(By Stephen Ellis) We believe National Oilwell Varco (
NOV) and Schlumberger (
SLB) have earned wide economic moats. After following these companies for years, we've gradually been convinced that it will be extraordinarily difficult to snatch away their competitive advantages. Furthermore, we were impressed by the management teams' response to the downturn, as they took advantage of it by making value-creating acquisitions. The downturn also demonstrated the resiliency of the companies' business models. It could be argued that the wide-moat advantages are as obvious now as they were years ago, but the same could be true for many firms in 2007-08, when many companies were turning in solid results only to crumble in the downturn. In our view, National Oilwell Varco and Schlumberger are the best franchises in oil services, and recent events (acquisitions, secular trends, weak competition, and increased bargaining leverage over key customers) only serve to reinforce their competitive advantages and wide economic moats.
National Oilwell Varco's Wide Economic Moat
Profile
National Oilwell Varco is one of the largest equipment suppliers in the drilling industry. It provides a comprehensive line of equipment for rigs and consumable products, such as blowout preventers and drill pipe used in oil and gas production. The company also provides distribution services, which include maintenance, spare parts, and repair services for its equipment.
Background
We upgraded NOV to a narrow moat in early 2008, as we recognized the value of its low-cost position in rig equipment. The company's equipment is on more than 90% of the world's rigs, and we estimate it has about 60% market share in rig equipment. NOV's competitive position has been built piece by piece through decades of acquisitions after the 1980s bust. The opportunity to acquire many of its competitors and rationalize the industry during a multidecade bust was unique, and existing and new entrants will find it impossible to duplicate NOV's size and reach. As a result, many offshore and onshore drillers have standardized on NOV's equipment, including Ensco (ESV) and Transocean (RIG), and large chunks of Patterson's (PTEN) and Nabors' (NBR) onshore fleets have come from NOV as well. The company is so dominant in the industry that its nickname is "No Other Vender."
Why Wide Now?
We believe National Oilwell Varco has a wide economic moat because of its low-cost, comprehensive position in rig equipment that was achieved through decades of acquisitions. In our view, this position cannot be duplicated by peers because NOV already owns brands with reputations and market positions that stretch back decades. Competitors that focus on extracting premium prices for niche product lines can weaken the dominance of a low-cost position. However, NOV has effectively marginalized competitors by raising switching costs for its customers that already largely standardize on its equipment. A few examples of these higher switching costs are rig stores on rigs, consistent acquisition activity that extends NOV's product line into new niches (APL, Grant Prideco), and the complete integration of all its rig equipment into a single operating system, which should boost rig performance over time while lowering costs and levels of rig downtime for the drillers.
Competitive Analysis
Bargaining Power of Customers: Medium and Decreasing
Our biggest long-term concern remains the bargaining power of NOV's powerful customers, which include national oil companies such as Petrobras (PBR). Petrobras is a particularly important customer because it is developing the Santos Basin, which encompasses tens of billions of barrels of oil and represents tens of billions of dollars in orders for NOV over the next decade. Petrobras produces roughly 20% of the world's deep-water oil, and Brazilian discoveries over the past five years make up a third of global deep-water discoveries, which suggests Petrobras' importance in the deep-water market is increasing rapidly. This opportunity for NOV is quite large in relation to its existing $7.8 billion backlog. The need for deep-water rigs and thus NOV's rig equipment is immense, and we view Petrobras as a key source of incremental demand. Other sources of demand are in Africa and the deep-water Gulf of Mexico.
Recent events have indicated that even Petrobras cannot leverage its bargaining power against NOV to cut prices. First, Petrobras' tender for 28 rigs, which has been ongoing since late 2009, was canceled after just 7 rigs, and Petrobras has indicated that it will retender for the remaining 21 rigs later. Petrobras wants to build the rigs in Brazil, yet refuses to acknowledge the additional costs (as much as 50% higher than building rigs elsewhere) in doing so. Thus, there has been immense pressure from Petrobras to force suppliers into offering lower prices, and the cancellation of the tender after 1.5 years of delays indicates the oil firm was unsuccessful. Second, shortly after the tender was canceled, Petrobras, through the EAS shipyard, awarded all seven rig equipment orders to National Oilwell Varco for $214 million per rig. By claiming 100% share from its toughest customers at a price that doesn't immediately indicate NOV discounted the orders (typical opportunity set is $200 million-$300 million per rig), NOV appears to have the upper hand in bargaining leverage.
Bargaining Power of Suppliers: Low and Stable
National Oilwell Varco is the largest company in the rig equipment market, and its suppliers have yet to demonstrate any type of bargaining power.
Intensity of Competitive Rivalry: Low
Competitors like Cameron (CAM) and Akers have struggled to compete with NOV over the years and are a fraction of NOV's size. Peers have generally found success in offering single product lines such as blowout preventers or drilling risers. Some drillers are willing to pick and choose rig equipment components, but the majority prefer to deal with a single vendor. Even in a difficult year, NOV's rig equipment division--at $7 billion in 2010 revenue--is much larger than its key competitors combined. Startups have failed because they cannot duplicate NOV's comprehensive product line, prices, or reputation. We view competitors as largely ineffectual.
Cameron's recent agreement to purchase LeTourneau for $375 million illustrates the uphill battle peers face against NOV in rig equipment.