The Market Is Already Expecting Big Things At Dril-Quip

By Stephen D. Simpson, CFA | September 24, 2012 AAA

There's ample business to come in offshore energy development, what with the huge discoveries of oil and gas in the waters off Brazil, and both East and West African countries. The question, however, is how much of that is already reflected in the valuation of equipment companies such as National Oilwell Varco (NYSE:NOV), Aker Solutions (OTC:AKKVF) and Dril-Quip (NYSE:DRQ). In the case of the latter, it looks like quite a lot.

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Brazil Comes up Big
Dril-Quip certainly got a boost to its prospects when Petrobras (NYSE:PBR) announced a huge order late in August. It was pretty much considered a given that Dril-Quip was going to win contract awards for subsea wellhead systems, but the actual four-year $650 million award was a major one. To put this into perspective, Dril-Quip's historical peak backlog was about $730 million and peak revenue was $601 million.

Now not all of this award will go immediately into backlog and it won't be recognized as revenue in a single year, but the fact remains that this is a big award. Moreover, I think it goes to prove that even the growing presence of the mighty General Electric (NYSE:GE) in subsea energy equipment does not preclude ongoing success for Dril-Quip.

SEE: A Primer On Offshore Drilling

But will Other Awards Materialize on Schedule?
Clearly Petrobras came through for Dril-Quip, and in a big way. Now the question is whether the rest of Dril-Quip's expected 2012 orders will appear as expected. Energy industry analysts are expecting numerous tension-leg platform orders to come from major energy companies like Royal Dutch Shell (NYSE:RDS.A), but there's a meaningful risk that these orders could slide. Elsewhere, the company still gets a sizable amount of its revenue from the Gulf of Mexico and permitting/project starts there have never been perfectly reliable.

Dril-Quip Does Things a Little Differently
Dril-Quip operates itself a little differently than most companies. Instead of buying shiny new equipment, Dril-Quip often buys older equipment and refurbishes it - allowing the company to save considerable cash on capital equipment.

That's a plus, but I'm not sure the company's approach towards Wall Street is equally positive. While the company does attend broker-sponsored conferences and seems to have some willingness to engage the analyst community, the lack of quarterly calls and the scant detail provided with earnings releases is a bit of a drawback. I realize that many investors believe Wall Street analysts are inept or corrupt, but the reality is that it can be difficult for a company to get ahead when it deprives investors of the information they need.

Will Labor Availability Limit Growth?
Over the past few years, it looks like Dril-Quip's revenue correlates pretty closely with the number of machinists it employs. I'm well aware that correlation is not causation, but investors should realize that the ability to find skilled machinists (or find and train suitable workers) could be a limiting factor on growth. The company is looking to increase its head count by about 25% for 2012, but there's a balancing act between under-hiring and limiting growth, and over-hiring and disrupting the margin structure.

SEE: What Are Economies Of Scale?

The Bottom Line
Dril-Quip has significant market share in many subsea equipment categories, and basically co-dominates the subsea wellhead segment with GE. That could make it an attractive acquisition target for a company like National Oilwell or Cameron (NYSE:CAM), though antitrust issues could start limiting some of the pace of M&A in the sector.

The upside to Dril-Quip is largely in the sizable orders that are still to come from subsea energy projects - orders that have to come if these announced energy discoveries are ever going to make it to market. The downside is that a lot of that growth already seems to be in the stock. Even assigning a 10 times multiple to 2013's average EBITDA estimate is not enough to generate an appealing price target. Instead, investors have to be willing to pay 13 or 14 times EBTIDA for this stock to look attractive, and while multiples can get that high in the bull cycles, it definitely increases the risk for new investors.

At the time of writing, Stephen D. Simpson has owned shares in Cameron since September 2012.

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