As I’ve mentioned a few times now, I’m a bit cautious on buying stocks in the energy sector. This is mostly due to the fact that I was fortunate enough to load up on many supermajors and pipeline companies at much lower stock prices that also happened to coincide with higher oil prices. As such, my exposure to energy in general is actually a bit heavy for my liking.
Additionally, I’m also unsure as to when oil prices might rebound. Thus, I’m being cautious here. A protracted drop in oil prices may result in better valuations down the road. Furthermore, some firms may have difficulties increasing their dividends if oil prices remain this low for, say, five or ten more years. I think that scenario is unlikely, but not impossible. The truth is that nobody really know where oil is going.
That said, I do see a few clear-cut values in energy, and it’s difficult for me, as a value-oriented investor, to ignore these completely. I always view short-term volatility as a long-term opportunity, so I decided to take advantage of that.
One of my holdings has continued to slide, most recently after releasing a fourth quarter report that was operationally great, but also uncertain about future growth. This allowed me to average down yet again, much to my delight.
I purchased 25 shares of National Oilwell Varco, Inc. (NOV) on 2/4/15 for $52.86.
With corporate history dating back to 1862, National Oilwell Varco is a leading worldwide provider of equipment and components used in oil and gas drilling and production, as well as oilfield services.
The company conducts operations in over 1,200 locations across six continents.
They operate in four segments: Rig Systems (42% of fiscal year 2014 revenue), Wellbore Technologies (24%), Completion & Production Solutions (20%), and Rig Aftermarket (14%).
NOV provides all the heavy equipment necessary for oil and gas drilling, including rigs, derricks, rotarys, blowout preventers, mud pumps, wireline winches, cranes, drill pipes, drilling motors, drill bits, and transfer pumps, among many other products. They are essentially a one-stop shop for their clients. Anecdotally, they are nicknamed “No Other Vendor” as a play on their stock ticker, referring to their dominance in their product lines.
This company sports some extremely impressive fundamentals across the board, made perhaps even more impressive by the fact that they also held up quite well during the last downturn in commodities back in 2009.
So let’s take a look at their growth over the last 10 years.
Revenue increased from $4.645 billion in FY 2005 to $21.440 billion in FY 2014. That’s a compound annual growth rate of 18.52% over that period, which is nothing less than outstanding.
But it gets better.
Earnings per share improved from $0.91 to $5.70 over the last 10 fiscal years, which is a CAGR of 22.64%. I can tell you that after investing in dozens of companies and analyzing far more, it’s not common to run into a business that has grown at such a phenomenal rate over a decade.
S&P Capital IQ is anticipating that EPS will grow at a -1% compound annual rate over the next three years, which is down significantly since their last report in the fall (that report anticipated compound annual growth of 14%). Again, it’s really impossible to forecast where oil and drilling activity will be over the next three years, as even the CEO of NOV can’t really tell where things are going. However, even if NOV goes nowhere over the next three years, the company is in an excellent position to capture growth when the market eventually rebounds. Furthermore, and more importantly to me, the dividend is so well covered that they could potentially continue handing out rather substantial dividend raises even absent core growth in the business.
Speaking of the dividend, the metrics there are also fantastic.
The company has increased its dividend for the past six consecutive years, after initiating a payout policy back in 2009.
And the raises themselves have been significant – the five-year dividend growth rate is 78.2%.
Yielding a very attractive 3.48% right now, the dividend seems more than sustainable with a low payout ratio of just 32.3%.
I love investing in companies that are responsible with shareholders’ cash. Using leverage too aggressively can cause grave harm to a business, especially when we’re talking about businesses that are exposed to cyclical commodities. NOV’s use of leverage is extremely responsible, with one of the best balance sheets in the industry.
The long-term debt/equity ratio is 0.15 and the interest coverage ratio is over 36.
NOV’s profitability is also solid across the board. The company’s net margin has averaged 12.28% over the last five years. Return on equity finished at 12.1% last fiscal year.
NOV is also aggressively buying back shares after announcing a $3 billion buyback plan in 2014. They purchased 11.6 million shares for $779 million during the year, which reduced the share count some 2.7%. That leaves more than $2.2 billion on the authorization to buy back shares on the cheap, which, as you can imagine, is something I’m particularly excited about.
It’s important to note here that the stock dropped rather heavily after the company reported Q4 2014 results, where the company beat EPS estimates by $0.09. However, that beat was helped by especially strong growth in Rig Systems, which is NOV’s largest segment. If you look at the fine print, though, you’ll notice that that segment’s growth was fueled by drawing down the company’s sizable backlog. The backlog for Rig Systems now stands at $12.5 billion, which is down 13% year-over-year.
But that backlog is still large enough to fuel the segment all by itself for more than an entire year, even if we were to factor in a worst-case scenario of 0% book-to-bill. Furthermore, this backlog is actually high by the company’s historical standards – CEO, Clay Williams, noted on the earnings conference call this this backlog is 19% higher than what the company entered the 2009 downturn with.
Of course, we invest where a company’s going, not where’s already been. While the short-term is volatile and uncertain for NOV as well as the entire energy sector, I remain confident about the long-term demand for energy when looking at global population trends and growing middle classes around the world.
From what I can tell, this appears to be an old-fashioned supply-and-demand issue. Oversupply in the market combined with softening demand causes prices to drop, as it should. However, cheap oil has a way of counteracting itself. Firstly, lower oil prices means major producers are less inclined to drill for oil, which reduces supply. Secondly, consumers and businesses alike are more likely to consume energy when prices are low, increasing demand. This combination will most likely normalize supply and demand, but it’s impossible to say how long that will take. In addition, it’s difficult to say what oil should be priced at over the long term, though I think it’s unlikely that a barrel of oil is still priced at $40 10 or 20 years from now since demand will very likely rise and supplies are naturally finite.
Where NOV shines is that they’re well positioned to capture growth from this eventual turnaround. They differentiate themselves via their product lineup and diversification. It’s estimated that they enjoy a #1 or close #2 market share in every product line in which they compete in. Even companies that compete in certain product lines, like Schlumberger Limited (SLB) purchase products from NOV.
The company manufactures nearly every single product necessary for drilling oil and gas. A rig manufacturer cannot viably avoid NOV’s products due to NOV’s diversification and dominance in this space. Moreover, the company produces most of the products necessary for the drilling process itself, meaning they should enjoy a comfortable stream of recurring revenue for years to come from not only initial product sales themselves, but also via consumables and spare parts.
The company is particularly acquisitive, with over 200 acquisitions over the company’s history. Commodity weakness has hit a number of companies in this space, which could present attractive acquisition opportunities. The company has seven letters of intent in play along with a number of potential prospects above and beyond that. For a net acquirer like NOV, this could provide them a short-term opportunity to pick up a few quality companies at cheap long-term prices.
NOV’s major risk is the potential for a protracted drop in oil prices. If this situation remains as such for a long period of time, it very well could impact NOV’s ability to grow operations and its dividend. NOV is diversified across products and geographies, but they still rely on producers’ capital expenditures budgets. In addition, they’re an aggressive acquirer, which could result in overpaying or integration issues. Lastly, failure of a major component could tarnish NOV’s brand name.
The stock is available for a rock-bottom P/E ratio of 9.27, which compares extremely favorably to not only the broader market, but also NOV’s five-year P/E ratio average of 14.1. Moreover, that five-year average seems cheap itself, considering the quality of the company. The issue here, however is that it’s difficult to forecast where earnings will be in a year from now, especially if the order flow remains low due to protracted weak oil pricing. Nonetheless, this appears extremely cheap for a long-term investor.
I valued shares using a dividend discount model analysis with a 10% discount rate and a 7.5% long-term growth rate. That rate is lower than what I’ve recently used for NOV, as I’m adjusting it to reflect near-term headwinds. However, the long-term story seems more than intact. That growth rate is about 1/3 of what NOV’s been able to produce in EPS growth over the last decade. Factor in a low payout ratio and strong cash flow, and I think this is reasonable. The DDM analysis gives me a fair value of $79.12.
This is a company that’s been around for more than 150 years, so they’ve prospered through much worse conditions than what we currently see today. They have the kind of breadth and diversification across products and geographies that should allow them to continue doing well over the long haul. In fact, between a sizable share repurchase program (more than 10% of the company) and the potential for cheaper acquisitions, it’s possible they’ll exit this period of turbulence in better condition than they entered it in. Fundamentally, this an excellent company.
The stock is down over 37% over the last six months alone, shaving ~$8 billion off the company’s market cap. I have to ask myself whether this company is permanently worth some $8 billion less today than it was just six months ago? This stock appears to be disproportionately punished, even among oilfield services stocks. Of course, I’m pleased with that, as it allows me as well as the company to purchase shares on the cheap. And I’ve been doing just that, as this is the second time I’ve averaged down since initiating a position in the company toward the end of last year. The stock is currently sold for book value, which is just incredible in comparison to other stocks in this space. In addition, that’s about 60% lower than the five-year average.
I’m going to include a couple of other valuation opinions below, as I use these to concentrate my reasonable valuation estimate:
Morningstar is currently revising their fair value estimate due to falling oil prices and reduced expectations for revenue. Up until fourth quarter results were announced, Morningstar rated NOV as a 5/5 star value, with a fair value estimate of $84.00.
S&P Capital IQ just updated their valuation after fourth quarter results were announced. They rate NOV as a 3/5 star hold, with a fair value calculation of $60.00.
This purchase adds $46.00 to my annual dividend income, based on the current $0.46 quarterly dividend.
I’ll update my Freedom Fund in early March to reflect this recent purchase.
Full Disclosure: Long NOV.
What are your thoughts on NOV? Are you interested in picking up energy stocks here? What have you recently been buying?
Thanks for reading.
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