By Denis Hurley
Despite chronic concerns of sputtering global growth, crude oil prices have been fairly buoyant both year-to-date and throughout much of 2011. The price of West Texas Intermediate crude is hovering just over $100/barrel with Brent crude prices around $120/barrel. Strong oil price performance has revived investment in oil and gas exploration in the energy sector, with current and planned exploration and development spending rapidly approaching pre-recession levels. Among the companies projected to benefit from the trends of greater exploration, increasing development of nontraditional oil deposits and more replacement and upgrades of existing rigs, National Oilwell Varco (NOV), a major oil and gas drilling, equipment, and services provider, is well positioned to capitalize on a revival in exploration and development spending.
The Oil and Gas Equipment and Services Sector
Demand for oil and gas equipment and services related to upstream petroleum and natural gas production is unsurprisingly highly correlated with the price of crude oil. Thus, as oil prices recovered in tandem with global economic growth (after approaching less than $30 per barrel (WTI) during the height of the United States' most recent recession), investment in new well developments recovered simultaneously. Greater expenditure on exploration and development around the world will stimulate demand for the necessary equipment and expertise provided by NOV and its competitors.
In the short-run, crude prices will be buttressed by fairly strong global demand combined with various supply constraints, primarily caused by geopolitical developments (such as American economic sanctions on Iranian oil, low levels of production in Libya in the wake of a revolution and subsequent political instability, and continued political instability in Iraq). In addition, demand for more efficient rigs, with horizontal or deep water drilling capabilities in particular, is projected to increase markedly. (However, the continued development of oil deposits requiring horizontal drilling or deep water drilling capabilities will ultimately have a greater long run impact.) The overall number of active rigs grew 21% between December 31, 2011 and February 3, 2012. Moreover, the current worldwide rig fleet is fairly aged and many rigs require replacement or upgrade in the near future. (However, natural gas prices have hovered near decade-low prices causing significant rig shutdowns and production cuts at some companies as well as less investment in new developments.)
In the long-run, steadily growing energy demand will exacerbate fundamental supply constraints as many of the world's major oil producing states, most prominently Saudi Arabia, approach maximum production capacity. The exhaustion of "easy oil" resources is beginning to force exploration of deposits that can only be developed at greater cost, increased environmental risks, and with the implementation of significant advancements in the upstream oil production technology. Along this vein, exploration of nontraditional deposits - offshore oil fields, shale deposits, the tar sands of Canada, and the Arctic - has increased substantially in recent years and is projected to continue to rise in foreseeable future.
Exhaustion of "easy oil" reserves will not only force greater expenditures on equipment and services necessary for exploration and development of less accessible reserves, but will also encourage development and utilization of more sophisticated extraction technology. As a result, providers of effective technologies designed to exploit nontraditional reserve extraction as well as efficient accompanying production services, will benefit from this long-term sector transformation. Moreover, equipment provisions and servicing for deep-water rigs in particular carry higher margins than onshore or shallow water operations. Some analysts suggest that possible regulatory changes may also stimulate a need for additional equipment purchases and rig upgrades.
From a fundamental standpoint, National Oilwell Varco not only posted sector-leading sales growth and improving metrics of management efficiency in recent periods, but also offers, and continues to refine, the high quality products and services necessary for the extraction of nontraditional deposits.
Company Overview: Products, Services and Competitive Advantage
National Oilwell Varco provides equipment used in oil and gas drilling and production as well as oilfield and supply chain integration services to upstream oil and gas companies. NOV is divided into three primary business segments: Rig Technology (the largest and most profitable segment), which designs and manufactures drilling systems and components; Petroleum Services and Supplies, which sells and services consumable goods of a less integrated nature used in the drilling process; and Distribution and Transmission, which provides maintenance services, repair and upgrade supplies and general customer support. (A more detailed exploration of the company's businesses is beyond the scope of this argument and quite riddled with industry jargon. However, a detailed list of the company's products and services can be found in its most recent 10-K filing.)
NOV's three segments' respective operations are mutually reinforcing. The company's highly differentiated products require aftermarket parts and services. An initial rig sale locks in a fairly consistent future revenue stream for the company's support segments for years after a rig sale is made. Thus, sales growth in the Rig Technology segment provides long-term support to company revenues earned by the two other segments.
At the conclusion of 2011, NOV had a sales backlog worth $10.2 billion - more than double the backlog at the end of 2010. The company posted slight declines in revenue growth in 2009 and 2010 - unsurprising given the drop in oil prices from their 2008 peak - yet revenue growth in 2011 topped 20%. Revenue growth occurred in the final three quarters of 2011 and accelerated into the fourth quarter. Net income increased a little less than 20% in 2011 with both gross and net income margins falling one-tenth of a percent to 30.7% and 13.6% compared to 2010, respectively. Nevertheless, both are above average compared to competitors in the sector. Both net income and gross profit grew in the final three quarters of 2011 as well. Margins and management effectiveness indicators fell nearly across the board during the recession but have rebounded with varying degrees of virility from 2010 to 2011.
Selected Annual Changes (%)
Notes: Numbers indicate percentage growth over prior fiscal year.
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Notes: Numbers indicate percentage growth over prior quarter.
Gross profits fell 9.1% from 2008 to 2009 but grew 17.4% from 2010 to 2011. Net income registered a similar movement falling 24.7% in 2009 compared to 2008 but rising nearly 20% in 2011 compared to 2010. Interestingly, total revenues fell by only 3.4% in 2009 and by 4.4% in 2010 which implies that management may have accepted slashing margins in order to retain a solid flow of revenue both during the accounting period in which a rig is sold, and for decades following through aftermarket sales, maintenance, and upgrades. Finally, management has sought aggressive expansion through acquisitions as well as organic growth in terms of capital expenditures. In 2011, NOV spent nearly $1 billion on acquisitions and increased capital expenditures by about 40% over 2010 outlays.
In terms of liquidity, NOV's current ratio and quick ratio at the end of fiscal 2011 were a comfortable 2.2 and 1.4 respectively. The company has a history of generating positive free cash flows, despite numerous acquisitions in 2011 and nearly doubling capital expenditures. Cash flow from operations increased 40% over 2010 numbers. The company repaid 42% of its total debt in 2011, reducing the total from $887 million to $510 million. In sum, company has a strong cash position for future acquisitions, possible dividend rate increases, and any unanticipated charges.
NOV is valued less than most of its competitors by most valuation ratios. Its current P/E of 17 is below the midpoint of its 52-week range and is just below the sector average. Its price/book and price/sales ratios are historically average, as is TEV/Total Revenue (LTM). However, when NOV's future valuation metrics indicate strong anticipated growth. Forward P/E is 13. TEV/Total Revenue (NTM) projected for the next 12 months is below historical company averages. Finally, PEG is a mere 0.9. This indicates that the stock may be trading at a considerable discount when one factors in projected growth.
The company's continued pursuit of consistently successful aggressive organic expansion and targeted acquisitions, the reinforcing nature of it equipment and services businesses, its rapidly growing revenues and net income since 2010, and its dominant presence in the sector (90% of the world's offshore rigs incorporated equipment manufactured by NOV), contribute to the company's advantageous position for growth.
In order to maintain and expand its competitive position, the company routinely makes strategic acquisitions of small companies possessing innovative related technologies that are then incorporated into NOV's product offerings complete with support services, as per its business model.
In its 2011 10-K filing, the company stated that new orders for drilling rigs "rebounded sharply" and that the Rig Technology segment notes "a high level of interest in new capital equipment." The company noted an expectation for lower margins on rig equipment in the beginning of 2012 on the current order backlog but expected increasing margins with the construction and supply of new orders of offshore rigs through the conclusion of 2012.
Moreover, the two support segments of company remain highly correlated with total active rig count and should perform well if year-on-year rig count growth since the recession remains steady and substantial: Between the end of December 2011 and the beginning of February 2012, the number of active rigs in North American increased 21%. With gas prices at decade low price levels, weak capital expenditure on exclusively natural gas rigs will weigh on sales growth. However, the countervailing trend of growth in commissioning of new oil rigs and updating of existing ones, especially higher margin types, should more than offset the negative impact in falling investment in gas development.
In the long-run, National Oilwell Varco is projected to benefit from: 1) the shift to development of more nontraditional oil deposits requiring more sophisticated rigs; 2) growth in overall corporate expenditure on upstream oil production and; 3) increasing dependence of customers on the services, upgrades and replacement costs sold exclusively by National Oilwell Varco.
NOV cites several significant risks to both the sector and the continued success of the company itself. First are macroeconomic risks - particularly the protracted euro crisis and its far-reaching effects and the pace of global economic growth (and by logical extension demand for oil and natural gas). Second are political concerns. Increased regulations on oil production could have either a negative or positive impact depending on the nature of the change. Political instability in many of the world's largest oil-producing countries could potentially dent exploration and production. However, instability in certain regions will likely simply stimulate more exploration and development in alternative, stable locales. NOV's considerable international presence also exposes it to currency risks. The possibility of a major catastrophe implicating NOV could foist disastrous environmental liability claims on the company. Many of these risks are simply inherent to business model but macroeconomic forces and extraordinary losses caused by one-time events are significant considerations for potential investors.
The company's internal risks include: NOV's ability to support the successful integration of a steady stream of strategic acquisitions; the sustainability of a rapid rate of technological innovation and organic expansion; and the company's ability to continue to increase margins to pre-recession levels and higher. NOV has a history of achieving the first two and logged remarkable revenue and income growth numbers in fiscal 2011. Margins have expanded since the depths of the recession but greater expansion has stalled in recent quarters. The company expects margins to continue to increase in 2012, particularly in the latter half of the year as the company begins filling more sophisticated orders.
Considerable Opportunity for Gains
National Oilwell Varco's dominant position in the market for oil rig equipment, macroeconomic trends that will support expenditures for the development of new oil deposits and hence, the purchase of new rigs, and the trend toward offshore and shale field developments, make an investment in National Oilwell Varco a very attractive way to both capture value from buoyant oil prices and the expectation of future price increases as well as invest in an increasingly efficient and expanding company. Greater provision of sophisticated extraction equipment is projected to support widening margins. The integration of equipment sales with post-sale support services should bolster customer loyalty and augment the stability of the company's revenue base. NOV had a stellar 2011 fiscal year in terms of growth and efficiency as well as profitability gains. Bottom line: the sector is projected to undergo substantial expansion and NOV is very well positioned to capitalize on the trend. The stock offers investors an excellent opportunity for long term gains.