the friend of the patient value investor. We should be ready to capitalize on it. The current undervaluation of NOV is a good example of Mr Market offering us a bargain.
MritikCapital
MritikCapital - 1 year ago
Hi Vgm,

Thanks for your comments. I am glad the Robbins & Myers purchase was with cash and not shares since we believe shares are undervalues considering prospects for growth. The cyclical nature of the sector in which NOV operates means that sometimes assets will be depressed and this allows good opportunities for acquiring other companies at reasonable valuations. It would be interesting to see what management does with free cash flow generated in 2013.
sersoylu
Sersoylu - 1 year ago
Great writeup.

One question, what is NOV's market share/exposure on fracking for natural gas in the US exactly ?
MritikCapital
MritikCapital - 1 year ago
Hi Sersoylu,

Thanks for the comments. It is a good question you raise. I have not seen a concrete number in those exact terms. NOV breaks its reporting into (1) Rig Technology, (2) Petroleum Services & Supplies, (3) Distribution & Transmission; so you may need to analyze all 3 operating segments and also products and services are used for both natural gas and oil so take that into account. Arriving at the exact number may be difficult. You could contact the Investor Relations contact at NOV in case they are willing to share this.

As per Morningstar "The company's equipment is on more than 90% of the world's rigs, and we estimate it has about 60% market share in rig equipment. National Oilwell Varco retains well over 80% of the mud pump market".

Please see information on NOV website under Rig Census and commentary as per NOV 2012 Annual Report states "The count of rigs actively drilling in the U.S. as measured by Baker Hughes (a good measure of the level of oilfield activity and spending) peaked at 2,031 rigs in September 2008, but decreased to a low of 876 in June, 2009. U.S. rig count increased steadily to 2,026 by late 2011, but began to decline with lower gas prices to average 1,809 rigs during the fourth quarter of 2012. At February 8, 2013, there were 2,390 rigs actively drilling in North America, compared to 1,967 rigs at December 31, 2012; an increase of 21.5% from year end 2012 levels. Recently low gas prices have caused operators to trim drilling, driving the average U.S. gas rig count down 52% from the fourth quarter of 2011, to an average of 423 in the fourth quarter of 2012.

However, with high oil prices, many have redirected drilling efforts towards unconventional shale plays targeting oil, rather than gas.

For the fourth quarter of 2012, oil-directed drilling rose to almost 77% of the total domestic drilling effort, and, while the average oil directed drilling rig count declined by 2% from the third quarter to 1,383 rigs, it remains near its highest levels in the U.S. since the early 1980’s.".

In case you arrive at an exact answer to your question please do share.
sersoylu
Sersoylu - 1 year ago
Thanks for the response. I have not been able to find a specific number yet, but I'll post it here if I do. Based on my limited amount of work in oil well drilling in the past, my guess is many of those on-shore rigs referenced as the 90% of market are probably used for shale gas fracking. NOV has ample amount of powerful pumps, drilling equipment and other tools that seem to be used in fracking.

Here are two great links I found on NOV today. One is a morningstar interview with the CEO, which talks about NOV's natural gas exposure a bit. The other is a couple-year old FT article that also mentions NOV.

http://www.morningstar.com/cover/videocenter.aspx?id=580263

http://www.ft.com/cms/s/2/bc3b52f2-283f-11e1-91c7-00144feabdc0.html#axzz2RtK5endC
MritikCapital
MritikCapital - 1 year ago
Hi Sersoylu,

Thanks a lot for posting the very useful links. I really enjoyed the interview of Pete Miller.
swnyc2
Swnyc2 - 1 year ago
MritikCapital,

One of the risks you mention is: "When the price of oil drops, the share price of National Oilwell Varco also drops."

If you are correct, then it's one of the reasons why NOV may not be such a great buy today. From 1986-1998 the average price of oil was well under $20/barrel. Even after adjusting for inflation, oil was selling for less than $30/barrel in todays dollars. Today, the price of oil is more than $80/barrel. Buying a company whose value is substantially affected by the price of oil can be dangerous. Just ask Warren Buffett who purchased COP when oil prices were high. It was one of his few major investments that did not work out so well.

I've heard many people take for granted the relationship between NOV's share price and the price of oil. They typically say that when oil prices are high, companies increase exploration and drill new wells. No doubt this is true, and why one might expect NOV's share price to follow the price of oil.

However, NOV does not make money selling oil. They make it selling oil equipment and drilling support. So, I'm wondering, what happens if fracking increases oil (and gas) supplies so that supply exceeds demand and the price of oil falls? In this scenario,cheaper oil may spur consumption and hence lead to even more production.

So, my question is this: Does all this mean that NOV may still do well even when oil prices are low - provided the low prices are due to increased supply (rather than decreased demand)?

Disclosure: Long NOV

MritikCapital
MritikCapital - 1 year ago
Hi Swnyc2,

Thanks for reviewing and commenting on the article. I have no special insight into the human mind as to how people will behave when the next panic sets in and how low price of NOV may fall to. Also there are too many economic and geopolitical factors that affect the price of oil which are unpredictable.

When I look at the company and its strengths and competitive market position and global operations it gives me a measure of confidence that this company can withstand the downturns and prosper and earn higher than what it is earning today in the future. Considering that they have a 12B+ backlog and not only sell equipment but also have revenue streams in terms of service and replacements etc provides some stability of cash flows to the business.

In early 2009 stocks of high quality businesses like V, MA, AXP, WFC were significantly down but the businesses as such were not impaired in any way from a long term perspective. The stocks were just punished since they were classified as financial/banking. The same may happen to NOV but if it does then I would buy more as the valuation would be more compelling.

skurka
Skurka premium member - 1 year ago
Great article.

One question: do you know if NOV is a Buffett pick or could it be one of his lieutenants', Todd Combs or Ted Weschler?

MritikCapital
MritikCapital - 1 year ago
Hi Skurka,

Thanks for reading the article and for commenting. This has not been publicly disclosed by Berkshire Hathaway as to who has initiated this position. As per Guru Focus data they owned 5.3 million shares at a cost basis of $70/share which amounts to $371 million and represents 1.24% of NOV shares outstanding as of Dec 31 2012. Given the smaller position size it is reasonable to assume that this purchase is from Ted Weschler or Todd Combs. Since the share price has been within the range of previous purchases ($65-$70) for most of last quarter there was an opportunity to increase the position substantially if they so desired. I am interested to see what position Berkshire declares for 2013 Q1 end when the data comes out May 15th.
MritikCapital
MritikCapital - 1 year ago
Berkshire has increased its National Oilwell Varco stake by 41.4 percent to 7.48 million shares as of 31 Mar 2013. At recent price pf $68 this is vaued at $509M. This represents 1.75% of shares outstanding for NOV and represents a modest 0.6% of the $85B portfolio.
tonysf
Tonysf - 1 year ago


This is probably a Todd Combs position. Ted Weschler portfolio is highly concentrated, may be in 4-5 positions. Todd tends to diversify into 10 positions (still very concentrated) and hold them in much for much shorter period than Ted or Buffett. But whether it is Todd or Ted postion really isn't important at all.
MritikCapital
MritikCapital - 1 year ago
Hi Tonysf,

Thanks for reviewing the article and sharing your thoughts. I agree that compared to the $85B total Berkshire portfolio it is not significant. Given that Todd & Ted were each managing only $5B until 2013 Q1 and the position from Berkshire was in excess of $500M it does account for 10% of the money that either of them who initiated the position was managing. As a Berkshire shareholder who believes NOV represents good value at these prices, I am interested to see whether Berkshire added in Q2 2013 as well.
handworn
Handworn - 1 year ago
Gurufocus's own numbers are that their 2003 FCF was ($0.01), not $0.75, and 2012 FCF was $0.09, not $7.25. What calculations are you using to reach these figures?
MritikCapital
MritikCapital - 1 year ago
Hi Handworn,

Thanks for reviewing the article and comments. I am using the numbers from the company annual reports (see Pg 151 of 2012 AR) and I am also using ValueLine and Morninstar reports. Also I am using CashFlow and not FreeCashFlow. Maybe I am not understanding the question properly. Please review and clarify further and I will take another look.
MritikCapital
MritikCapital - 1 year ago
Hi,

NOV management has decided to increase dividend by 100% to $0.26/Qtr. At current price of $68.50 this would imply a modest dividend of 1.5% but only represents a small payout ratio of 16.5% to projected 2013 earnings.

MritikCapital
MritikCapital - 1 year ago
Looks like Oil Services activity is picking up across the world including North America. HAL, SLB, BHI are all close to 52 week highs or on the way to making one. I am looking forward to commentary from Pete Miller and Clay Williams on 30 Jul 2013 conference call. Assuming earnings rebound to $7 in 2014 a very reasonable 12-13 P/E would lead to price range for NOV between $84 - $91.
MritikCapital
MritikCapital - 1 year ago
NOV getting close to Fair Value. Strong balance sheet and possibility of prudent capital deployment which may grow fair value are an attraction.
stevenramsey
Stevenramsey - 1 year ago
I'd consider that one of the new Berkshire guys (Ted/Todd) bought the stock between $60-80. I highly doubt they bought with such a low margin of safety implied by your $84-91 value. If they bought at the $60-80 range, they're probably pegging it at $100+.

MritikCapital
MritikCapital - 1 year ago
Hi Steven, Thanks for sharing your thoughts.

There is today's fair value and there needs to be consideration of how value will grow to over the next few years. To my estimation current fair value is $85-$90. Considering the strong balance sheet and excellent management team and upcoming spin-off of the distribution business and the fact that NOV has strong growth prospects to the next decade. I suspect you may be right in that Ted/Todd are looking a few years forward.
johnsf1980
Johnsf1980 premium member - 1 year ago
Wasn't Pete Miller lead independent director of Chesapeake during a time when Aubrey went overboard on his debt binge?
MritikCapital
MritikCapital - 1 year ago
Hi John, Looks like he was lead independent director indeed. Its hard to judge though as we cant be sure what his advice was to the board.
MritikCapital
MritikCapital - 11 months ago
Good read Vgm, thanks for sharing. I think the reforms in Mexico related to oil sector may spur some extra growth as well for NOV.
jisare
Jisare - 3 months ago

Sorry for digging out this old thread.

Any view on Pete Miller moving to DNOW? Especially the new incentives for Pete Miller at DNOW.

jisare
Jisare - 3 months ago

And also the consolidation opportunity of distribution business of the industry? Was pete miller actually constrained to consolidate distribution at NOV and moving to DNOW would unleash it?

DNOW doesn't look cheap to me, though.

Please leave your comment:


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