National Oilwell Varco manufactures and sells equipment and components used in oil and gas drilling operations and provides services to the upstream oil and gas industry. It operates through three segments: Rig Technology, Petroleum Services and Supplies, and Distribution and Transmission.
Due to the company’s ability to constantly outperform its peers and to the macroeconomic tailwinds that are likely to help its revenues grow, I believe that the current valuation is very attractive. I expect the share price to increase significantly due to revenue growth and multiple expansion.
Companies involved in exploration & drilling and their suppliers are the main customers for NOV’s products. The determining factors of these companies’ propensity to invest in new machinery are mainly 1) the economic feasibility of drilling operations; 2) advances in drilling technologies and 3) expansion of drilling capacity.
1. Generally speaking, a drilling operation is economically feasible when the price per barrel is higher than the extraction cost per barrel. As the spread between the two widens, investments tend to increase.
The U.S., Western Europe and Japan experienced amazing increases in oil consumption per capita over the last century. If there is anything to learn from history, it is that oil-consumption per capita is likely to increase dramatically in emerging markets. In China, for example, oil-consumption per capita is approximately 2.5 barrels per person per year, far lower than the 22 barrels per person per year consumed in the United States. Translated into numbers, with a population of 1.3bn people, an increase of ¼ barrel in yearly demand per person will cause an increase of almost 1 million barrels per day in overall demand. The same goes for India: with a population of 1.2 billion, even a small increase in demand per person will lead to large increases in total demand.
To put this into perspective, total world consumption is 88 million barrels per day. If demand per person in India and China increases to a level that is merely ¼ of the US level, total world demand would increase by almost 50%. Note that growth in demand for oil is highly correlated with GDP growth, so as the economies of emerging countries grow, oil consumption is destined to rise.
While oil demand seems poised to increase, there is significant evidence that supply is likely to contract. The output of an oilfield tends to follow a bell-curve shape. The top of the bell curve is referred to as “peak oil” – or in other words the point at which production begins to decline. The US reached peak oil in the ‘70s and there is an ongoing debate whether the world has reached peak oil or not. Either way, peak oil will be reached sooner or later and supply will begin to contract.
Oil Extraction Costs
Easy oil is gone. Extraction is becoming more and more difficult and drilling projects are becoming more complex and expensive. Surging oil prices made even the most complicated and expensive projects economically viable and ultimately led to a boom in deep water drilling. With peak oil on the horizon, it is likely for extraction costs to continue to increase.
Summing it all up
The inability of supply to keep up with demand is not the only matter to consider. The costs associated with ever more complex extraction projects are likely to further drive oil prices up. The only thing that remains to be seen is how much money the upstream oil companies make in the process. Apart from them, their suppliers such as National Oilwell are likely to benefit from the increased spending.
2. The oil extraction process is becoming more and more complex. Currently, it is estimated that only 40% of the oil contained in existing wells can be extracted due to technological limitations. As oil supply shrinks however, there will be more and more incentive to invest in R&D and subsequent upgrades to machinery. Moreover, with increasing oil prices, the deep water drilling industry is likely to continue in its remarkable growth.
3. As technology grows to encompass a wider range of extraction methodologies, it becomes possible to extract oil from more places. For example, the maximum water depth at which drilling is currently possible is approximately 12000ft. With increased investments, deeper drilling is likely to become an option. Also, if the spread between price per barrel and extraction cost per barrel widens, it would become likely for upstream oil companies to expand their drilling capacity on existing wells.
National Oilwell’s Positioning
National Oilwell’s revenues are likely to benefit regardless of the scenario. Any spending to expand rig capacity or spending in technological upgrades is likely to be passed on to National Oilwell thanks to its pricing power. Moreover, with increasing complexity in drilling techniques, the wear on the machinery is likely to increase, thus pushing revenues from replacement parts.
The Good, the Bad and the Ugly of Deep-Water Drilling
In the deep-water drilling industry, shipyards manufacture the drilling rigs, rig operators buy them and upstream oil companies rent them. With the tailwinds of the past few years due to increasing oil prices, almost everybody has benefited substantially: shipyards’ prices are not being bargained down, day-rates (the daily “rent” on the rigs) are increasing and upstream oil companies seem to do fine (albeit they are subject to fluctuating oil prices). Anyhow, this trend is not likely to continue much longer if costs continue to increase for the upstream oil companies. In particular, day-rates may be bargained down (after all, the major oil companies do have bargaining power since there are not many of them and each one usually accounts for a large percentage of the operators’ revenues).
Shipyards on the other hand have “sticky” building costs due to the technology that they must install on the rigs combined with the fact that they have virtually no bargaining power over their suppliers. This poses an effective limit under which they can’t allow their prices to fall.
For this reason, the pressure on revenues from the oil companies and impossibility to significantly bargain down shipyards’ costs could potentially crush the operators.
In the meanwhile, in such a disastrous situation, while the good shipyards, the bad oil companies and the ugly rig operators are fighting for every penny, National Oilwell can watch from aside, for it is not threatened by the woes of any single industry component as it is a supplier to all three.
National Oilwell’s three segments are industry leaders in terms of ROIC, margins and market share. One of the reasons behind such fantastic performance is the company’s customer loyalty. Due to the fact that many of their products are integrated, switching costs can be high. Also, replacement parts are a major revenue driver so, since each initial sale leads to subsequent purchases of replacement parts and services, the company has effectively created a method of customer retention thereby giving it a sustainable competitive advantage.
Their crown jewel is the Rig Technology segment, with 50% ROTCE and operating margins in the mid 20’s, which are fantastic considering that competitors such as GE, Tesco and Cameron have averaged operating margins in the mid teens. ROTCE and EBITDA margins are respectively 30% and 21% for their Petroleum Services & Supplies segment and 13% and ~5% for their Distribution & Transmission segment.
Acquisitions are a leading part of the company’s growth strategy. Management has shown, time after time, that they are conservative in their capital allocation policy and will not overpay for acquisitions. They strictly value their acquisitions at EBITDA multiples based on past earnings. For no reason, they say, will they base their acquisition price on projected earnings or anticipated synergies. In other words, they don’t pay for growth.
National Oilwell has a fantastic financial position with $3.3bn cash on the balance sheet opposed to $3.1bn debt. Its debt-to-equity ratio is less than 0.16 and it has a Debt/EBITDA ratio of 0.75.
The economic value of National Oilwell’s assets, net of all liabilities (NAV) is approximately $16bn.
Revenues & Earnings
From 2004 to 2012, revenues have grown at roughly 27% (compounded). Most of the growth has come from acquisitions. Goodwill increased by $816mm p.a. during the same period.
Net profit grew at a compounded rate of 40.7% from 2004 to 2012. The company’s reported earnings are fairly in line with its cash earnings. Considering all that has been stated above, there is sufficient reason to believe that the company can sustain $2.5bn in profit for the foreseeable future (assuming no growth).
Considering that the company has earned above-average returns on capital with significant profit margins and management has proven itself capable of growing the company through aggressive acquisitions at conservative prices, I believe that National Oilwell has a sustainable competitive advantage and can continue to earn above average returns and grow at above average rates.
I estimate the company’s EPV to be in the range of €27bn with a growth value of approximately $48bn. Such valuation would put the share price north of $110.
Should the company continue to compound its invested capital as it has in the past (as all evidence suggests it will), the value of the company is likely to appreciate substantially as illustrated in the following table.
Alternative method of valuation
The company is currently trading at roughly 11x earnings and 6.7x EV/EBITDA. Considering its growth potential, it is not out of the question that the market will eventually give National Oilwell a more generous multiple.