National Oilwell Varco's Short-Term Concerns May Dissipate Over The Medium Term

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About: National Oilwell Varco, Inc. (NOV)
by: Badsha Chowdhury
Summary

Increased activity in the international markets and higher project tendering activity in offshore can improve NOV’s revenues and margin in 2019.

Pricing pressure and excess supply in North America onshore will continue to downplay the company’s short-term outlook.

Significant impairment charges were recorded in Q1; similar charges may reduce the earnings in the future as well.

NOV’s Outlook Does Not Improve Yet

National Oilwell Varco (NOV) provides equipment and technology to the upstream oil and gas industry. I think the stock will stay under pressure or may even decline in the near term. However, with relatively low leverage, the stock is more suited to withstand an energy market downturn.

Overcapacity in the OFS industry, a lack of demand for hydraulic fracturing and pressure pumping activity in North America, and longer-than-expected recovery in the international market is likely to cause the current softness to prolong. If the pricing pressure continues and the drilling market deteriorates further, impairment charges similar to Q1 may reduce the company’s net earnings.

On the other hand, the mix of offshore drill pipe is expected to go higher, which can also improve the company’s margin. In onshore, the fracking and the premium drill pipe business can expand in various international territories. Although it has been streamlining costs for the past couple of years, the full benefits of the restructuring process are yet to improve margin effectively.

Industry Indicators Do Not Exhibit Strength

The trouble with the energy servicing space does not seem to pass quickly. As many upstream companies plan to slash spending, which can amount to 10% to 20% in 2019 according to estimates, the overcapacity of the OFS equipment and tools present in the market has compounded the situation. The average number of U.S. rigs also dropped by 5% from Q1 to Q2 in 2019. Despite a marginal recovery in the crude oil price (9% up), the energy producers see enough volatility in the crude oil price to keep new drilling plans on hold for the next few quarters.

From Q1 to Q2 of 2019, the number of drilled wells, as well as the drilled-but-uncompleted (or DUC) wells, declined by 3%. A slowdown in the drilling activity in the key energy Basins in North America and excess supply of servicing equipment has caused significant pressure on the surface equipment, downhole tools, and rig site services.

International Activity May Come To The Rescue

To beat the softness that has developed in North America, the company has been diversifying into international territories, where growth is slowly happening. From Q1 to Q2, the share of international operation increased from 55% to 59%.

Also, increased tendering activity has led to additional order booking in Q2, which resulted in a consolidated book-to-bill of 1.3x. A majority of the new order booking came from the international offshore business, which indicates the market is likely to turn around. A value higher than one typically signals potentially higher future revenue generation. However, investors should keep in mind the long gestation period in executing the projects, which means revenues may not get materialized soon even if bookings go up.

In essence, NOV’s longer cycle capital equipment businesses received a booster due to increased international E&P activity, particularly in the offshore. So, in Q2, its revenues from the international market grew by 18% compared to Q1, while revenues from the U.S. clocked a much modest 2% growth during this period. The company is currently pursuing projects in the Middle East, Argentina, India, and other regions. In June, it sold two 20K blowout preventers (or BOPs) to Transocean (RIG), which marks a milestone in the exploration and development of high-pressure formations.

Wellbore Technologies: Drivers And Outlook

Improvement in markets outside North America, higher volumes, and cost savings initiatives translated into 5% higher revenue and while the segment EBITDA margin inflated to 16% in Q2 from 14% in Q1. Among the markets outside North America, Asia, the former Soviet Union region, Africa, and Norway saw the most robust growth. In the U.S., not all the markets witnessed a decline, as steady pricing in the advanced drilling motors pipelines offset the drilling activity decline partially.

In this segment, the downhole business unit is a key function because it enhances efficiency in drilling, workover or intervention operations. To adapt to the constant change in competitors’ offerings and to reduce costs, the company has rationalized operational and manufacturing hubs and support infrastructure. During Q2, it recognized $399 million in restructuring charges. These initiatives are expected to offset the pricing pressures in North America partially. As a result, in Q2, operating margin in this unit increased by 36% over the previous quarter.

Outlook: In Q3 2019, the company’s management expects revenue for the segment to decline between 1% to 3%, while margin is likely to remain relatively steady (0.1% fall). The primary drivers for the expected move are declines in the U.S. activity and continued growth in international operations.

In the medium to long-term, the U.S. and the international markets can transform from the current state. Although the drilling market seems to be languishing at this point, many drillers and rig makers are using the period as a breather to upgrade their less capable rigs to adapt to more pervasive pad-drilling and other modern techniques to gain more efficiency. Such initiatives will let the Tier I Super Spec rigs to improve utilization and increase margin once rig count stabilizes.

On the other hand, even though tendering activity indicates that growth is imminent in the international E&P offshore, the upstream investment is still inadequate. A budget constraint may delay some of these projects, leading to a slower-than-expected recovery in this space.

Completion And Production Solutions: Drivers And Outlook

The company’s Q2 revenues in the Completion & Production Solutions (or CAPS) segment increased by 14% compared to Q1, while the segment adjusted EBITDA margin inflated to 8% from 5% during the same period. As I discussed earlier in the article, strong growth in order booking in the international markets led to the revenue rise.

According to the company’s management, the increase in bookings marks a turnaround from the trough in Q1 because the offshore business, starting from 2018 until Q1 2019, was a drag on the segment margin. As the offshore E&P projects gather steam in many parts of the world, NOV can generate incremental margin that can range between 30% and 35% consistently. Not only does the additional revenue over a long period will benefit margin, but the company’s cost-saving initiatives during the downturn will also add to it.

So, given the rise in backlog, the company expects the CAPS segment revenues to increase by the upper single-digit range in Q3, while the operating margin may reach mid-to-upper 30% range in Q3.

What Are The Possible Growth Accelerators?

Product-wise, among the most sought categories for NOV in North America and internationally, was SelectShift, an adjustable Downhole motor and MWD tool for the directional drillers. In recent times, the company’s closed-loop automated drilling helped drill pipers improve drilling efficiency. The company sees traction for this product in North America and international markets in 2H 2019. In well intervention and stimulation technologies, the company offers higher-capacity, higher-diameter coiled tubing units that can reach out further down laterals.

Does The Impairment Charge Point To More Downturn?

In Q2, NOV recorded $5.37 billion charge goodwill, intangible assets, and fixed asset write down. The impairment charge followed a steep fall in the stock price, which reached a 14-month low in Q2. The steady fall in the stock price reflects a prolonged energy market downturn and a weak outlook. The Oil Services Index (or OSX) also reached its lowest point since 2004. The OSX’s fall from Q1 to Q2 suggests energy producers’ capex cut and its adverse effect on the OFS industry. As the U.S. rig count fell compared to Q1, there was further evidence of an E&P activity fall and the deteriorating impact on NOV’s short-term outlook. As a result of the decline in stock price, the company’s market capitalization fell below the carrying value, which triggered the impairment test, and subsequently, the impairment charges.

Led by the fall in OSX and the management’s revision of the mid-year plans and further deterioration in market condition, there can be more impairment charges in the coming quarters. Currently, the company has ~$2.6 billion of property, plant, and equipment and $2.5 billion of other intangible assets, which together, accounts for ~60% of the company’s current market cap. The Wellbore Technologies segment accounted for most of the impairment charges (60%) in Q2.

Dividend

NOV pays a $0.05 quarterly dividend per share, which amounts to 0.91% forward dividend yield. In the past five years, its dividend has decreased by ~25%. TechnipFMC’s (FTI) and Halliburton’s (HAL) forward dividend yields (2.0% and 3.4%, respectively) are higher.

FCF, Capex, And Debt

In 1H 2019, NOV’s cash flow from operations (or CFO) turned negative (-$118 million) compared to a year ago. Despite the rise in revenues in the past year, the company’s CFO deteriorated as working capital as a percentage of revenues increased in 2019 so far. The build-up of inventory for increased order intake led to the working capital deterioration in 1H 2019.

Negative CFO resulted in negative free cash flow (or FCF) in 1H 2019. The company aims to reduce the working capital-to-revenue run rate in the mid-30% range, which would lead to $300 million to $500 million of FCF generation. The company is focused on reducing capex for the year to reach the target. However, given the current trend in the financials, it will take stupendous effort to generate that much of FCF.

NOV has a relatively low debt-to-equity ratio (0.23x) compared to peers. Nabors Industries’ (NBR) leverage was 1.4x as of June 30, Baker Hughes, a GE Company’s (BHGE) leverage was 0.26x as of June 30, while Superior Energy Services’ (SPN) leverage was 4.5x.

What Does The Relative Valuation Imply?

National Oilwell Varco is currently trading at an EV-to-adjusted EBITDA multiple of 23.2x. Based on sell-side analysts’ EBITDA estimates, the forward EV/EBITDA multiple is 12.9x. The company’s EV/EBITDA multiple was excessively high in FY2016 as a result of low EBITDA. Excluding the extreme figure, between FY2013 and FY2018, the average EV/EBITDA multiple was 9.1x. So, the stock is currently trading at a significant premium to its past average.

NOV’s forward EV-to-EBITDA multiple contraction versus the adjusted trailing 12-month EV/EBITDA is much steeper compared to the peers, which implies the EBITDA is expected to improve more sharply compared to the EBITDA for peers in the next four quarters. This typically results in a higher current EV/EBITDA multiple compared to the peers. The company’s EV/EBITDA multiple is sharply higher than its peers’ (SPN, NBR, and BHGE) average of 7.3x. I have used estimates provided by Seeking Alpha in this analysis.

Analyst Rating

According to data provided by Seeking Alpha, nine sell-side analysts rated NOV a “buy” in August (including “outperform”), while 19 of them rated it a “hold.” Four of the analysts rated a “sell” or “underperform.” The consensus target price is $26.7, which at the current price yields ~33% returns.

According to Seeking Alpha’s Quant Rating, the stock receives a “Neutral” rating. Its rating is high on EPS revisions, while they are moderate-to-poor on value, profitability, growth, and momentum. I agree with Seeking Alpha’s assertion of a moderate rating on growth. Although the growth rates for some of its key metrics are close to peers, the company’s sequential revenue growth has been inconsistent over the past quarters. I think Seeking Alpha’s very high rating on EPS revision is aggressive because its earnings missed analysts’ estimates twice out of the past four quarters. Also, I think its relative valuation multiples are reasonably placed, as I discussed earlier in the article, and so, the low rating on value is conservative.

What’s The Take On NOV?

Overcapacity in the OFS industry and a lack of demand for hydraulic fracturing and pressure pumping activity in North America will continue to take its toll. Even the international market may take longer than expected to recover, thus causing the current softness to prolong. If the pricing pressure continues and the drilling market deteriorates further, the company may incur further impairment charges in the coming quarters. I think the stock will stay under pressure or may even decline in the near term.

On the positive side, increased share of higher-margin offshore drill pipe and the fracking and the premium drill pipe in the international business can improve margin over the medium to long term. With relatively low leverage and expected improvement in margin, I expect the stock to rebound in the medium term.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.