Dril Quip Is A Value Trap

| About: Dril-Quip, Inc. (DRQ)

Summary

A strong balance sheet, past growth and earnings track record suggest the company is a buy.

While the oil industry as a whole might be recovering, the worst for Dril Quip is still ahead.

I suggest long investors to be very cautious - a lot of downside risk is associated with this stock.

A short position on the stock might yield interesting returns.

Dril Quip Inc. (NYSE:DRQ) is a manufacturer of offshore drilling and production equipment for use in deepwater, harsh environments and severe service applications. Major customers include Chevron (NYSE: CVX), Petrobras (NYSE:PBR) and integrated, large independent and foreign national oil and gas companies.

The results

Dril Quip Inc. is a mid cap which has grown revenues at a steady rate of almost 8% during the last 10 years. The company has benefited greatly from a nice niche positioning. And despite the ongoing global slump, the company financial results have remained outstandingly positive throughout all of 2015. For fiscal year 2015, the company has been able to post EPS of $4.98, only slightly down from record high EPS of $5.19 in 2014. Gross profit margin has been steadily improving from 41% in 2013 to almost 46% in 2015.

The company is debt free and its strong balance sheet translates into a strong cash position with NNWC of over $20 per share and a tangible book value of almost $36 per share. At the current price of $57, this turns into a P/B of 1.58 and P/E of 11.5, which puts Dril Quip below value levels, suggesting for a strong buy.

Yet, a more qualitative analysis on the prospect is necessary to evaluate the stock trend.

The outlook

A first alarm bell should have been ringing in investors' ears as DRQ reported 2016 Q1 revenues more than 25% down when compared to the first quarter of 2015. The revenues shortfall is unlikely a one-off problem. When looking at the company backlog we see a constant reduction with new orders halved during the last 12 months. The company has declared it is expecting to fill approximately 60% to 70% of the December 31, 2015, product backlog by December 31, 2016. In other words, the company is expecting a medium term loss of revenues in the order of 30%-40%. A major contract awarded by Petrobras to Dril-Quip do Brasil LTDA, the company's Brazilian subsidiary, in August 2012 is going to expire in 2016. Given the current unstable economic situation and political unrest in the country, there are few chances of new major contracts in sight.

DRQ has nevertheless proved to be a well-scalable company, capable of enduring the revenue drop and maintaining similar profitability levels of the previous quarter, with operating margin holding close to 30%. This resulted in a comfortable EPS consensus beat while missing on revenues (article). Analyst outlook remains nonetheless bleak with an estimated median EPS of $0.26 for the next quarter (article). This would mean a 75% reduction from last year's same quarter.

But why has the outlook suddenly become so negative for DRQ if the oil industry seemingly has left the worst behind with the recent price recovery?

There's a very likely explanation for this: the time lag between economic and investment cycles.

An offshore rig is not the kind of facility that appears overnight: investments from major oil companies, which translate into backlog increases for DRQ, must go through several phases. 2015 has been likely a transition year for Dril Quip, which has lived off old projects (finalized before the slowdown) being completed and cashed in. All the major effects on investment disruptions are therefore yet to be felt by the company. The slash of capital expenditures of DRQ's customers has still unleashed potential to put the company under severe distress. Here's a breakup of Dril Quip's scheduled rigs projects

Floating

Rigs

Jack-Ups

Total

2016

34

89

123

2017

15

29

44

2018

12

6

18

2019

8

2

10

After 2019 or unspecified delivery date

2

1

3

71

127

198

Click to enlarge

(Source: DRQ 10-K, 2015)

A further confirmation to the theory can be moreover found by looking at the cash conversion cycle of Dril Quip, which appears quite long and stretching further, especially on the inventory side. This might suggest the company is holding more inventory for orders that are being delayed by its customers.

The valuation

The current valuation at low multiples is, given the presented outlook, a value trap. At present, there also are high chances that the market is not fully discounting the reduced prospects of Dril Quip.

If EPS are likely to fall following the company guidance on backlog, we might see a 30%-40% reduction in EPS the next few quarters, which is not as bad as the -75% talked above as per analysts forecast, but still far from negligible.

I assume that a conservative evaluation of the company would not go much higher than the underlying hard assets of the business, suggesting a downside of around 40% from current levels.

Conclusion

Predictions have high chances of failure as we have seen last week with the totally unexpected Brexit event. However in the case of Dril Quip, the outlook does not seem impacted by the result of unforeseeable events, quite rather the opposite. Inevitable investment disruption caused by last year's global oil slowdown has just likely yet to fully impact this company.

I remain skeptical that the global economy will become oil-free anytime soon, so there can be time for a long run on this company. There's no doubt that the clean balance sheet and high operative efficiency demonstrated by the company are inviting. As for the outlook, to put it in Buffett's words, no matter how bleak it is, as "this too shall pass."

Nevertheless, both current and potential investors should be warned that there's a considerable downside risk associated with the stock in the short to medium term. The company might be able to continue to beat EPS consensus and therefore lessen the extent of an otherwise likely huge sell-off, however there is no other positive catalyst foreseeable for the company at the present time. All considered, I would therefore suggest that the wisest possible position on the stock at the moment is a short.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in DRQ over 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.