National Oilwell Varco's Supercharged Growth Drivers

| About: National Oilwell (NOV)
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National Oilwell Varco (NYSE:NOV) is the global leader in providing capital equipment to the upstream oil and gas industries. NOV primarily serves drilling contractors, shipyards, well servicing companies, pressure pumping companies, oil and gas companies, supply stores, and pipe-running service providers. The company's products include major mechanical components for on and offshore drilling. NOV's three business segments include: Rig Technology, Petroleum Services and Supplies and Distribution Services. To begin, NOV's Rig Technology segment designs, manufactures, sells and services complete systems for the drilling, completion, and servicing of oil and gas wells. Furthermore, the Petroleum Services and Supplies segment provides a variety of consumable goods and services used to drill and complete oil and gas service flowlines. Lastly, in the Distribution Services segment, NOV provides maintenance, repair and operating supplies to drill sites and production locations worldwide.

Source: National Oilwell Varco

The Opportunity:

National Oilwell Varco is a great way to invest in the oilfield equipment revolution that is impacting both on and offshore drilling. NOV is the dominant provider of equipment used worldwide for drilling in all environments. I believe NOV is the only major oil service company that supplies other oil service companies, the on and offshore drillers, and the oil companies, as NOV supplies everybody. In fact, NOV is commonly nicknamed "No Other Vendor." I think that the NOV story is shifting from a relatively new rig constructor to a rapid earnings growth play for investors seeking opportunity in the oil equipment upcycle. NOV is trading near a 5-year low relative to peers on P/E, indicating that the market's view on this rig cycle is overly pessimistic. At 13 times earnings, NOV is trading near a 30% discount to its peers, and is also cheaper than other alternatives such as Halliburton (NYSE:HAL). I argue that the rig-building cycle is no longer the most appropriate industry for NOV's future earnings. The market is not giving NOV any credit for its ability to invest the cash it generates, despite having a long history of successful acquisitions. In situations such as these, it seems that the Street is taking a pessimistic view on a company that has a clear outlook where high returns are made. It is quite clear that: 1) the company will continue to make acquisitions, and 2) current earnings numbers do not incorporate any earnings potential from future acquisitions.

NOV also has been increasing its operating margins over time in nearly all aspects of its business segments, and it seems that margins will continue to expand.

Operating Margin By Segment, 2005A-2013E

Wall Street Estimates Exclude Future Acquisitions, Hiding Potential Earnings Power:

NOV has acquired hundreds of companies since its IPO in 1996 but Street estimates assume the company just sits on its growing pile of cash. NOV's management has been quite successful in preventing what Peter Lynch calls "diworseification," in that they make smart acquisitions that generally don't constrict margins or narrow their moat. With a $3 billion cash depot and $2-3 billion more free cash generated yearly, NOV's true earnings power is likely much higher than the Street's view. Assuming a conservative 15% ROE, nearly every $3 billion used to make acquisitions can add around $1 of earnings each year.

Major Acquisitions of NOV Chronologically

Growth-Fueling Catalysts:

Catalyst 1: The New Offshore Rig Building Upcycle Continues

To begin, NOV is the dominant rig equipment provider and is playing a key role in the replacement of the world's aging offshore rig fleet. The deepwater business is quite premature in what analysts expect to be a multi-decade expansion, and it is believed that the current new building cycle will reach more than 200 units. Deepwater is the main theme of this cycle and recent success in new areas such as French Guinea, East Africa and Southeast Asia are only adding an already strong demand for new deepwater equipment. In addition, roughly two-thirds of the global fleet is older than 25 years and will need to be replaced. With a dominant market share nearing 70-80%, NOV is the beneficiary of the upcycle, as the new rig construction cycle that began long back in Q4 2010 continues. Current macroeconomic and fleet over the age of 25 and the oil and gas industry trends are supportive of the offshore rig market, in my opinion. The deepwater business in the early ongoing ordering cycle is being driven by the secular growth in deepwater, a continued days of secular growth, bifurcation towards higher quality assets, an aging of offshore equipment (a significant expect this newbuild cycle to portion of the existing fleet is at or near retirement age) and an increased focus on safety in reach north of 200 units. Furthermore, I see two additional factors supporting new orders: 1) elevated oil prices; and 2) operator interest in developing offshore resources as an alternative to traditional onshore resources. The majority of rigs in the worldwide fleet today are from the rig construction cycle of the late 1970s and early 1980s, at which time inflation adjusted oil prices were in the $80-100 range and operators tried to diversify supplies following various nationalizations in the mid 1970s and the Iranian revolution in 1979. I believe these two factors have converged once again in the wake of sustained oil prices above $90.

Oil Price Forecast, 1985A-2015E ($/Barrel)

Offshore Rig Construction Cycle, 1970-2012 ($ in millions)

Source: Company Filings

Catalyst 2: FPSOs are set to begin replacing rig orders starting in 2012

In addition, NOV's current award potential is $120-150 million per vessel, and that figure should grow over time as the company continuously expands its portfolio. As deepwater production gains traction later this decade, additional flexibility in oil and gas processing will prove to be quite useful. With a current floating production storage and offloading (FPSO) fleet of only 150 vessels, the fleet has the ability to double over the next decade and NOV is readying itself to become a massive independent provider of FPSO equipment. Lead times on FPSOs are commensurate with the size and complexity of the projects, with conversions taking 2 to 2.5 years to complete and newbuilds taking 3 to 3.5 years. Given the higher costs and longer lead times, operators continue to gravitate towards conversions over newbuilds. I think the existing fleet is roughly 70-80% conversions, and newbuilds remain only 10-20% of new FPSO orders. There are a finite number of tankers available for conversion at any given time, however, and I believe that the possibility exists down the road for a tanker short squeeze developing, pushing operators towards newbuilds. FPSO demand is strong presently, and shipyard capacity is somewhat tightening with the requests for newbuild rigs, supply vessels, FPSOs, etc. FPSO deliveries have been light in 2011 as a result of the sharp drop-off in tendering in 2009. FPSO operators such as SBM Offshore are increasingly seeking out Brazilian shipyards over the traditional Asian builders, reflecting the local demand from Petrobras and greater excess capacity. In fact, The global FPSO fleet currently stands at roughly 150, and around 50 are already on order. Analysts expect roughly 15-20 FPSO orders per annum over the next five years while the total conversions and newbuilds for this cycle could double the worldwide fleet. NOV is targeting over 150 projects that are planned for the next 5-10 years and working directly with the operators on the Front End Engineering & Design (OTC:FEED) studies. Analysts estimate an average FPSO conversion costs $500 to $800 million, while a newbuild can run from $1.2-2 billion. Only a small portion (perhaps 20-30%) of the cost is the conversion of the hull. NOV completed its acquisition of Hydralift, a Norwegian company concentrated in offshore drilling equipment, at the end of 2002. Through this acquisition, NOV was able to provide offshore products specific to FPSOs, such as cranes and winches. In 2011, NOV acquired the Advanced Production and Loading subsidiary (NYSE:APL) of BW Offshore Limited, which designs and produces turret mooring systems ($40-$80 million) and has the leading market share for FPSOs. The only FPSO in the Gulf of Mexico currently is owned by Petrobras and utilizes an APL system. With APL, NOV can provide a more complete FPSO equipment package, with potential content now reaching $120-$150 million per vessel. I would indeed expect that number to continue to climb as NOV acquires more businesses and products until it has a "complete" equipment offering. Given the size and scope of these vessels, I believe that number could easily match the $200-300 million NOV earns on an offshore rig.

Diagram of a Floating, Production, Storage and Offloading (FPSO) System:

Catalyst 3: The Onshore Rig Upcycle Is Accelerating

Furthermore, it seems apparent that contractors are retiring older models and are beginning to seek out new replacements that can meet the demands of unconventional drilling techniques. Roughly 150 mechanical rigs have been retired by public drilling contractors, just this year alone. Only 25% of all rigs are using new technology, and analysts believe over 1,000 new land rigs will be ordered this cycle. Each complete land rig order represents around $20 million for NOV. This signals a tremendous revenue boost over the next 10 years for "No Other Vendor." Also, a growing rig fleet in addition to increasing safety standards will drive margins even after the upcycle. The outlook for shallow-water activity is improving as well. In the North Sea, for example, operators are looking to heavy market share this cycle. duty and harsh environment (HDHE) jackups to take the place of aging semisubmersibles. In Mexico, Pemex is undertaking efforts to significantly increase its rig count in an effort to stave off ailing production at various onshore oilfields. Roughly 30% of rigs in the worldwide fleet are currently over 30 years old. By 2015, following approximately 150 deliveries, analysts estimate that the number of rigs over 30 years old will make up roughly 51% of the worldwide fleet. The increase in obsolete rigs from now to 2015 is a result of the 1980 rig construction cycle which saw close to 250 orders from 1979 to 1981. As a result, I believe that we are in the early stages of a retooling of the global jackup fleet. There have been roughly 53 jackups ordered globally since October 2010, and there are options for about 27 additional units. The revenue potential on a new jackup is smaller compared to a floater but, at $50 million to $75 million, it is still material. Ultimately, I estimate NOV's market share to be 60-70% for rig packages on new jackups this cycle, consistent with its performance last cycle.

Catalyst 4: Essential In The Current "Oil And Shale Renaissance"

Finally, after many years of lackluster production, there are now more oil than gas rigs in the U.S. Without NOV's rig equipment and technology, the revival of the North American oil industry would be impossible. Key players in the oil field are now beginning to invest in NOV's technology, signaling huge earnings increases over the next decade. The "oil renaissance" underway in North America has been a considerable positive for NOV, as major oil companies invest in technology to exploit the shale plays and higher oil prices. There are now more rigs drilling for oil than gas for the first time in decades in the U.S., and the new directional drilling methods have higher service costs as equipment wears out faster. While seasonality and weak natural gas prices are likely to weigh on the rig count in the U.S. over the next two quarters, WTI's recent rebound back to $100/bbl coupled with continued strong activity in unconventional oil drilling and liquids rich shale plays makes a rig count collapse unlikely. The return of the majors to NAM is beneficial to NOV, as the majors have long relied on technology to gain efficiencies. Longer term, opportunities for the majors to export the North American knowledge and technology to shale plays abroad, whether it be Europe, Asia, etc., would be a significant catalyst for NOV. I also expect increased shale drilling internationally to be a long-term driver for the oil service industry. Likely candidates for development of shale gas basins would be countries that are believed to have ample recoverable resources and significant domestic energy needs (China, Middle East) or significant export opportunities (Australia, Eastern Europe). NOV is watching opportunities in all of these regions and its global infrastructure leaves it well- positioned to capitalize. As early adopters, like Poland and China, achieve success in developing their resources, and I expect others in Asia, Eastern Europe and Africa to follow. In addition, I believe the number of international shale play prospects will continue to grow over the next several years as oil majors and national oil companies begin to transfer North America's technology to the rest of the world.

A Map Of 48 Major Shale Gas Basins In 32 Countries:

(Click to enlarge)

A study commissioned by the U.S. EIA showed international shale resources to be at least 10 times those discovered in the U.S.


In conclusion, NOV makes a great investment in the current oil upcycle. As opposed to the competition, NOV is trading at a large valuation discount nearing 30%. Investors should consider purchasing exposure, as shares are modestly priced at the moment. Through a multitude of factors, the price will continue to be driven over a long-term outlook. Through the supercharged growth drivers mentioned above, NOV over time will indeed be a great way to play the North American oil renaissance. Hopefully over time, NOV can evolve into an oil giant, such as its' larger peers including Exxon Mobil (NYSE:XON) and Chevron (NYSE:CVX). While although I currently believe that margins may contract in the near term, NOV's outlook based upon these catalysts looks bright over a much broader horizon.

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.

Additional Disclosure: Although I am by no means an expert in the oilfield services industry, I concur with the opinions of Barclays on the industry, and this article was shaped by their position on this particular field.