National Oilwell Varco: Widening Moat And Fair Price Make For A Compelling Long-Term Buy

May. 4.13 | About: National Oilwell (NOV)

With the S&P 500 crossing the 1,600 mark, I find myself deviating further than I ever have from the crowd or the indexes in terms of asset allocation. I don't have the slightest interest in 99% of consumer staples, pharmaceutical or utility companies. Duration risk petrifies me in long-term fixed income, and the thought of buying 10-year treasuries with a yield of 1.6% is about as attractive as getting another root canal. With that said, we are heavily invested in a concentrated portfolio of businesses that trade at significant discounts to intrinsic value. These opportunities are focused in industries with serious "hair" on them, or anxiety associated with them such as financials, energy and large-cap technology. National Oilwell Varco, Inc. (NYSE:NOV) is an example of a great business that is constantly separating itself from its competitors and is available at a very fair price despite what I believe to be a rather pricey equity market. This is a cyclical business that I'd increase my exposure to in a recession that I believe has the potential to double its earnings per share over the next decade.

As of March 31, 2013 NOV had roughly 427,216,689 shares outstanding, so at a recent price of $66.88, the company has a market value of approximately $28.6 billion. NOV carries about $4.349 billion in long-term debt offset partially by $2.441 billion in cash and equivalents, so the enterprise value is approximately $30.508 billion. I'm not a fan of using EBITDA, but in 2012 the company generated $4.182 billion in EBITDA, so EV/EBITDA is about 7.3. NOV is not an energy producer or rig operator, but instead is a high-margin designer and manufacturer of the key products and technologies that go into offshore and onshore oil and natural gas production. The company is involved all throughout the value chain and has incredibly deeply integrated relationships with customers that would be almost impossible to replicate. Since 2006, returns on invested capital and equity have been in excess of 10%, often significantly greater than that, despite significant increases in capital invested. The company earns high single-digit returns on assets and has been robustly growing earnings and book value per share over the last decade.

There is a tremendous amount of talk about North American energy independence and the immense ramifications of this, and no company is better positioned to take advantage of the movement than NOV is. Even better, the same complex deepwater and hydraulic fracturing technologies, which have revolutionized the industry over the last decade, can be used in other regions of the world where NOV is the go-to manufacturer and distributor. Monetary stimulus is at a fever pitch and while over the short-term, high global unemployment might pervade deflationary sentiments. Over the long-term energy prices and demand are likely to go higher, causing the demand for NOV's products and services to increase. Now to be sure, there will be times when demand will wane, and earnings will be lumpy, but if I could only buy one stock in the energy space and I had to hold it for a decade, my choice would be NOV. This is not even a tough call to make for me because while I'm optimistic on the value propositions of a BP (NYSE:BP), Devon Energy (NYSE:DVN) and Apache (NYSE:APA), I have no idea what energy prices will be over the next decade, but I'm confident that much of the equipment used to develop the energy resources will be provided by NOV.

According to Morningstar, the mean analysts' estimates for 2013 and 2014 are $6.01 and $6.79, respectively. I believe these numbers are reasonable but I'm much more interested in what the business will look like 5-10 years from now. This is a company that can grow earnings per share at a low double-digit rate during that time frame, and paying just around 10 times forward earnings is too cheap for a company that I believe possesses durable competitive advantages. The multiple of the stock isn't likely to decline much, so the biggest downside would be if we saw a cyclical downturn in energy demand, which in my opinion would actually create an opportunity for NOV to further increase its competitive advantages by making attractively priced acquisitions. If recent signs of commodity deflation prove to be transient (I have no idea) then I believe a higher multiple is a very likely possibility.

On April 26th, NOV reported 1st quarter net income of $502MM, or $1.17 per diluted share, compared to 4th quarter net income of $668MM, or $1.56 per fully diluted share. The 1st quarter included transaction costs associated with the Robbins & Myers acquisition and the currency devaluation in Venezuela, which combined for a total of $73MM in pre-tax costs and charges. Excluding these costs and charges, earnings were $553MM or $1.29 per fully diluted share. Revenues in the 1st quarter of $5.31 billion were down 7% from the 4th quarter of 2012, and were up 23% YoY. Operating profit for the quarter, excluding the transaction charges, was $816MM, or 15.4% of sales. This was down 14% sequentially, and 7% YoY.

First quarter revenues for the Rig Technology unit were $2.63 billion, down 9% sequentially, but up 16% YoY. Operating profit for the unit was $557MM, or 21.2% of sales. In the Petroleum Services and Supplies unit revenues were $1.7 billion, down 4% sequentially and flat YoY. Operating profit was $311MM, or 18.3% of revenue. The Distribution and Transmission unit generated revenues of $1.23 billion, down 3% sequentially and up 118% YoY. Much of these gains were due to recent mergers that had a disproportionate impact on this business. Operating profit in the quarter for the unit was $65MM, or 5.3% of sales.

NOV ended the quarter with a backlog for capital equipment orders in the company's Rig Technology segment of $12.92 billion, which was up 8% sequentially, and up 24% YoY. NOV had new orders in the 1st quarter of $3.04 billion, which reflects the continued strong demand for NOV's oilfield equipment. The company received orders for 17 drilling equipment packages for jack-up rigs and 8 drilling equipment packages for floating rigs, including 3 for Brazil in the 1st quarter. The company saw strong demand in FPSO orders and jack-up rigs. In addition, the company is seeing good demand for land rigs in international markets but North America is very weak. U.S. rig counts declined another 3% sequentially, and 12% YoY, while Canadian spending on consumables and production equipment declined despite a seasonal increase in rig activity. Because North America accounts for 57% and 83% of PS&S and Distribution and Transmission sales, respectively, these units were most adversely affected by recent trends. Both divisions saw sales decline by low single-digits due to the combination of price discounting and lower volumes, which obviously hurt margins. The outlook is much brighter in markets in the Middle East, Russia, Africa and Latin America. NOV has the finest technologies pertaining to offshore and unconventional drilling, which will be the primary avenues for future growth. Amazingly, management cited that of the total backlog, approximately 92% is offshore and 92% is destined for international markets. Improving natural gas prices in North America is a spark that could eventually lead to increased demand for onshore drilling technology in North America.

Despite Russia's prodigious energy resources, the technology exploiting the resources is in many cases in dire need for improvement. NOV's global manufacturing and distribution model, combined with its wide breadth of products and services, make it the go-to company to more efficiently produce these resources. NOV has manufacturing facilities in key regions across the globe enabling it to get equipment wherever it needs to be in a very short time frame, and the company is spending to enhance its Latin American manufacturing capabilities with a plant in Brazil. The cost incurred in developing this infrastructure reduces short-term profitability, but what I like about NOV is that everything that is done is designed to enhance the company's durable competitive advantages or "moat." NOV's management understands that it can't control energy prices or even product demand, but by constantly widening the moat and reinforcing walls, the company positions itself to scoop up the lion's share of the industry's profitability pie.

In the 1st quarter, NOV closed its largest acquisition ever with Robbins & Myers. The acquisition should improve NOV's competitive position in progressing cavity pumps, flow line, artificial lifts, and downhole drilling motors along with other key technologies. In the last 4 years, NOV has completed 51 acquisitions, which have vastly improved the company's offerings in floating production systems, oil fuel distribution, and supply technology into unconventional shale developments. During that period, NOV has generated $6.9 billion in cash from operations, while also raising $3.4 billion in debt financing. Of this $10.3 billion in capital raised and generated, the company has paid out $1.1 billion in dividends, invested $1.7 billion in capital expenditures and allocated $7.4 billion into acquisitions. Normally, this type of acquisitive behavior would be alarming if the goal was simply to increase the size of the business, but NOV's acquisitions have incredible strategic significance and the returns on invested capital have exceeded the company's cost of capital. If I want to be in the energy business, ideally I want to be providing the tools and services of the trades, as opposed to speculating on geological formations.

Moving forward, management is guiding that Rig Technology revenues should increase in the low single-digit percentage range, as continued declines in pressure pumping and coil tubing will be more than offset by a full quarter of Robbins & Myers and continued growth in the offshore and aftermarket businesses. The aftermarket and technician businesses are very strong for NOV, and management expects strong maintenance revenues as the first floaters constructed in this cycle are now five years old and will be returning to shipyards for their five year surveys. Because NOV is such an integral part of the technology chain for drilling equipment, the company has multiple opportunities such as this to enhance its relationship with customers by providing additional value. NOV's technologies designed for hydraulic fracturing has seen diminishing demand due to low prices, but there is a huge opportunity long-term in Chinese shale. I don't believe it is a worthwhile endeavor predicting short-term demand and margins, but instead as an investor I want to see management prudently allocating capital, and increasing the company's competitive position.

I'll be the first to tell you that I'm as confused about the short-term direction of energy prices as anybody is, but I do believe that demand will be much higher over the long-term, and the need to develop our resources will increase. NOV is not an investment for the next three months, but instead is a business to look at for a much longer holding period. We have been building up positions and will continue to do so if the price of the stock declines. One strategy that an investor might consider in addition to buying the stock outright is to sell the January 2015 $65 puts for $9.70 per contract. On a maximum risk of $5,530, the target profit of $970 assuming the stock expires above $65, would equate to a 17.5% return. On an annualized basis this is about 10.3% but your breakeven on the stock is $55.30 if the stock expires below $65. This is a great way to utilize a disciplined approach to either generate income or dollar-cost-average into a really good business at a fair price.

Disclosure: I am long NOV, BP, DVN, APA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.