National Oilwell Varco: Deep Sea Pressures Creating Buying Opportunity

May.20.14 | About: National Oilwell (NOV)

Summary

What has been anchor on capital appreciation?

Analyzing catalysts moving forward.

What is the mid-term and long-term outlook for the company?

Valuation at this point in the market.

Over the past year or so companies that are associated with deep-water drilling have underperformed. National Oilwell Varco (NYSE:NOV) has been no exception. Even though the company earns a significant percentage of their revenue outside offshore activities, National Oilwell Varco holds a dominant share of the market for key offshore-drilling gear. Being the worlds largest supplier of deep-water rigs and equipment, it is estimated that NOV has products on ~90% of all rigs.

NOV Chart

NOV data by YCharts

Through expensive M&A's, NOV's revenues have increased substantially over the past four years. In 2011, NOV reported a revenue of $14.658 billion while in 2014 TTM the company reported revenue of $23.339 billion. This is an increase of 59.22%. But as the chart above indicates the stock price over the past three years has remained range bound.

Why the disconnect?

The offshore drilling market has been a double edged sword for NOV. The market has supplied NOV with substantial growth over the past number of years in regards to revenue and earnings but associated with that market comes substantial risk. One example of this came this January when the majors indicated they were going to focus on increasing margins.

In a press release issued by Exxon (NYSE:XOM), Rex Tillerson, chairman and chief executive officer for Exxon, stated:

Capital spending will decline to $39.8 billion this year from a peak of $42.5 billion in 2013. Excluding potential acquisitions, capital expenditures are expected to average less than $37 billion per year from 2015 to 2017.

As many of these deep-water reserves are more capital intensive than their onshore counterparts, many E&P companies put some of their more expensive projects on the back burner.

These statements had a direct and significant impact on the capital extensive floater market. As the chart below indicates Morgan Stanley research estimates a weak floater market for the next few years.

As National Oilwell has an estimated 80% share of the market for floater packages the company will be hit hard by these announcements.

Even though the floater market looks to be in a state of malaise, Jack-up market continues to remain robust.

As the jack-up market looks strong there are some issues on the forefront. National Oilwell customers such as Ensco PLC (NYSE:ESV), Transocean (NYSE:RIG) and Noble Energy (NYSE:NE) have some decisions to make. With an aging jack-up fleet on their books and long-term demand increasing, these companies have to decide whether to refurbish or scrap the older rigs and replace them. As the chart below indicates nearly 2/3rds of the global jack-up fleet is over 25 years old.

Chart provided by (Rowan Companies)

Whatever the offshore drillers decide to do, this is a positive for National Oilwell Varco. In Q1 management stated:

"orders for three deep-water floating rig equipment packages, and seventeen drilling equipment packages for jackup rigs, contributed to total order additions to backlog of $2.3 billion."

Even though there has been significant pressure for the offshore drilling market the overall picture for NOV looks decent. Despite worries form investors, management is predicting the book to bill ratio to approach 1-to-1 in Q2 of 2014.

So, as there are concerns in the offshore market, where does National Oilwell Varco stand on a valuation standpoint.

Valuation

In the section below, I will use the EV/EBITDA to estimate where National Oilwell is regarding its valuation.

EV/EBITDA = Enterprise Value / Earnings before interest, Taxes, Depreciation and Amortization

In the next section, I will use the EBITDA to calculate the EV/EBITDA. The EV/EBITDA ratio is one of the most commonly used valuation metrics, as EBITDA is commonly used as a proxy for cash flow available to the firm.

Enterprise Value or EV = Market Capitalization + Total Debt - Cash and Cash Equivalents

  • EV - $35.02 billion + $3.149 billion - $3.688 billion = $34.481 billion
  • EV = $34.481 billion
  • EBITDA = 4.247 billion
  • EV/EBITDA = 8.12

As the oil and gas service stocks trade in the 8.63x trading range, an EV/EBITDA ratio of 8.12 states, at current levels the stock is trading below fair value. Based on the ratio's above NOV is trading at a ~6% discount to fair value thus creating a short-term target in the $87.00 range.

Strategy

At this point in the market, I would not be surprised if there was a 5-10% correction over the next few months. If such a correction were to occur, this could present an excellent opportunity to add positions in a company with excellent growth prospects. Currently, I believe there is further upside to equity markets, as major world economies are either recovering or on the verge of recovering. As interest rates continue to remain near zero, this should favor equities.

Conclusion

Driven by pressures in the deep sea market, National Oilwell Varco has underperformed the S&P over the past three years. The company's fundamentals look strong but the stock price has remained range bound. Currently, the deepsea market is in a state of malaise as capital spending issues from the majors are delaying deep-water growth. Having stated that, calmer waters are on the horizon. The fact is, the oil and gas is there and the market will want it. At this point in time, the majors have stated they will wait for the right market conditions to access the energy. As the offshore market is in the midst of renewing itself as far as the jack-up market is concerned, National Oilwell Varco is on the front line.

The future does look bright for the company, the onshore drilling market is currently very strong and looks to be strong for the foreseeable future, as offshore capital spending is expected to increase again in 2016, this market again will pick-up. I believe as the two markets gain strength, NOV will have another year like 2010.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.