National Oilwell Varco

National Oilwell Varco is the world’s leading provider of equipment and technology for oilfields. It has a strong industry position. By market share it is #1 or #2 in everything that it does, and in some categories it is so dominant that people jokingly refer to its ticker symbol “NOV” as “No Other Vendor”.

It’s equipment powers more than 90% of the world’s offshore rigs, and 50% of large land rigs put into place in the last two decades. Its reputation is stellar: it is seen as a dependable partner in a high-risk, high-cost world.

Let’s break down NOV’s main business lines. It has four reporting divisions:

  1. Rig Systems (40%)
  2. Rig Aftermarket (15%)
  3. Wellbore Technologies (25%)
  4. Completion and Production Services (20%)

NOV1

The numbers in the parenthesis reflect the average revenue generated by the segments over the 2013-2015 time-period. Its overall business mix is levered towards off-shore rig demand.

The Bad

The recent downturn in oil prices has hit the stock brutally. There is plenty of headline risk in this stock.

NOV consistently traded above $50/share from 2010 to mid-2015. And for good reason: its earnings per share grew from $0.64 in 2004 to $5.85 in 2014 – greater than 9x increase. This stunning 25% compounded return in earnings saw the stock rise from around $15 in 2004 to nearly $80 in 2014 – a nearly 20% CAGR.

By early 2016, however, the stock was completely banged up. It fell nearly 70% from a high over $80 to a low near $25, as its backlog began drying up, and future became murkier. For 2015, NOV reported a net loss per share of nearly $2. For full context, the loss was due to a large ($1.7B) impairment charge on intangible assets. NOV operating business was actually cash-flow positive.

Over the past 12 months, its rig system backlog dropped precipitously from $15B to around $3B as offshore projects were shelved or canceled. Demand for their products also suffered as producers began cannibalizing equipment from idle rigs. Even the products they could sell had to be discounted, leading to a further erosion in margin.

The top-line is crumbling. Margins are deteriorating. Not surprisingly, the bottom-line is getting hammered.

In 2012-2014 (the good recent past), total revenue averaged over $21B, and the EBIT margin was around 16%. In 2015, the revenue fell by a third to $14B, and EBIT margin nearly halved to 8.8%.

EBIT ratio = revenue * EBIT margin
           = ($14B/$21B) * (8.8%/16%) = 0.36

The market seems to have absorbed this deterioration in the business rationally: 0.36 * $80 = $29, which is roughly where the stock price is currently hovering.

Oil is a tough cyclical industry. We still seem to be stuck near a cyclical low. It is impossible to know how long this lull in oil prices will last. It may last 6 months, or 6 years. As Howard Marks (quoting Rudiger Dornbusch) remarked,

In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.

NOV’s business and stock price is intimately linked to the price of oil – something that it exercises no control over. Management seems to be hunkering down, cutting costs, and turning the dials it can turn, as NOV braces itself to weather this storm.

It is also conceivable that when the recovery in oil prices materializes, North American onshore might delay a pickup in international offshore. Thus, it is possible (some may say likely) that NOV will lag the recovery in oil prices. In an extreme bear case scenario one might paint a picture where onshore drilling (shale/unconventional etc.) semi-permanently displaces offshore drilling. This scenario could be extremely tough for NOV to navigate.

The Good

Can NOV survive this downturn?

Plaster their $2B cash and $5B working capital buffers, manageable debt (net debt $1.8B), and access to $3.5B revolving debt, on top of their (still) cash-flow positive operating business, it is a good bet that they will survive this cycle.

There is, in fact, a decent chance that they will come out stronger. NOV is highly acquisitive. It has chowed down more than 200 companies over the past 15 years, without showing too many signs of indigestion. The weakness in the oil sector might allow them to gobble up companies and assets in financial distress.

Aside: I’ve lived through two major downturns (2000 and 2008). In both these periods, a particular industry (tech and finance) got brutalized. Picking the strongest companies in battered sectors, with financial strength to survive the downturn (AMZN and WFC, for example) is a generally good idea. I have a prior bias for strong companies in beaten up sectors.

NOV has an entrepreneurial DNA. The amount of high-tech innovation that NOV has brought online seems at odds with an industry with a reputation for tradition and things old-school. Fossil fuel seems so 18th century in a world of Teslas and SolarCities? While “we help our customers reduce their marginal costs,” might not seem world-shattering, they play an essential role in the smooth functioning of modern civilization.

NOV seems to develop and disperse talent like a university/business school. From a recent interview with their CEO Clay Williams, it seems their focus on employees mirrors that of Publix or Costco. Given the diversity of geographies and businesses NOV operates in, NOV adopts a decentralized decision-making posture, trusting people close to problems to come up with ways to solve them.

Overall, management seem to be excellent stewards of capital. They deploy cash-flow opportunistically, with an all of the above approach. From their recent investor presentation, the mix of capital allocation buckets includes M&A, buybacks, dividends, and organic growth.

Screenshot from 2016-07-19 08:10:02

NOV used to pay a $0.46/share dividend. They slashed it to $0.05/share in mid-2016, even though they had enough financial muscle to continue to pay it. Unlike oil majors (Exxon and Chevron for example), which haven’t cut their dividends even though they have to borrow money to pay it, NOV doesn’t seem to care about short term oscillations in share price. They seem focused on the long-term: if cash can be deployed more productively elsewhere, then the dividend must go! And it did.

In 2014-2015, as NOV’s stock price declined, management brought back 12% of the outstanding shares (share count declined from 428M to 375M currently) at an adjusted average price of around $45. Clearly, at that time NOV’s savvy management thought its stock was undervalued.

Did they misjudge? Probably. They could have certainly bought a lot more at $25/share.

But hindsight is 20/20. What I find reassuring is that they did not buy any when the stock was trading at its highest levels, like so many other companies often do.

Valuation

NOV is in a cyclical industry, and I feel very uncomfortable doing a DCF analysis without knowing when oil prices will recover. Hence, I will employ a simpler Earnings Power Value (EPV) method to come up with a “no growth” estimate for NOV.

To determine the EPV, we model normalized earnings of the company as an annuity:

EPV = normalized after-tax EBIT/cost of capital

Normalized Earnings

We turn to history, and make reasonable assumptions to come up with a value for normalized earnings. NOV has been growing like kudzu, so historical information has to be parsed through a forward looking lens.

The average EBIT margin has been 17.7% over the past 10 years. Since this period has included two downturns in the oil business, including the current one, it seems like a reasonable number to use.

The average revenue has been $15.3B over the past 5 years. This seems like a reasonable number to use in the intermediate term.

Thus, normalized EBIT = $15.3B * 17.7% = $2.7B.

The average non-recurring charges over the past 10 years have been $195M/year. The tax rate has hovered around its average of 32%. Since 2011, depreciation and amortization has exceeded capital expenditures by about ~$100M. Furthermore, since the normalized revenue represents a decline in sales from peak revenue, I assume that maintenance CapEx is currently zero.

The normalized after tax operating income = (EBIT – nonrecurring expense – net maintenance CapEx) * (1  – tax rate). Conservatively, I assume (depreciation – maintenance CapEx) is zero. Thus, normalized earnings = ($2.7B – $195M- 0) * (1-0.32) = $1.7B. Dividing by the number of shares outstanding (375M), this implies, normalized EPS = $1.7B/375M = $4.55.

Cost of Capital

I assume a risk-free rate of 2%, an ERP of 7% to account for NOV’s international exposure, a reasonable beta of 1.65 (Google Finance) and get cost of equity = 0.02 + 1.65 * 0.07 = 13.55%.

NOV’s interest coverage is over 12. Using default spreads for Aaa bonds (1%), and tax rate of 32%, I get a cost of debt = (0.02 + 0.01) * (1 – 0.32) = 2.04%.

The ratio of the total long term debt to the net asset value is about 40%. Using this as a proxy for the debt ratio, I get a weighted average cost of capital that is nearly 9%.

The EPV is $19.1B ($1.7B/0.09). Subtracting net debt ($1.8B), the value of the equity is $17.3B. Dividing by the number of shares outstanding (375M), this yields value per share as $46.

Note that this estimate does not make any growth assumptions. NOV has a history of extraordinary growth. As such, this estimate probably undervalues NOV’s true worth.

At prevailing prices of $32/share, it represents a 70c dollar.

Personal Backstory

I bought 500 shares of NOV over 2015 and 2016 at an average price of slightly over $40. Currently, I am sitting on a 20% paper loss. In the meantime, NOV has paid me over $850 in dividends and option premiums.

I plan to hold this one for 3-5 years, perhaps more.

Aside: A part of me fantasizes that if BRK operated in a cyclical industry they would look something like NOV.

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