National Oilwell Varco: A Thorough Analysis

| About: National Oilwell (NOV)
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Summary

Although NOV posted record results in Q3, the big question is how it will be affected in an adverse scenario of a low oil price throughout 2015.

A low oil price is expected to affect mostly the major of the four segments of the company, which however accounts for just 44% of its total revenue.

The article discusses the features of the company that provide great protection to its earnings against a scenario of a low oil price throughout 2015.

National Oilwell Varco (NYSE:NOV) is an exceptional company that has grown consistently for more than a decade. Only in the last decade, it has grown its earnings by more than 7 times, from $0.80 in 2004 to $6.0 in 2014, with only 2 down years in a whole decade. In the last quarter, the company reported record operating profit of $1B and earnings per share (EPS) $1.62. Nevertheless, the big question is how severely the company will be affected by the recent plunge of the oil price, particularly if the oil price remains suppressed throughout the whole 2015.

To have a clearer understanding of this impact, it is useful to know the four categories of the company's revenue:

Q3 Revenue ($B) % of Total Revenue Backlog ($B)
Rig systems 2.7 44% 14.3
Rig aftermarket 0.8 13%
Wellbore Technologies 1.5 24%
Completion & Production Solutions 1.2 19% 2.1

Shale drilling

As the oil price has plunged by about 1/3 in the last 5 months, some shale oil projects have become unprofitable and hence reduced activity in the segment of rig systems is expected in 2015 if the depressed oil prices persist throughout next year. Nevertheless, it is important to realize that the impact will be felt mostly in the segment of rig systems, which accounts for just 44% of the total revenue. The other three segments will just experience slower growth due to the reduced new activity; they will not experience contraction, as they largely depend on past projects.

In its last conference call, the management stated that it expects any reduction in shale drilling to cause rapid decline in the output and hence it considers such events to be short-lived. Even if the management is proven wrong, the company has sufficient backlog, equal to the revenue from rig systems of 1.5 year, to weather a temporary decline in new orders. This is actually what the company did in the last quarter; it reduced its backlog by 6.8% and thus managed to report record results. As is evident from the amount of the backlog, the company has ample backlog to keep posting record results even if the rebound in the oil price is not realized in 2015. It is remarkable that the company managed to convert 34% more revenue out of backlog in Q3 vs. last year thanks to some recent additions in its production capacity.

Offshore drilling

The depressed oil price has also resulted in fewer new orders for offshore rigs. After a record number of orders in 2013, new orders have already decreased and are expected to decrease further, due to the low oil price and the saturation of the offshore rig market. However, International Oil Companies (IOCs) are expected to somewhat mitigate this problem, as they are expected to enhance their deepwater projects in order to outweigh the natural decline of their current oilfields. Moreover, as the requirements of the offshore rigs become increasingly strict, several old rigs will be retired, thus somewhat buffering the downtrend in new orders. Just like the shale drilling, the reduced activity in the offshore drilling will mostly affect the major segment of National Oilwell Varco, which however accounts for just 44% of the total revenue. As the high backlog of the company provides an excellent buffer, the company has posted record results even though it has already experienced a significant decrease in new orders for offshore rigs.

Diversification

An important competitive advantage of the company is the great variety of its products and the lack of synchronism among them. To put it in simple terms, most of its products are cyclical but their cycles are in different phases. Therefore, while some of its products experience a down-cycle, others are in an uptrend, thus protecting the company from headwinds in its business. For instance, in Q3, the company received fewer orders for drilling equipment but more orders for coil tubing, drill pipe and land rigs. More importantly, the company has enough flexibility to direct its production towards the items that temporarily face higher demand and hence it does not incur any losses from idle production capacity when some categories face headwinds.

Balance sheet

Finally, National Oilwell Varco has the strongest balance sheet among all its peers. More specifically, its net debt is just $2.1B, which is less than one year's earnings, and its interest expense is minimal, standing at just 2% of its operating profit. This enables the company to easily withstand any headwind and, most importantly, greatly reward its shareholders even during rough times. To be sure, the company initiated a share buyback program for the first time in its history this year, which accounts for 10% of its outstanding shares. Thanks to its strong balance sheet, the company can easily complete this program in 12 months and renew it in order to keep repurchasing 10% of its shares per year for many years ahead. Thanks to the contracting share count, the stock will have limited downside and great upside whenever the oil price returns to its recent range of $85-$105.

Tax rate

As a side note, I would like to mention that the company's earnings in Q3 were somewhat elevated thanks to the reduced tax rate of that quarter (28.8% vs. 31.8% in Q2). The management expects the tax rate to return to about 31% in Q4 and hence its EPS will face a one-off headwind of $0.05 due to this issue. Of course this is just a minor detail, as the company is expected to report Q4 EPS $1.61 (just $0.01 lower than its record performance in Q3).

Risks

As analyzed above, National Oilwell Varco will probably exhibit EPS growth even in the adverse scenario of suppressed oil prices during the whole 2015. Therefore, the only risk for the company is a scenario of a low oil price for at least 2 years. However, as the oil consumption increases by about 1 M bbl/day every year and many oil wells are unprofitable below $80, such a scenario is very unlikely, in my opinion. Nevertheless, even if it is realized, it will curtail future oil projects at such a degree that an appreciable supply shortage will be inevitable at some point, which will result in an even stronger rebound in the oil price and a glut of new investment projects. Moreover, as the company derives about half of its revenue from already operating wells, it is expected to incur limited EPS contraction even under this adverse scenario, with its share repurchases setting a solid floor to its stock price.

Conclusion

To sum up, even if low oil prices persist throughout the whole 2015, National Oilwell Varco has wide product diversification, a sufficient backlog and great production flexibility to protect its results. That's why the analysts' estimates for next year have been reduced by only 9% and still call for 3% EPS growth. As the stock currently trades at a current P/E=11, I consider it a great bargain, particularly given the downside protection by the extensive share repurchases and the potential for even higher shareholder returns thanks to the strong balance sheet of the company. Whenever the oil price returns to a more sustainable level of $80-$90, the company will probably grow its EPS to the previously expected level of almost $7.0, which will probably boost the stock to about $100, implying an approximate 50% upside from its current price.

Disclosure: The author is long NOV.

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.