Cameron Showing Some Much-Anticipated Margin Progress

| About: Cameron International (CAM)
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Summary

Cameron still has a lot to do to improve margins in the core DPS business segment, but capacity additions are largely complete and Q2 results showed progress.

Orders were underwhelming, but Cameron has some attractive mid-term opportunities particularly as the venture with Schlumberger picks up momentum.

Between 9x and 10x EBITDA Cameron is either roughly fairly valued or modestly undervalued, though there is still rerating potential from better margins and improving demand fundamentals.

Owning Cameron (NYSE:CAM) shares hasn't always been the easiest investment play, as these shares have delivered plenty of volatility in response to order flow and margin progress (or lack thereof). Management dug itself into a hole on the margin side with inadequate production capacity, but that issue seems to be on its way to a strong resolution. Cameron has also regained a lot of momentum in the subsea market and the joint venture with Schlumberger (NYSE:SLB) should continue to pay off in opening doors to new business.

The issue with Cameron shares typically comes down to timing. Cameron should be looking at several years of good revenue and margin/FCF performance as it delivers on its large order book. At the same time, I believe we are looking at an extended cycle as more and more energy companies go offshore to find production growth. Discounted cash flow unsurprisingly isn't a lot of help, but the difference between a 9x and 10x EBITDA multiple on the shares swings the fair value by almost $9.

A Very Welcome Set Of Results

Investors wanted to see signs of real margin improvement and Cameron obliged. Revenue rose 15% yoy this quarter (and 9% qoq), good for a 3% beat versus the sell-side. Drilling and Production (or DPS) led the way with 32% yoy and 12% qoq growth, while Valves and Measurement (or VM) were flat/up 9%. The smallest business (less than 10% of revenue), Process and Compression Systems (or PCS) saw a 36% and 14% decline in revenue.

Gross margin declined 70bp from last year and improved almost a point sequentially, but EBITDA rose 19% over both periods - beating expectations by 9%. Operating income was likewise much better, rising 17% yoy and 24% qoq. DPS led the way (up 20%/28%) and margins improved by 160bp sequentially. At the bottom line, Cameron delivered a 13-cent beat compared to the average sell-side estimate.

Orders were a little weak, rising less than 5% yoy and falling 2% from the first quarter. This is about 12% lower than expected, but a quick look at sell-side reports suggests that a few very high estimates skewed the average higher. Even so, this result is broadly similar to the order behavior seen at FMC Technologies (NYSE:FTI) and fits in with my prior expectation that orders would slow this year as energy companies revisit their long-term plans and project designs.

DPS Margins Still Aren't Where They Need To Be

On an EBITDA basis, Cameron saw its DPS margin improve sequentially to 16.0% (from 14.6% in Q1'14 and down from 16.6% last year). Management has increased the number of rig-up pads at Berwick, LA significantly and the company is largely through with the capacity expansions. There's still work to do with integrating the new capacity and improving the supply chain, though, and the company still has a backlog of past-due BOPs to build and deliver. Cameron has been taking margin hits from this business due to overtime, inefficient operations, expedited shipping and so on, and clearing this backlog out does raise the promise of better results in the future.

I'd also expect to see DPS margins get a boost from improving contributions from the OneSubsea joint venture with Schlumberger. This tie-up has looked promising from Day One, but has faced the reality that costs arrive before revenue and the single-digit margins haven't helped overall DPS performance. Schlumberger and Cameron didn't agree to this venture on the basis of single-digit margins, though, and results should improve as orders and deliveries pick up.

Multiple Plays To Drive Better Results

There are a lot of parts to the Cameron business that I like. Starting with the subsea business, I think it's worth remembering that Cameron is the leader in installed BOPs and trees. The company's market share plunged as rivals get more aggressive on price, but Cameron won almost a third of 2013 tree awards (FMC won 35%) and has been showing better recent performance versus General Electric (NYSE:GE) and National Oilwell Varco (NYSE:NOV) in BOPs.

I'm also looking for more expansive offerings in the coming years; Schlumberger and Cameron intend to roll out integrated subsea offerings through OneSubsea and Cameron is looking to participate significantly in subsea separation. There haven't been all that many truly deepwater awards in this cycle yet, but subsea processing is looking increasingly desirable as a way of reducing capital costs for large offshore production fields. FMC Technologies has staked out an early lead, but if Cameron can respond there could be significant business to be gained here.

While the story(ies) on Cameron often centers on the subsea/deepwater opportunities, I wouldn't overlook the company's other operations. Relative to GE and FMC Technologies, Cameron is very strong in surface wellheads and trees and unconventional wells (like those drilled in the Bakken or Eagle Ford) can offer 4x as much revenue per well. Cameron has been making significant investments in technologies based around fracking infrastructure and a recently introduced new frack tree and manifold offers improved safety with quicker set-up/teardown. I also expect management to be on the hunt for small tuck-in deals - particularly in the valves sector.

Buy The Orders… Stay For The Delivery?

One of the tricky aspects to FMC Technologies and Cameron as equities is that the shares often trade more on orders and expectations and less on delivery. With that, I have some concerns that Cameron's significant ramp in margins and FCF generation over the next years will be overshadowed by fears that large energy companies won't be as aggressive in committing to capital to offshore projects. Ultimately I think there's little choice but to exploit offshore reservoirs, but with large companies trying to balance production growth, returns on capital, and capex demands, orders could get lumpy.

Constructing discounted cash flow models for companies like Cameron and FMC Technologies involves above-average difficulty (the timing of cash flows has a big impact on value), but I do believe that Cameron can return to double-digit FCF margins over the next few years and perhaps deliver a new peak level of FCF generation. In the shorter term, the company is looking at low-to-mid teens EBITDA growth. Assign a 10x multiple to 12-month EBITDA expectations and you get a fair value of $77.50; reduce that multiple to the company's historical average of 9x, though, and the target drops to about $69.

The Bottom Line

Between 10x and 9x EBITDA, Cameron is either a fairly-valued capital equipment manufacturer with ongoing execution risk or an undervalued play on ongoing offshore/subsea production growth and internal improvement. I think the truth leans more toward the bullish interpretation and I intend to continue holding these shares, but a run into the mid-to-high $70s might lead me to consider trimming back my bet.

Disclosure: The author is long CAM. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.