|Shares Out. (in M):||428||P/E||11.9x||9.9x|
|Market Cap (in $M):||30,880||P/FCF||12.0x||10.3x|
|Net Debt (in $M):||1,908||EBIT||0||0|
Historically, the stock has had a very high correlation with the direction of its backlog growth. As such the key risk is whether this stock can work if the backlog for new orders in Rig Tech is falling while the substantial free cash flow builds. There is no question that the surge in rig orders is behind us and so bears would argue that you can’t own NOV when backlog for new builds is stagnating or falling. However, for perspective, by 2015, I think its non-“new-build businesses” can earn north of $4/share. Perversely, the weaker the market gets the more accretive their acquisitions are likely to be.
Today, the stock is priced as though its RigTech business is going to decline meaningfully while ignoring many scenarios in which this business can continue to create value and earnings growth even if the backlog steps down from its current $12bln+ levels. This segment has generated 20-25% ROAs in the past 3 years off margins in mid to low 20s. If NOV were comped against other cyclical manufacturing companies of similar size, the value discrepancy would be obvious but the market is caught now in a fear of orders dropping off a cliff with margin deterioration in the segment in recent quarters fueling this sentiment. I believe margins will rebound as I will discuss below and I believe orders will be healthy (though not at recent years robust pace) all while NOV has dramatically reduced its earnings cyclicality.
NOV has 3 business segments:
Petroleum Services and Supplies (PSS)
Distribution and Transmission
Main tenets to bull case:
(1) Free cash flow + balance sheet strength + strong history of creating value via acquisitions + appetite to continue to do so = earnings revisions higher.
In 2012, the company completed $2.9bln of acquisitions and on their Q212 call, they said to expect a 14% after tax return on the acquisitions implying EPS of close to $1.00 off ~$5.50 of EPS. In addition, they recently closed their acquisition of Robbins and Meyers for $2.5bln. I estimate earnings accretion from this deal of $.25 for the first 12 months of ownership and between SG&A synergies and the recovery of North American land cycle that will move up close to .75/share as North America goes through its cycle.
I expect pre-acquisition free cash in 2013 and 2014 of ~$2.3bln and $3.5bln respectively. Assuming half of this is re-invested in M&A at a 10% return that is another ~$1.25 of earnings. This is a reasonable assumption given the 300+ deals the company has done in the last 15 years (or about 20 per year).
What is effectively happening, in my opinion, is that the company is using its dominance in the Rig Tech business and the associated cash flow of that businesses’ backlog to build its other two lines of businesses into more meaningful contributors. As that happens, the street will likely be forced to expand the company’s multiple due to less reliance on the deeply cyclical rig building cycle.
(2) Earnings More Stable than Stock Implies Driven by After-Market, Petroleum Services, Distribution
First, let's look at how the after-market business in the Rig Tech segment has evolved. The drivers here are the "installed base" of rigs in the global fleet. Over-time we have seen increasing expenditures on the fleet due to aging, Macondo-related redundancy requirements, and drilling in harsher/deeper environments. Management has qualitatively talked about margins here being notably higher than segment averages. I assume 30% through channel checks and conversations with others in the business. For modeling purposes, I assume that each floater takes on $8mm of expenditures per year and each jackup takes on $2.5mm per year as corroborated by a couple of offshore drilling contractors. (I also model deliveries by quarter so the total marketed supply doesn't exactly add to the base + delivery numbers below due to averaging.)
|Rig Technology - Aftermarket||2011||2012E||2013E||2014E||2015E||2016E||2017E|
|AFTER MARKET DRIVERS|
|Rev per floater||$ 8.0|
|Rev per jackup||$ 2.5|
|NOPAT||$ 1.11||$ 1.24||$ 1.30||$ 1.41||$ 1.50||$ 1.55||$ 1.62|
|Petroleum Services & Supply||2007||2008||2009||2010||2011||2012E||2013E||2014E||2015E|
|% Change YoY||26.2%||52.0%||-19.5%||11.7%||35.2%||23.2%||-0.5%||7.1%||6.6%|
|% Change Sequentially|
|% of Revenues||23.9%||25.0%||12.1%||14.0%||19.4%||21.8%||19.9%||22.3%||23.6%|
|NOPAT||$ 1.20||$ 1.90||$ 0.74||$ 0.96||$ 1.79||$ 2.48||$ 2.26||$ 2.71||$ 3.06|
This segment is also driven by the rig count but at a higher tax rate given the much larger North American presence here. The margin uplift modeled is also based on certain assumptions of being able to consolidate the recently acquired business from SLB and another major competitor as well.
|% Change YoY||4.0%||24.5%||-23.8%||14.5%||21.2%||109.7%||37.7%||3.0%||3.0%|
|% Change Sequentially|
|% of Revenues||6.6%||7.3%||3.7%||5.0%||7.3%||6.4%||6.5%||6.8%||7.2%|
|NOPAT||$ 0.13||$ 0.18||$ 0.07||$ 0.11||$ 0.19||$ 0.35||$ 0.50||$ 0.53||$ 0.58|
Putting these three "non-backlog driven" earnings contributors, shows ~$5/share in EPS by 2015 (before segment elimination and other corporate expenses which total about .75). This is before the unwind of today's backlog and deploying free cash in any value-creating manner. In the previous cycles, these earnings contributions were less than $1. This is a material change in the company's earnings cyclicality and the market has not yet seen or appreciated this. What we have now is one of the more valuable global manufacturing franchises (Rig Tech) that is buffered by far less cyclical (yet decent (though not great) in terms of business quality) earnings contributors.
I will get into some more details on the RigTech business below but here is a stab at the normalized earnings power of that business:
|Normalized Rig Tech EPS|
|Units||Profit per Unit|
|Floaters per year||15||75||1,125|
|Jacksup per year||15||50||750|
|Per Share||$ 3.31|
We have been running well north of these numbers in recent years (including this year) and I'd argue (1) my assumptions on units above are actually below replacement levels, (2) don't take into account any FPSO orders which the company has been aggressively investing in the infrastructure for, (3) doesn't include any non-offshore rig orders such as land rigs internationally and domestically. But even still we get well north of $7/share in earnings power for the company as a whole putting it at 10x "normalized" earnings at today's levels (after backing out eliminations and corporate expenses).
The delta between the company's reported sub $6 EPS for the last 2 years and this normalized number are the following: (1) The nearly $3.5bln of acquisitions that the company has made in the past 3 years with most it coming in 2012 that is not being modeled properly, (2) my estimate of .45/share of "investments running through last year and this year's P/L by way of investing in facilities in Brazil and Asia to service local markets that are backed by existing contracts set to kick-in when the investments are completed, (3) and the debacle that has been the North American land industry for the oil field service industry in 2012/3.
Not least, the company is set to deliver north $10/share in cash over 2013 and 2014 (we started to see some nice working capital improvement in Q113 over Q112 which is a big driver to potential upside here).
So assuming the cash creates no value, I think the company is trading at 8.5x normalized earnings giving credit to the cash but not assuming any value creation. Note that this is among the most highly regarded management teams in the industry in terms of capital deployment.
Actual Earnings Projections:
Given the robust backlog, the very strong start to the year in jackup orders, my assumptions on other orders and how the backlog unwinds over the next 2 years, I believe NOV will earning $5.90 this year and $7.10 in 2014 and north of $8/share in 2015 before any free cash is deployed. I am modeling a slow and steady recovery in North America but more importantly a recovery in RigTech operating margins due to revenues coming in from spending that is going on right now in preparation of new contracts and the slowdown of the robust pace of infrastructure investments.
The real delta is, however, likely to be higher from incremental M&A that I presume we will hear about over the next 2 years. In two years time looking back, I think NOV will have built out another nice franchise in FPSOs, will have taken a lot of value out of its already-completed acquisitions in the distribution business, and for the reasons I will get into below, I think orders will hang in better than the stock implies (which is almost nothing right now for future orders).
The more consensus bull case (which has seeming evaporated in recent months) on the stock is that we are in the midst of a major replacement cycle for jackups, floaters, and land rigs. And it is here where NOV has 50-70% market share and a material moat around its business born out of its scale and ability to deliver higher quality rig packages at much better margins than its peers. More specifically, NOV has delivered some 70% of the top drives and draw works for jackups and floaters since 2000 despites repeated efforts at entry from competitors over the time frame.
On a more macro basis, the number of rigs older than 30 years today is over 30% of the existing floater fleet and 55% of the existing jackup fleet. As we can see from the downtime in the offshore drilling companies and the pressure on those companies to not only keep up with competitors’ new build programs but to also keep their own portfolios relevant. What I’d add to this is that the majority of rigs built before 2000 cant readily take another BOP and so will either need to be replaced or more structural work which will benefit NOV.
Taking these two dyanmics (along with things like the trends toward deeper and harsher water to grow global oil production) with the robust new build economics available today, there is actually little reason to believe we are on the verge of a nasty downturn in order-rates for UDW rigs. In fact, for many players (see my DO write-up) there is actually more reason to believe that the rig owners will feel pressure to continue to invest in rigs even if/when day-rates come off a bit.
|Daily OpEx ($k/d)||(165)|
The development of the Chinese shipbuilding industry, the financing they are providing, are further reasons to believe order rates will continue to be solid for the foreseeable future.
If anyone wants to discuss how I model the unwind of the backlog and how I think about where and how management will deploy its excess cash flow, please post the questions and I'll provide more detail.