I recommend going long on shares of National Oilwell Varco (NOV). The valuation looks attractive at an estimated discount of 17% to 38%. The company is preparing to spin-off its lower margin Distribution division leaving a market dominant Rig Technology division and highly profitable Petroleum Services & Supplies division. Both parent and spin-off have significant growth opportunities as drilling and well servicing demand increase with the impending shale boom. Catalysts include the planned spin-off and a reversal of the company’s temporary manufacturing inefficiencies.
Business & Industry Overview
NOV designs, manufactures, sells & services equipment and consumables for oil & gas drilling and intervention. NOV has operations in over 1,235 locations across six continents and generates 65% of its revenue outside the U.S. NOV operates three divisions:
- Rig Technology (Rig Tech) designs, manufactures and sells rig equipment for drilling and servicing oil & gas wells including complete offshore & onshore rig packages.
- For FY2013, Rig Technology revenues comprised 49% of company sales while making up 63% of operating profits.
- Revenues are primarily dependent on capital spending for drilling & intervention equipment, but also on the level of oilfield drilling activity (drives demand for spare parts of installed base of equipment).
- Customers include:
- Drilling contractors.
- Oilfield service companies.
- O&G companies.
- Among rig component manufacturers NOV is the dominant player with an estimated market share of 60 to 70% rig equipment packages; this has earned the company the nickname “No Other Vendor.” Major drilling contractors Transocean and Ensco have basically standardized on NOV equipment. Within the rig equipment space, Aker Solutions represents NOV’s biggest competition; however, they are focused almost exclusively on offshore rig equipment whereas NOV competes in both the offshore and onshore equipment markets. Cameron (CAM) has also recently stepped up to compete with NOV by offering complete rig packages to offshore floaters.
- Petroleum Services & Supplies (PS&S) manufactures, rents and sells consumable goods & services for drilling, completing, remediating and working over oil & gas wells. This includes drill pipe, surface equipment, downhole tools and pipe inspection services.
- For FY2013, PS&S contributed 30% of revenues and 30% of operating profits.
- Revenues of PS&S are mostly driven by the level of oilfield drilling and workover activity.
- Customers include:
- Drilling contractors.
- Oilfield service companies.
- O&G companies.
- Pipe distributors, processors & manufacturers.
- Pipeline operators.
- The competitive landscape is much more fragmented for PS&S than for Rig Tech. Included in the list of competitors are the big oil & gas service companies including Schlumberger (SLB), Halliburton (HLB) and Baker Hughes (BHI).
- Distribution & Transmission (D&T) provides pipe maintenance, repair and operating supplies (“MRO”) and spare parts to the drill sites and production locations, pipeline operations, processing plants, and industrial facilities worldwide. During drilling & completion activities, there is an ongoing need for various consumables & spare parts. Since it is not practical for each rig site to have all these items in stock, NOV’s distribution & transmission stocks and sells these spares and consumables (NOV and other 3rd party parts) at their various locations. The company has approximately 450 distribution branch locations worldwide (20 countries). 80% of sales are in North America.
- For FY2013, D&T was responsible for 21% of revenues and 6% of operating profits.
- Distribution & Transmission revenues are primarily driven by level of drilling, servicing, and oil & gas production activities.
- D & T’s distribution business has a very strong competitive position within North America with a comprehensive network of field locations (estimated at 75% share).
- NOV plans to spin-off the distribution portion of their business in mid-2014 (approved in SEP-2013), calling the new company DistributionNOW (ticker NOW). This portion of the business is expected to be ~10% of current revenues. The spin-off was approved
Health & Profitability
The company carries little debt with a debt-to-equity ratio of 0.2 and has annual operating income equal to 32X its annual interest expenses.
Industry profitability should follow a cyclical trend, yet despite the economic downturn of 2008-2009 and an industry slowdown caused by 2010’s Deepwater Horizon disaster, NOV’s profitability has been excellent each year since 2006. Return on capital has ranged between 35% and 70% during the eight years starting in 2006.
Profitability is driven by good operating margins and high capital turnover. High margins can be attributed to product quality, customer lock-in and economies of scale. The company’s strategy of making targeted acquisitions of complementary businesses, while being mindful of the price paid, has allowed it to build scale and benefit from distribution and cross-selling synergies.
Historical growth has been driven by strength in oil prices over the last 10 years and subsequent drilling activity. In response to the increased activity, NOV has made numerous bolt-on acquisitions that have accelerated growth. Growth has also been driven by the need for higher specification rigs and associated equipment as drilling conditions have continually gotten more harsh and demanding. Additionally, the Deepwater Horizon disaster led to increased focus on rig safety and inspections, resulting in a perpetual need for rig upgrades.
The pace of offshore rig builds should remain robust through 2016. Meanwhile, shale drilling demand for land rigs is expected to increase 23% by 2017; to meet this demand, many new rigs will be built while aging rigs will need to be refurbished. According to a forecast by Douglas-Westwood, 4723 subsea and 20222 surface wells will be drilled between 2013 and 2020. Through its Rig Technology division, NOV is the main provider of rigs and equipment packages whereas its PSS division will benefit from the increase in drilling activity. Add these growth opportunities to the company’s current record backlog ($16.2 billion at end of FY2013 vs. $11.9 billion at end of FY2012) and there’s plenty of room to grow.
Pete Miller, who served as CEO from May 2001 to January 2014 will become executive chairman of the firm's soon to be spun-off distribution business (NOW) while Robert Workman who has been president of NOV’s distribution division since 2001 will become NOW’s first CEO. NOV’s new CEO, Clay Williams served as NOV’s CFO from March 2005 to December 2012. Williams owns over 100,000 shares of NOV stock resulting in stock ownership of more than 12X his annual base salary; this should help to ensure incentives are aligned with shareholders’. Beyond share ownership, management is incentivized by linking bonuses to operating profit, a capital employed threshold and discretionary bonuses for taking a long-term view.
Continuity in management should bode well for NOV as the company's 10 year share performance has been excellent (up 400%) suggesting that the market approves of management’s leadership. The company has paid a dividend since 3rd quarter 2009 and its continued distribution should ensure management and the board remain mindful of their capital allocation practises. The company has shown a history of conservative financing by carrying little debt. NOV does not have a track record of share repurchases, instead choosing to reinvest free cash flow via its acquisition based growth strategy. Management has generally been patient with their acquisitions; making sure not to overpay. Based on conference calls and interviews, management seems open and honest in their communications with shareholders. My biggest criticism would be that the role of CEO and chairman of the board is not independent.
The major risks associated with NOV include:
- The oil & gas industry has historically experienced high volatility.
- Oil & gas drilling activity is heavily influenced by oil & gas prices worldwide.
- The company’s primary method of growth is via bolt-on acquisitions and hence, overpaying for acquisitions presents a risk. While the company has historically been very careful to not overpay, the goodwill on the books from acquisitions in 2013 was 57% of the total purchase versus 27% in 2012 and 25% in 2011.
- Comparable EV/EBIT Multiple: A comparable firm would trade at a tax adjusted EV/EBIT of 13.1 (comparable firms used were SLB, HAL, BHI & CAM and the factors considered for inclusion were industry, growth, profitability and tax rate). NOV is currently trading at an EV/EBIT of 9.7. This results in a 38% discount.
- Historical Company P/E Ratio (2001 to 2013):
- median low = 10; median high = 20; estimated forward P/E 12; discount 25%.
- Median Industry Multiples (Oilfield services / equipment 1998 to 2012):
- EV/EBITDA = 9.9; NOV currently 8.2; discount 17%.
- EV/EBIT = 15.8; NOV currently 10.0; discount 37%.
- EV/(EBIT*[1-tax rate]) = 20.9; NOV currently 14.9 (assume normalized tax rate of 33%); discount 29%.
Why it’s cheap: Despite enjoying its three most profitable years in history over the last three years, profitability has been trending downwards (ROC of 49%, 37% and 35% for FY2011, FY2012 and FY2013 respectively). This reduced profitability seems to be weighing on the stock as it has been relatively stagnant over this time period (stuck fluctuating in the $60-$80 range). The reasons for the reduced profitability include:
1) Margin diluting acquisitions,
2) Expenses associated with acquisition efforts,
3) Incremental expenses to fuel growth initiatives,
4) PSS and D&T’s margins hurt by drop in U.S. land drilling rig counts over prior year,
5) Rig Tech’s offshore projects contracted in 2007 & 2008 were manufactured in lower cost environments and increased equipment manufacturing demand has caused production capacity problems and led to higher cost outsourcing.
Profitability should increase as the capacity problems get sorted and the planned spin-off takes place.
Additional reasons why it may be cheap include recent demand for Rig Tech’s offshore rig equipment being very high and investors fearing a backlog decline and the market viewing the stock as trading at its cyclical peak.
I am long NOV.
- Operating margins revert to historical averages as manufacturing inefficiencies get sorted.
- The spin-off of the company’s more capital intensive, lower margin distribution business:
- Will show the true profitability of the company’s two largest divisions and could result in multiple expansion.
- Increasing FCF of parent company & possibility of increasing dividend.
- Upside for parent company selling through other distributors
- With help of former NOV CEO Pete Miller, DistributionNOW, will be freed up to grow rapidly and implement the same consolidation strategy NOV used to make itself the dominant player in rig equipment manufacturing (improve margins & build scale).
- Upside for distribution business selling other company’s products.
- Reduced cyclicality (company & industry).
- Most international activity currently being driven by national oil companies; historically, less susceptible to short-term price fluctuations.
- Value adding acquisitions.
- 2013 was not a great year for North American onshore drilling, but a turnaround could drive sales increases particularly for the PSS division:
- North American onshore rig count appears to be rising (rebounding natural gas prices).