As the BP oil spill fades into oblivion, oil well service providers are well positioned to surge. Discount rates in present valuing future streams of free cash flow will come down at the same time that the economy goes up. In this article, I will run you through my DCF model on National-Oilwell Varco (NOV) and then triangulate against a review of the fundamentals of Halliburton (HAL) and Baker Hughes (BHI). I find that all three of these companies are substantially undervalued.
First, let's begin with an assumption about the top-line. NOV finished FY2011 with $14.7B in revenue, which represented a 20.6% gain off of the preceding year. I model 15.8% per annum growth over the next half decade or so.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold eating 69% of revenue versus 10.5% for SG&A and 2.5% for capex. Taxes are estimated at 32% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital to get free cash flow. I estimate this figure hovering around 3.4% of revenue over the explicitly projected time period.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 10% yields a fair value figure of $89.21, implying just north of 30% upside.
All of this falls within the context of stellar operating performance:
National Oilwell Varco [had] first quarter 2012 earnings of $606 million or $1.42 per fully diluted share on revenue of $4.3 billion. Excluding transaction cost, earnings were $1.44 per fully diluted share. This compares the year-earlier results of $0.96 per share on revenues of $3.15 billion. We are extremely pleased with these earnings and feel they are indicative of the great product offerings National Oilwell Varco offers to the industry, and the excellent execution of our outstanding employees.
From a multiples perspective, NOV also appears cheap. It trades at a respective 13.3x and 10x past and forward earnings versus 10.5x and 9x for Baker Hughes and 9.4x and 8x for Halliburton. The Street is highly bullish on all three of these stocks - a sentiment that I share given how overblown the BP oil spill has been.
Consensus estimates forecast Halliburton's EPS growing by 4.5% to $3.51 in 2012 and then by 13.1% and 18.9% in the following two years. Assuming a multiple of 13x and a conservative 2013 EPS of $3.94, the stock would hit $51.22 for 60.9% upside. According to NASDAQ, the stock is rated a "strong buy".
Consensus estimates forecast Baker Hughes' EPS falling by 12.6% to $3.67 in 2012 and then growing by 26.7% and 32.3% in the following two years. Assuming a multiple of 13x and a conservative 2013 EPS of $4.60, the stock would hit $59.80 for 43.3% upside. With the stock being 58% more volatile than the broader market, Baker Hughes is well positioned to recover lost shareholder value over the last six months.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer.