National Oilwell Varco: Offshore Slowdown Concern Is A Gift

| About: National Oilwell (NOV)

Summary

Commentary from major offshore contractors and secular industry trends suggest that market's negative sentiment on offshore drilling slowdown is likely overblown.

The negative sentiment is believed to be fully priced in, as NOV is trading at large discount to its long-term earnings growth potential and S&P 500's valuation level.

NOV's diversified growth prospect, significant dividend growth potential and opportunity for share repurchase and/or acquisitions are expected to drive the price upside going forward.

The share price of National Oilwell Varco (NYSE:NOV) has declined by almost 12% since reaching its 52-week high of $84.71 in November 2013 primarily owing to market's concern that the company will see decline in offshore rig orders as drilling activity is expected to weaken. In my view, the negative sentiment creates an invaluable buying opportunity for this cash king because 1) the offshore concern is likely overblown; 2) the stock valuation has become cheap and appears to have baked in the negative sentiment; and 3) opportunities of significant dividend hike, share buyback, and/or tuck-in acquisitions should bolster share performance.

The current offshore concern arose from the fact that day rates for deep-water (DW) and ultra-deep-water (UDW) drilling has been deteriorating since 2013 and this was echoed by comments from some major offshore drilling contractors. As a result, some investors expect demand for NOV's floater to weaken through 2015. However, it appears the fear is exaggerated due to the following reasons:

  1. According to comments from Seadrill (NYSE:SDRL) management, they do not consider the current slowdown in offshore drilling to be a typical cyclical downturn, as the weakness is not driven by commodity prices, which remain solid. They believe the slowdown to be temporary and expect the market to recover starting in late 2014 given that UDW drilling remains a long-term growth story. As a note, UDW oil production is forecasted to rise from 1 mmbbl per day to 5 mmbbl in the next 5 years as discovery of UDW and onshore unconventional oil reserves would become the primary driver for global oil reserve growth going forward.
  2. There has been a secular trend that offshore drilling contractors, such as Transocean (NYSE:RIG), have been in the process of replacing old floating rigs with new rigs with higher-specifications to meet enhanced drilling requirements. One key driver of this trend is that higher-specification rigs would allow contractors to secure better rates, especially amid the tough market environment. As such, it is believed that the demand for ongoing rig upgrade/replacement would partially offset the negative impact from the overall offshore slowdown.
  3. Given a strong regional demand, offshore drilling activity in West Africa, Brazil, and Mexico remains solid and pricing is much better in these regions.
  4. Despite the weak environment, Transocean in late February announced construction contracts (worth of approximately $1.24B) for 2 new UDW drillships with an option to build up to 3 additional drillships of the same design. Given NOV's solid relationship with Transocean, it is believed that the company has the potential to win some subcontracts on this project, which would be a positive surprise.

Thanks to the concern, NOV now trades at 10.8x estimated 2015 EPS, which is at a 31% discount to the same multiple (15.7x) for S&P 500 Index, despite the fact that NOV's consensus long-term earnings growth estimate of 12.5% is notably above the average estimate of 9.8% for the S&P 500 companies. After accounting for the earnings growth potential, NOV trades at just 0.87x PEG, compared to S&P 500's 1.57x. Given that NOV's relative valuation discount to the market averaged at just 20% in the past 12 months and the company continued to perform well with healthy growth in the backlog and cash flow generation in the period, I view that NOV's current discounted valuation is reflective of the offshore slowdown concern, which is exaggerated (see chart below).

Click to enlarge

Looking forward, I expect price upside to be driven by the following catalysts:

  1. Given the current strong backlog of $16B for NOV's Rig Technology segment and that the company has diversified exposure to floating production storage and offloading as well as land rig equipment markets, which have been experiencing solid growth (i.e. the US onshore unconventional rig market), NOV should continue to deliver better-than-expected performance.
  2. The company generated $2.7B free cash flow in 2013. Even with a flattish free cash flow performance in 2014, NOV has ample capacity to increase the dividend by 50% to 100% (a growth of 100% would imply a dividend payment requirement of $0.8B in 2014) and still have sufficient cash remaining to pursue other capital deployment options; such as share buybacks and/or acquisitions.

In light of the above, investors should buy on the current price weakness owing to the compelling risk reward.

All charts are created by the author, and data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.

Disclosure: I am long NOV. 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.