Can National Oilwell Varco Win Back The Love?

By Stephen D. Simpson, CFA | June 14, 2013 AAA

It doesn't feel like it was all that long ago when National Oilwell Varco (NYSE:NOV) was a darling in the energy equipment space. Sure, there was always strong cyclicality to the business and the stock (as the multiples tend to expand and contract with the book-to-bill ratio), but this was one of the companies that consistently got above-average multiples and the benefit of the doubt.

Now, though, investors' enthusiasm has turned more toward those companies with bigger subsea and offshore surface exposure, companies like FMC Technologies (NYSE:FTI) and Cameron (NYSE:CAM) for instance. Although I don't want to suggest that investors should ignore the risks that National Oilwell Varco will struggle to improve margins, that the equipment cycle peak is in sight, and/or that the company will be challenged to expand into subsea and surface, today's discount to historical multiples and current rivals seems a bit overdone.

SEE: 5 Common Trading Multiples Used In Oil And Gas Valuation

Can Margins Improve In The Coming Cycle?
While most of the equipment stocks appear to trade on orders, revenue, and margins (in declining order of significance), it seems like margins are one of the big sticking points with NOV right now. In particular, the company's efforts to expand into subsea/offshore surface markets like FPSOs, BOPs, manifolds, trees, and so on are hurting the company's margins today due to a lack of scale and operating efficiency. That's a problem that can only get better with time and competitive share gain – something that FMC, Cameron, General Electric (NYSE:GE), and Aker Solutions aren't going to let happen without a fight.

On a more promising note, the company's business mix may be more inherently profitable than the Street currently assumes. Management has talked about its expectation to see more consumables revenue in the coming years, and likewise I think the company is less vulnerable to areas like pressure pumping than commonly believed. Given that I think Helmerich & Payne (NYSE:HP) has proven that oil/gas customers will pay for modern, efficient technology, I think there's more growth and profitability left in the land rig business than commonly believed.

Will Deals Bring The Same Bang For The Buck?
It is interesting to me to see how Wall Street sentiment has changed regarding NOV's capital philosophy. NOV has always been an exceptionally active acquirer and has never made any bones about the fact that it's primary use of cash flow will be M&A transactions. Wall Street used to cheer that on heartily, but now it seems like there are more than just scattered complaints about the cash that goes into deals as opposed to dividends or buybacks.

Maybe this is just a cyclical phenomenon, as I don't think the company's integration execution or internal return on M&A as declined significantly. Moreover, companies like GE, Forum Energy (NYSE:FET) and Dover (NYSE:DOV) seem to believe that there are still ample high-quality deal targets out there in the energy space. With so much of NOV's cash located overseas anyway (where it cannot be repatriated for dividends or buybacks without paying taxes), it makes sense to me for NOV to consider acquisitions in areas like Russia and Asia to maintain its strong global rig equipment market share.

SEE: Mergers & Acquisitions – An Avenue For Profitable Trades

Watch The Order Cycle
One area where I do have some concern is in the size and shape of this spending cycle. In the past, it seems as though large drilling companies and oil/gas companies just spent madly into the bullish parts of the cycle and then slashed spending to the bone when things turned down. Now it sounds like NOV's customer base is talking more about long-term economic returns and rates of return on capital – in other words, managing these businesses with a responsible long-term perspective.

To that end, offshore drillers like Diamond Offshore (NYSE:DO), Ensco (NYSE:ESV), and Transocean (NYSE:RIG) seem a little cautious about ordering rigs on a spec basis (that is, not covered by contracts). Likewise, while major global energy companies like Chevron (NYSE:CVX) and Exxon Mobil (NYSE:XOM) continue to pursue huge offshore energy projects, they're being more careful with their cash.

I don't believe that we're looking at any meaningful decline in global energy spending, but rather just a different shape than in years past. All told, I think it will be better for NOV – the peak will be lower, but the good times will likely last longer, and I believe that will be good for margins.

SEE: A Look At Corporate Profit Margins

The Bottom Line
Although I don't much care for the idea of following what other fund managers are doing and replicating their holdings, it's worth noting that Berkshire Hathaway (NYSE:BRK.A, BRK.B) owns a sizable position in NOV (it's a top-20 position). Draw from that what you will about National Oilwell Varco's potential status as a value play in the energy equipment space.

Looking at cash flow and EBITDA valuation methodologies, I think NOV shares should be trading somewhere between the mid-to-high $80s and the low $90s, or approximately 20% to 30% higher than they are today. While there are risks that orders disappoint from here (and compress the multiple even further), I think NOV is a company that has earned the benefit of the doubt and still presents a relative bargain in the sector.

At the time of writing, Stephen D. Simpson owned shares of Cameron.

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