Cyclical Pressures Cloud National Oilwell Varco's 2013 Outlook, but Aftermarket Offers Upside
Near-term cyclical pressures and investments are weighing on margins.
National Oilwell Varco (NOV) has a wide economic moat and stellar capital allocation, and it is run by Pete Miller, Morningstar's reigning CEO of the Year, so it is puzzling that the market has dinged the firm for its currently margin-dilutive investments and mix shift. Ultimately, today's margin-dilutive investments around international rig markets and floating production, storage, and offloading units should support National Oilwell Varco's wide moat and open up new markets for it to dominate. Even if 2013 performance from its rig technology segment might be a bit weaker than what the Street initially expected, the petroleum services and supply segment's outlook appears more in line with the Street's and our expectations. However, the Street may still be missing the company's aftermarket opportunity in 2013 and onward, given the return of the initial 2004-07 rig orders for aftermarket work at higher-than-average margins (we estimate 30%-35%).
Rig Technology Margin Pressure Is a Headwind in 2013
During its fourth-quarter conference call, National Oilwell Varco provided some detailed insights into what the expected 2013 margin performance from its key rig technology segment, which contributed about 60% of fourth-quarter operating income. The fourth-quarter segment operating margin was 22.4%, down from 23.9% in the prior quarter, which is the lowest the firm has reported since the early days of 2007. There are a number of reasons why, and most are generally healthy for long-term shareholders, in our view.
First, despite healthy rig demand, rig equipment pricing remains 8%-10% below 2008 levels. Pricing declined from 2008-10 and has yet to rebound despite a huge wave of newbuild orders. Pricing has remained weak as a result of competitors partnering with Asian yards and offering 10%-20% discounts on rigs. We don't see this as a competitive threat, particularly as the firm is already selling select equipment into the Chinese yards without discounting it. In addition, we believe the company is aligned with the more innovative yards that are best positioned to move down the rig construction learning curve. We think this alignment will protect National Oilwell Varco's competitive position, letting it build up enough equipment volume to ensure the Chinese business generates respectable margins similar to the company's average.
Second, the industry's lack of urgency around building new rigs, in contrast to the relative frenzy of 2004-07 when $85 billion in rigs were ordered, is hurting the firm's ability to raise prices. Recent interest from the industry appears more from startups, such as Sigma Drilling/Vantage. Small drillers are more amenable to ordering from competitors, as they value a lower up-front price on the rig equipment rather than the greater operational savings that can be achieved by standardizing with National Oilwell Varco across a larger rig fleet. We believe startups entering the market is a cyclical phenomenon, similar to the amount of entries we saw in the late days of 2007 and 2008. Given that being sold is the long-term goal for many of these firms, they don't represent a change in the overall market structure for rig equipment, which ensures National Oilwell Varco's moat is protected. In the onshore markets, which we estimate make up about 10% of the rig equipment segment, the firm is seeing cyclical pressure on pricing as land rig orders slow alongside demand for its petroleum services and supply consumables.
However, National Oilwell Varco is also making strategic investments with an eye toward strengthening its moat and opening up new markets. Chief among these are the startup costs associated with the NOV (formerly NKT) Flexibles plant in Brazil. Shortly before National Oilwell Varco purchased it in early 2012, NKT won a four-year $1.7 billion order with Petrobras, the world's largest consumer of flexible pipe. As part of the agreement, NKT agreed to construct a plant in Brazil at a cost of $175 million, an obligation that National Oilwell Varco subsequently assumed. In fact, most of the $150 million in lower-than-average margin FPSO orders during the fourth quarter were related to this agreement and plant, which we think has yet to reach optimal volume. Flexible pipe pricing is actually doing very well per the company, which adds credence to the volume shortfalls driving the weaker margin performance. However, the agreement should generate around $120 million in annual EBITDA for National Oilwell Varco, which puts the headline EBITDA multiple paid for NKT at a more attractive 5.6 times 2012 EBITDA versus the initial 12.6 times multiple paid.
International markets and incremental hiring also had an impact. National Oilwell Varco experienced margin pressure because of several large international rig orders at lower-than-average margins. However, these rig orders are going to markets such as Russia (more than 800 active rigs recently that are not included in the Baker Hughes rig count) and the Middle East (400 active rigs), where the onshore rig fleets are generally old and out of date and need to be upgraded to the more modernized rigs that work in North America today. As rig demand and volume pick up, we expect margins to improve, as this is a manufacturing business where scale makes a difference. We think National Oilwell Varco should pursue markets like these, even at the expense of its short-term margins, because of the long-term opportunities.
Finally, National Oilwell Varco indicated that it hired employees to handle the commissioning and installation needs for its 2013 rig order levels, which are projected to be twice 2012 levels. Again, these are the types of investments that the firm needs to make to ensure its reputation as a reliable supplier that can deliver rigs on time and on budget. We expect the investment to be repaid over the next few years.
We expect these investments to weigh on the rig technology segment's margin performance throughout 2013. However, 2014 should show improvement, as we expect segment margins to exit 2013 at 24%, on an upward trajectory toward our 25% long-term (midcycle) forecast. The NOV Flexibles plant's startup costs should roll off, as well as the incremental employee expenses, and the international and FPSO (flexible pipe orders for now) should also contribute to improved margins as the rig and pipe orders increase, driving economic efficiencies. We don't necessarily expect rig equipment pricing to improve, but if the industry starts to see private equity players enter the market with new rig orders, the pricing trade-off in exchange for increased order volume might be incrementally positive for the segment's overall margin performance.
PS&S Results Still Look Weak
Results from National Oilwell Varco's petroleum services and supply segment (slightly more than 30% of operating income in the fourth quarter) largely met our low expectations, and the outlook is still difficult, in our view. Most important to note, a sharp deterioration in North American drilling activity from this point onward appears unlikely. However, PS&S is a key area where if performance materially deviates from our expectations, we may cut our fair value estimate.
PS&S is unusually important in 2013, as the segment generates the majority of the firm's cash flows, by our estimates, given the temporarily negative working capital trends in the rig technology segment. A weak North American drilling environment is leading to lower order levels and cyclical levels of pricing pressure. Specialized drilling tools such as XL Systems generally have fared better, while demand for consumables related to pressure pumping has fallen off, particularly as contractors have chosen to consume existing inventory rather than replenish it. Furthermore, the company isn't seeing any signs of an improvement in the business despite some industry optimism around an uptick in activity in early 2013. The segment's results generally match the overall North American drilling activity performance with a slight lag, because there is some backlog (National Oilwell Varco doesn't report it on a quarterly basis) that provides a cushion during the downturn. This backlog is why fourth-quarter revenue was up 3% sequentially while North America dropped almost 100 rigs.
At this point, we believe National Oilwell Varco generally has burned through its backlog and is working on a spot market basis, which means its 2013 performance will better reflect the North American rig count. There are some positive signs in the Baker Hughes North American rig count--the horizontal rig count has ticked up to 1,130 as of early March after dropping nearly 90 rigs in the second half of 2012 to around 1,100 rigs in late December, but this is a very small positive in a challenging environment.
The Street Is Missing the 2013-16 Aftermarket Opportunity
One of the most important areas we'll be watching in 2013 is the aftermarket side of the house for National Oilwell Varco. This segment is already growing 15%-20% per year, and it increased revenue to around $2.4 billion (about 25% of rig technology's revenue) in 2012 from $1.7 billion in 2010. At 35% operating margins (our estimate), the aftermarket has contributed roughly $840 million in operating income, which is about 35% of the overall rig technology segment's operating income in 2012. This growth has come primarily from drillers returning to National Oilwell Varco for aftermarket services after Macondo, as safety and using high-quality OEM equipment suddenly became more important than saving money with a third-party aftermarket supplier. However, we anticipate a unique event that will start to take place in 2013 and continue until 2016 in the aftermarket business, which could lead to meaningful upside for our rig technology segment forecasts.
We expect the rigs that were ordered in 2004-07 (all $85 billion worth) to start coming back to suppliers for their five-year major surveys. A rig that was ordered in 2004 was typically delivered in 2008, and 2013 presents the first opportunity for that rig to return to the original equipment supplier for its first survey. National Oilwell Varco has delivered approximately 150 rigs since 2005, or around 20-30 rigs a year, and has yet to see any of them for major work. If we assume $25 million-$50 million per major survey, this cohort of rigs could represent $500 million-$1 billion in extra revenue opportunity (using a best-case scenario) and about $175 million- $350 million in incremental operating income. The difference in this cohort is that they are for the most part fully integrated rigs based around National Oilwell Varco's products, providing the company a much greater chance to win the survey work and capture more of the revenue opportunity per rig than it has in the past. We think the aftermarket opportunity represents about $0.33 of upside to our 2013 earnings per share estimate, or around 6%. We expect the firm to have a similar opportunity with the 2010-13 class of rigs that will be returning for five-year surveys in 2018-21. This kind of aftermarket opportunity is one of the key benefits that National Oilwell Varco derives from its wide moat.
Today, we estimate that the 150 rigs that National Oilwell Varco has delivered since 2005 make up around 20% of the global rig fleet, which is still a far lower number than the 70%-80% share that the company has in integrated rigs. We expect the global rig fleet to transition to integrated rigs over time. As a result, we expect that the company's ongoing Macondo-related share gains will be supplemented by integrated aftermarket gains as well. Given we estimate that the aftermarket market is around $12.6 billion today, versus National Oilwell Varco's $2.4 billion in aftermarket revenue, we think the growth pathway is long.
Stephen Ellis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.