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In the first half of 2012, the energy sector had underperformed compared to the major indices, possibly because of weakness in prices of crude oil and natural gas, disappointing growth outlook globally and Europe's sovereign debt problems. In July 2012, I had stated the possibility of a turnaround in the energy sector in this article, and highlighted top picks in the sector - National Oilwell Varco (NYSE:NOV) was not part of that list. Now as most of the major indices hover around their 52-week highs, I believe this company is prepping up for a huge rebound in the long term.

National Oilwell Varco designs, manufactures and sells parts and equipment used in oil and gas drilling and production and provides related services such as oilfield inspection and supply chain integration.

Key Catalysts

There are several catalysts and important business drivers that indicate that this company is due for a fine rebound:

  • There is a demand for drilling equipment capable in deepwater operations, and this demand will increase because of safety related regulatory impacts in the N.A. region. Most of the region's rig-fleets have been aging lately and these regulations will require the industry to respond by retooling the rig-fleets. Companies such as National Oilwell Varco that are involved in rig equipment manufacturing will thus benefit.
  • The demand for drilling equipment and services also depends on the global energy demand in general. Companies involved in oil and gas drilling and exploration venture into capital intensive projects based on the projected demand numbers in the coming years. Take a look at the global energy demand projected by the World Energy Outlook in 2012 - it appears that National Oilwell Varco is poised to benefit from an increasing demand for the next several years.

    (click to enlarge)Global Energy Demand By Region

  • According to Quest Offshore, capital spending directed towards deepwater exploration and drilling is expected to increase by more than 80% in the next 5 years, compared to the spending in the previous 5 years.
  • In February 2013, Warren Buffett's Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) increased its stake in National Oilwell Varco by almost 27 percent.
  • The 28 analysts that cover the stock have a median price target of more than $85 a share on the stock. Their average earnings estimate is $5.96 for FY 2013 and $6.84 for FY 2014, an approximate 15% growth from previous year. The annual EPS trend for the next few years is included below, based on these consensus numbers.

    NOV - Annual EPS Trends Till 2015

  • Revenues are expected to rise from $20.04 billion in FY 2012 to $22.72 billion in FY 2013 (a 13.40% increase) and analysts expect this uptrend to continue into FY 2014 (7.6% increase to $24.4 billion).
  • National Oilwell Varco has recently been a major player in industry consolidation. In January 2013, it announced a merger with Robbins & Myers, Inc, a major supplier of engineered equipments for energy and industrial businesses. In 2012, the National Oilwell Varco also acquired Schlumberger Limited's (NYSE:SLB) distribution business involved in safety products/services and other parts. Also in 2012, the company acquired CE Franklin Ltd., a top supplier of parts and services used by many energy companies. These acquisitions of top industry leaders in the energy parts and equipments business has helped the company expand its product portfolio and position itself well in this space.

Low Valuation

At its current price of about $70 (as of March 29, 2013 when I write this article), National Oilwell Varco's stock is undervalued because of a PEG value of 0.85, which is well below the Energy Equipment industry's median PEG (1.77).

The company also has a low P/E of about 12, well below the sub-industry median of more than 16.

Strong Fundamentals

The company's Interest Coverage ratio of 226 and a Quick ratio of 1.7 indicate that its debt repayment capabilities are sound.

NOV is one of the more profitable companies in the Energy Equipment and Services industry with a net margin of 12.39%. Its net margin and operating margin are both among the strongest of any peer, while its gross margin is inline with the industry median.

Risks

  1. One of the reasons why shares of National Oilwell Varco have underperformed is a contracting rig fleet in recent times, as well as the increased country risks. Geopolitical risks will always challenge National Oilwell Varco as its presence is dispersed across the globe.
  2. Regulatory risks will continue to raise challenges for companies in the energy equipment and services business.
  3. Because of so many recent acquisitions, investors must consider risks related to synergies and integration.
  4. Macro-economic factors such as higher energy prices, lesser than expected energy demand and a continued and long-term contraction in rig-fleet count are also important risks that affect the company.

Conclusion

Of the 28 analysts that cover National Oilwell Varco, 8 have a Strong Buy and 16 have a Buy opinion on the stock. Four analysts have rated the stock as a Hold and there are no Sell recommendations. TheStreet.com has a target price of $78 and Standard & Poor's have an even higher target price of $95 - a solid 35% appreciation in price from here. Looking at the risk-reward for this investment and the energy industry undercurrents as well as energy demand numbers, National Oilwell Varco seems like a very good energy play in your portfolio for the long run.

Source: Rig Makeovers And Energy Demand Will Benefit National Oilwell