(By Stephen Ellis) In recent months, as National Oilwell Varco's (NOV
) stock price declined, we've seen a number of investors' concerns come to light. The bear argument we hear goes like this: First, rig orders are poised to collapse in 2013 because of macroeconomic uncertainty, leading to weak rig technology results. Second, Brazilian rig demand is falling after Petrobras canceled five contracts with Ocean Rig. Third, petroleum services and supply segment results will suffer as North American drilling activity declines in 2013. Fourth, the OneSubsea joint venture and Cameron's (CAM
) first deep-water package win is a chink in the armor of National Oilwell Varco's wide economic moat. Fifth, CEO Pete Miller's eventual retirement means the firm won't be as capably managed in the future. We think all of the concerns are either overblown or misunderstood by investors. National Oilwell Varco is trading at just 12 times 2013 earnings and 7 times 2013 EBITDA, which we consider too low for a wide-moat firm with expanding competitive advantages being led by an exemplary management team.
Are Rig Orders Poised to Collapse in 2013?
The rig equipment business is an important contributor to National Oilwell Varco's results; we can see why investors consider ordering trends an indicator of its near-term prospects. However, we think this focus on ordering trends is somewhat misplaced.
First, a severe decline in orders doesn't result in a similarly brutal decline in the financial results for the rig equipment segment. In the last cycle (2008-10), orders dropped far faster than NOV's actual revenue and operating profits. The firm's large backlog ensures a steady stream of cash flow, and it took nearly two years for rig equipment revenue to decline from $2.2 billion in the first quarter of 2009 to $1.6 billion in the first quarter of 2011. The segment's operating margin actually increased for most of the period, thanks to manufacturing efficiencies. We expect the backlog to be around $12 billion at the end of 2012, which is essentially the same as at the end of 2008 ($11.8 billion). We do not see any significant differences in the quality of the backlog that would suggest a materially different financial performance in the case of an equally violent drop-off in new rig equipment orders.
Second, we're still amid a 20-year replacement cycle as the industry retools after the 1980s bust. The 2005-08 cycle saw more than $85 billion worth of rig orders versus about $3.5 billion in 2001-04. Despite the high level of orders, the major drillers still have a collection of largely older assets that still need to be upgraded or replaced to meet today's more demanding drilling standards post-Macondo. Other than age, we focus on three attributes: deck load, the number of blowout preventer rams, and whether the rig is dynamically positioned or moored. Each rig data point, in our view, is fairly critical to the tasks that drillers will increasingly be performing over the next decade. We expect to see deeper wells in more challenging environments while shifting to development mode for many of the offshore discoveries made over the past few years. The increased deck load for Rowan's rigs (22,000 tons versus 10,000 tons average for the rest of the group) puts Rowan in a good position to serve customers that want to drill prospects farther offshore, as it can store more equipment and consumables and better manage the logistical challenges that occur from being far away from resupply base. The higher number of blowout preventer rams is an upgrade that we think operators are looking for as well, given the failure of the Deepwater Horizon's blowout preventer to shear Macondo's drill pipe successfully. More rams indicate more chances to successfully close the blowout preventer in the event of a blowout. Also, we think dynamically positioned rigs will become more popular with operators than older moored rigs. As we put more subsea infrastructure on the seafloor, the dynamically positioned rigs will be able to maintain position over the well without disturbing the subsea infrastructure while the moored rigs will be unable to do so.
Finally, the offshore drilling industry has evolved substantially since 2005, which has positive implications for National Oilwell Varco's ordering trends. The new crop of CEOs at the major drillers has had a completely different environment to work with compared with the industry executives who toiled through the difficult 1980s to the early 2000s. The biggest change is an increased comfort around structurally higher oil prices than in the early 2000s. Other changes include an increased willingness to use debt to fund fleet investment given improved access to credit, low interest rates, and longer contract terms for deep-water rigs. On average, excluding Seadrill, debt/capital for the major offshore drillers has increased to 33% in 2012 from 19% in 2008. Another industry shift is consolidation, as several key acquisitions of relatively inexperienced new entrants over the past few years with poor balance sheets and under-construction rigs that did not have contracts served to reinforce the fact that major oil and gas firms generally prefer to work with established rather than startup drillers. The Macondo blowout served as a catalyst for drillers to upgrade their fleets to the newest rigs in order to meet more demanding customer requirements around pressure control and safety systems. Finally, unlike in prior cycles, today's major drillers have a huge fountain of cash from contracts signed in 2005-08. This cash needed deployment at the same time that rig prices dropped to $600 million each and day rates improved to more than $600,000, which has created some compelling rig economics.
In this environment, we think the traditional factors that the drillers have taken in account when considering whether to order a new rig (day rate environment and rig costs) have changed. Today, we believe drillers also consider rig crew availability, balance sheet capacity, the credit environment, and the risks of delays in building. At this time, we think the environment for the drillers remains stable across these factors, and we do not anticipate near-term ordering trends driving any changes in our fair value estimate.
Is Brazilian Demand for Rigs Declining?
Recently, Petrobras canceled a five-rig tender with Ocean Rig. Its stated rationale was that due to better well productivity, fewer wells needed to be drilled to meet its production goals, and therefore the rigs were no longer needed. However, we don't think this was the actual reason. First, we suspect that Petrobras doubted Ocean Rig's ability to finance the construction of the rigs, given the latter firm's net losses and $2.7 billion in debt. Second, there was doubt on Petrobras' part around whether Ocean Rig's original partner, Synergy Group, could successfully build the new shipyard in Brazil that was to construct the units. It seems that Ocean Rig started to negotiate with an alternative shipyard partner, OGX, which also was building a shipyard in Brazil. Synergy seems to have threatened legal action in response, as Ocean Rig may have violated its original agreement. Thus, it is not surprising to see Petrobras walk away from the increasingly troubled deal. We expect Petrobras to come back to the market with a new tender for additional rigs shortly, as it has done after other failed tenders.
We think there are a number of takeaways from this event. The first is that rig demand from Petrobras, a key deep-water customer, is not declining. Second, the event reinforces our stance that the major drillers do have some healthy competitive advantages in terms of fleet composition, operational expertise (rig uptime), financial strength, and shipyard relationships. Since all of the major drillers are National Oilwell Varco customers, we think this dynamic is ultimately beneficial for the firm. Furthermore, we estimate Petrobras (through its proxy Sete Brasil) is about 9%-10% of National Oilwell Varco's revenue, a percentage that should remain constant over the next few years, as Petrobras executes on its presalt plans. Short of Petrobras announcing that its presalt finds are now uneconomic to develop (which we consider very unlikely) or oil prices falling below $50 per barrel and remaining there, we struggle see a reasonable scenario where Petrobras' rig demand materially declines for any length of time. We note that Petrobras typically issues open-ended tenders for rigs with no specified number of rigs required, in an effort to snare as many rigs as it can with each proposal.
What Is the Outlook for PS&S in North America in 2013?
National Oilwell Varco's petroleum services and supply segment results in 2013 will be driven by drilling activity levels, not the pressure pumping market dynamics that FMC Technologies (FTI) is heavily exposed to (about two thirds of its surface technology segment), or wellhead aftermarket services where Cameron has a larger book of business (a $1.3 billion annual stream of revenue for Cameron versus very little for National Oilwell Varco). PS&S' largest product lines are drill bits, drilling motors, jars, and shock tools, followed by solids control equipment, then drill pipe and Tuboscope, which are roughly tied in terms of size. Historically, PS&S performance has closely tracked the North American rig count, and about 60% of the business today is tied directly to U.S. and Canadian rigs.
The North American rig outlook for 2013 is plagued by uncertainty. We think exploration and production firms are dealing with budget uncertainty driven by low natural gas and natural gas liquids prices, as well as uncertainty over the stability of oil prices given the ongoing European crisis. In response, we've seen premium rigs laid down in the latter stages of 2012 in order to promote rig-on-rig competition rather than renew the contract. Premium rig orders have also dropped off, with Helmerich & Payne reporting no new rig orders during its last quarter. The weakness for National Oilwell Varco also progressed throughout the year. In the first quarter of 2012, quoting activity for well intervention products was brisk, and the firm was still receiving orders for pressure pumping equipment from startups. In the second quarter, the firm saw declines in bookings for drill pipe and well servicing pump products, and in the third quarter, pressure pumping equipment orders dropped off to nearly zero, and backlogs across many product lines dropped 10%-30% sequentially. Drillers appear to be consuming existing inventory rather than ordering new equipment in a cautious environment.
In our view, drilling activity in North America is unlikely to pick up substantially before the second half of 2013, as E&Ps adjust their drilling plans due to the changing NGL economics and their individual ability to take advantage of lower services prices (particularly pressure pumping). As a result, we believe a reasonable forecast for 2013 is that the average North American rig count will decline around 250, from 2,158 active rigs (as of Dec. 21) to around 1,900. Our boundaries around this forecast are set by oil prices in 2013, currently $91 per barrel (West Texas Intermediate). Significant ($25) variations from an average $91 per barrel would shift our forecasts more toward our worst- or best-case scenarios as we would expect a negative or positive impact on the level of oil drilling activity.
We acknowledge the potential for a more difficult downturn in North America, but we think the scenario is more than priced into NOV's stock. PS&S has gained great importance to National Oilwell Varco's cash flow, given the increased working capital requirements (and negative impact) of the rig equipment segment over the past few years. The increased working capital requirements for the rig equipment segment are related to the additional inventory required to meet faster rig delivery schedules, and we consider it a cyclical phenomenon that will reverse as the rigs are delivered. Alternatively, if new rig equipment order levels decline, we would also expect additional cash to be freed up.
What Do OneSubsea and Cameron's Sigma Deep-Water Win Mean for NOV?
Cameron and Schlumberger (SLB
) have announced the creation of OneSubsea, a joint venture that will manufacture and develop systems and services for the subsea market. OneSubsea is unique in the industry as it marries the equipment design, manufacturing, and installation expertise of Cameron with Schlumberger's deep reservoir knowledge and well-completions expertise. This offers customers a completely integrated subsea solution, and the combined efforts of the two companies could point to meaningful improvements in well productivity, reservoir recovery rates, and equipment reliability, which will serve as a competitive differentiator. Schlumberger's marketing muscle, customer relationships, and industry-leading expertise in offshore well completions should also not be underestimated. Stand-alone subsea systems firms like FMC Technologies and GE Oil & Gas, which lack the reservoir knowledge that Schlumberger has, are the initial losers at this stage.
What OneSubsea means for National Oilwell Varco is very different, in our view. We believe investors consider National Oilwell Varco's FPSO (floating, production, storage, and offloading) ambitions and OneSubsea's subsea efforts to be competitive, when they are instead different niches. In our view, National Oilwell Varco and OneSubsea can co-exist peacefully. The existence of OneSubsea has probably effectively blocked any ambitions of NOV to enter the subsea equipment market (which may be seen as a disappointment by investors), but it should sharpen investors' focus on National Oilwell Varco's underappreciated and misunderstood FPSO efforts. We had not specifically factored in any subsea growth in our model, and a review of the joint venture and National Oilwell Varco's product portfolios for the two niches shows no product overlap, so we do not see any competitive threats to National Oilwell Varco today.
National Oilwell Varco's strategy with its FPSO efforts is to duplicate its success with rig equipment, which is a prospect that should excite investors. The FPSO equipment supplier market is highly fragmented, with no standard supplier or any standard FPSO design. This situation creates substantial economic uncertainty for the equipment suppliers (no standard placement, shape, or size for routine pieces of equipment), shipyards (every project is a one-off), and operators (uncertain ultimate project economics as well as delivery timeline risk). Bidding for FPSO equipment is still usually done on a component-by-component basis. National Oilwell Varco wants to work with shipyards and FPSO owners to create a more standard FPSO design that reduces economic uncertainties for all parties, while encouraging the industry to standardize around a single supplier to achieve the best economics. We think National Oilwell Varco stands alone (even post-OneSubsea) in terms of its portfolio of FPSO equipment, and it is pushing packaged offerings already while also working on its own standard FPSO design that should improve overall FPSO economics. We forecast that the number of FPSO deliveries will roughly double over the next few years, and the company's opportunity set per FPSO is now more than $100 million per vessel. Thus, we see the FPSO opportunity as compelling and the firm is well positioned to take advantage of it.
We think investors can rest easy at this stage regarding the Sigma Drilling deal, where Cameron won a complete rig equipment package for $275 million for an ultra-deep-water rig to be built in South Korea. We consider this a high-risk order. Sigma is a joint venture of Skeie Group and Vantage Drilling, a startup driller founded in 2007 that is still losing money and has more than $2 billion in debt. The joint venture was created in November 2012 as a way for Vantage to pursue a newbuild effort despite its poor financial condition. We wouldn't be surprised to see Vantage/Sigma run into financial difficulties before the rig's delivery in 2015, which could make the order quite a headache for Cameron. While the win clearly demonstrates Cameron's improved capabilities in deep-water rig equipment, it's not a particularly convincing one.
We still believe National Oilwell Varco has several significant advantages over Cameron. For example, National Oilwell Varco has supplied more than 140 total offshore rigs since 2005, including more than 70 floaters, with only one delay, whereas Cameron has won a single highly risky floater order that has yet to be delivered. Cameron is winning only its first deep-water package seven years after the global fleet retooling began, and the major drillers and much of the industry have already standardized around National Oilwell Varco's robust product portfolio. To encourage switching, Cameron's solutions need to be substantially better than National Oilwell Varco's. In addition, Cameron has yet to integrate its equipment offering into a single operating system, so drillers are unlikely to achieve the same level of operational savings in terms of improved rig uptime and lower training, maintenance, and installation costs compared with National Oilwell Varco. Next, we estimate Cameron's drilling equipment operations are around $1.3 billion-$2 billion in revenue versus National Oilwell Varco's $10 billion annual revenue run rate. This gives National Oilwell Varco significant scale advantages and should allow it to underprice Cameron and still achieve healthy margins on any competitive bid. Also, Cameron has yet to prove its reputation and its reliability at delivering a complete deep-water package.
Thus, we consider Cameron's best competitive edge at this stage is winning work with any new offshore driller entrants. The new entrants, such as Vantage, are probably using a build-to-sell strategy where any up-front savings on the rig equipment is of greater importance because of their small fleet size and limited financial flexibility. In contrast, larger drillers are not as price sensitive on the up-front equipment cost. They want to take advantage of the more meaningful ongoing operational savings that can be earned by standardizing with a single supplier using an integrated operating system across a larger fleet of rigs.
How Will Miller's Eventual Retirement Affect NOV?
With the appointment of Clay Williams as COO, CEO Pete Miller is stepping back from day-to-day operations after a stellar run since 2001. Miller, Morningstar's 2012 CEO of the Year, has successfully convinced the offshore drilling industry as well as the shipyards to use a more standard rig design, which has made the entire rig equipment industry more cost-effective by standardizing the size, shape, and placement of key pieces of equipment on every rig. Furthermore, Miller has closed nearly 300 deals that have largely consolidated the rig equipment industry to National Oilwell Varco's benefit. As a result of the changes in rig design, offshore drillers saw the advantages of standardizing around a single supplier. They began to take advantage of improved rig uptime and other cost-saving benefits, which let National Oilwell Varco build significant scale and switching cost advantages over time.
How can Williams possibly follow up such an outstanding executive? We think he is up to the task and the COO appointment gives him a fantastic chance to handle the day-to-day responsibilities. Williams has served as CFO since 2005, when he arrived at the firm through the Varco merger, and has worked with Miller through the key big acquisitions. On the quarterly conference calls, Williams typically details key strategic and competitive insights on a regular basis along with a financial overview of the quarterly results. Miller follows up with similarly detailed strategic thoughts. However, unlike most CFO-CEO tandems, Williams didn't just stick to the numbers; we think this was a deliberate choice by Miller, indicates Williams has been groomed for the CEO role for some time. We think Miller and Williams share a deep understanding of National Oilwell Varco's strategy and competitive position, as well as an ability to execute deals successfully. As a result, we don't expect any material changes in National Oilwell Varco's corporate strategy, and given Williams' talent, we consider the company to be in good hands.