During the Californian gold rush in the late 1840s and 1850s, it was far more profitable on average to be a provider of tools and supplies, as opposed to an actual gold miner. Today's world is not much different in the fact that many market participants are infatuated with the large producers of natural resources, while the technology and equipment providers tend to earn the higher returns on invested capital.
National Oilwell Varco, Inc. (NOV) is the cream of the crop when it comes to providing equipment and components used in oil and gas drilling, and production. The company's products are estimated to be used on approximately 90% of rigs around the world, and with projects becoming more complex and costly, companies are finding the additional efficiency that NOV's wide range of products can provide are more important than ever. A current slowdown in North American onshore drilling amid uncertainty on the short-term trajectory of oil and natural gas prices has created an opportunity to begin establishing a position in this high quality business.
NOV has three primary business units:
1. Rig Technology is the largest and most profitable unit of the company. The unit designs, manufactures, sells and services complete systems for the drilling, completion and servicing of oil and gas wells. This is an extremely comprehensive collection of products and services that are extremely technically advanced and are integral to the operation of the rigs.
2. Petroleum Services & Supplies provides a variety of consumable goods and services used to drill, complete, remediate and work over oil and gas wells. This also includes servicing drill pipe, tubing, casing, flow-lines etc. This segment manufactures, rents and sells a variety of products and equipment used to perform drilling operations and is the second largest division.
3. Distribution & Transmission provides maintenance, repair, operating supplies and spare parts to drill site and production locations worldwide. The segment employs advanced information technologies to provide complete procurement, inventory management and logistics services to its customers around the globe.
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These are just summaries of these divisions' capabilities and for a more comprehensive and interesting breakdown of NOV's vast portfolio of technologies and products I'd refer you to the 10-K.
NOV is constantly on the cutting edge in developing emerging technologies for the drilling industry, and in addition to this organic innovation management has engineered dozens of successful acquisitions over the years. The primary objective of these acquisitions has been to widen the capabilities that NOV can offer its customers and to enable the company to produce at greater capacities. Management has long since favored acquisitions with a focus on increasing its wide-moat versus other drill equipment providers, as opposed to stock buybacks. This can be a risky strategy but NOV's management has a stellar track record and the company has made it extremely difficult for its competitors to encroach on its market share, so instead these companies tend to focus on smaller fringe-type products.
NOV's product line is extremely well-suited to the key growth areas in the oil and gas industry. Large deep-sea discoveries off the coast of Brazil and in the Gulf of Mexico have increased demand and day rates for deep water rigs. NOV has experienced tremendous growth as it provides numerous high-tech products that are essential for the safe and efficient operation of these rigs. One example is the company's expertise in blow-out preventers, which gained notoriety after BP's (BP) Macondo disaster. Nationally controlled oil companies such as Brazil's Petrobras (PBR) are huge clients for NOV, and while the Brazilian government is incentivized to foster domestic competition in developing the products and services required for the exploitation of those deep water assets, it is rarely economically or operationally practical to bypass trusted providers such as NOV. Therefore the company likely has many years of increasing revenues from its deep water technology and product assortment.
Another key growth area for drillers, particularly in North America is the horizontal drilling industry. While the massive increase in gas supplies has depressed prices, drillers are focusing on maximizing the productivity of their onshore drilling with fewer operational rigs. This wouldn't be possible without NOV's deep product line. While the decrease in North American onshore rigs is stunting short-term growth for the company, the long-term production trends should lead to favorable tailwinds. The international drilling environment has been far more robust of late than domestic drilling and NOV's scale and distribution allow it to capitalize on this trend. NOV has invested in manufacturing and distribution centers across the globe, which allows the company to meet customers' demands, whatever they might be. While it is customary to have to order deep water rigs several years in advance, onshore rigs in the Middle East for instance, are expected to be procured in a much quicker time frame, which NOV can meet because of its facilities in the region.
Over the last decade NOV has grown its revenue from around $1.5 billion to about $18.6 billion. While increasing energy prices have contributed greatly to this growth, it is important to mention that the share count has nearly quadrupled. This is a function of management using equity to fund its acquisitions and while I'm generally not a fan of that unless management deems their stock to be overvalued, NOV's stellar track record of incorporating acquisitions into enhancing the product line and competitive advantages has allowed the company's strategy to pay off in spades. Per share earnings have grown from $0.45 in 2002 to about $5.64 over the last 12 months highlighting the accretive nature of these acquisitions. NOV's revenues and earnings are highly reliant on capital expenditure budgets of drilling companies. Because of the cyclicality of the industry and its impact on NOV's revenues and earnings, the company has wisely taken a conservative approach to its balance sheet. At the end of the 3rd quarter NOV was only carrying about $1.175 billion in long-term debt versus shareholders' equity of roughly $19.5 billion. The company is in the process of closing a fairly sizable acquisition and is using low-cost debt, which I view as being very intelligent. This conservatism assisted the company during the difficult 2008-2009 period when declining energy prices drastically reduced the global rig count, pressuring NOV's business.
I'm somewhat agnostic about energy prices, particularly over the short-term. While China, India and other developing markets are likely to require more of these natural resources over the long-term, huge technological breakthroughs such as horizontal drilling are really changing the game in many respects. The cyclical nature of the industry is likely to stay the same as it always has been, but NOV's strong balance sheet and management team should allow the company to increase its competitive advantages by making strategic acquisitions. NOV's business model is highly attractive due to the razor blade nature of its products and services, which require NOV's customers to replace key tools as a standard procedure. This leads to recurring revenues and the more deeply ingrained NOV's products are into drilling companies across the globe, the more reliable and significant these recurring revenues tend to be.
Since 2005, NOV has averaged a mid-teens return on invested capital and equity. These returns are significantly in excess of the company's cost of capital and I believe there is still a large platform for growth. NOV's return on assets have been just under 10% and capital employed has been increasing significantly due to the small dividend payouts, and the lack of share buybacks. NOV's operating margins have hovered around 20%, and I believe that as the company continues to scale up its three key divisions that it is possible to see margins increase to 22-25%. If energy prices plummet, it is likely that NOV's stock would follow suit. The large drilling companies have been spending more than their operating cash flow in many circumstances, so we might be seeing some normalization with the decrease in North American demand that NOV experienced in the 3rd quarter of 2012. Despite a sluggish onshore American and Canadian environment, NOV posted record earnings and revenues in the quarter.
According to Morningstar, the low estimate for 2013 earnings per share is $6.45. I rarely concern myself with one-year earnings estimates; instead I look at the huge runway that NOV has to keep improving its product lines, and to enhance its competitive position amongst drillers. This should lead to 7-10% top line growth assuming energy prices remain buoyant. The company has been working hard to integrate its numerous recent acquisitions and as the company works on maximizing the synergies, I'd expect to see operating margins improve over the long-term, so EPS growth should be more robust than the top line. Based on 427MM diluted shares outstanding, NOV has a market capitalization of roughly $27.7 billion. This is just over 10 times trailing twelve month earnings and less than 10 times estimated 2013 EPS estimates. With the company's potential to grow earnings by greater than 10% per annum over the next 5 years, I believe the stock is deserving of a higher multiple in the 14-17 range. In a couple of years, NOV should earn in excess of $7 per share, so assuming a 14 multiple on earnings, the stock would be trading around $98. I believe NOV is one of the best bets on the energy industry and any material pullbacks should be looked at as buying opportunities.