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National Oilwell Varco Earnings Lag Energy Cycle

Posted: Oct 28, 2008 16:13 PM by Eric Fox

Tickers in this Article: TESO, RDC, SII, NOV

National Oilwell Varco's (NYSE:NOV) recent strong earnings report is deceptive, since much of its business is not directly tied to the drilling cycle. Instead, it mainly consists of selling capital equipment to oil and gas companies. This business will be the last to be cut during a down cycle in energy. Since orders for this equipment lag the drilling cycle, earnings will stay strong longer even if business is deteriorating.

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NOV is an oil services company that provides capital equipment and other products and services to the energy industry. The company has three divisions: rig technology, petroleum services and supplies, and distribution services. It recently purchased Grant Prideco, a manufacturer and seller of drill pipe. Its competitors include Smith International (NYSE:SII), which has a large distribution services segment, and Tesco (Nasdaq:TESO), which manufactures top drives for use on rigs. The LeTourneau Technologies division of Rowan Companies (NYSE:RDC) also manufactures offshore rigs for use in exploring for oil and gas. (Learn about investing in oil exploration by reading Unearth Profits In Oil Exploration And Production.)

A Good Quarter
NOV reported net income of $547.7 million, or $1.31 diluted EPS in the third quarter. Its backlog of orders, a closely watched indicator of business, reached $11.8 billion, a $1 billion sequential increase from June 30. The company even received $2.4 billion in new orders during the quarter despite a fall in commodity prices.

During Q3, NOV reported rig technology division sales of $1.9 billion, or 53% of total revenues. This division is where the company reports all of its large orders for capital equipment, including mud pumps, top drives, cranes, draw works and pipe-hoisting systems. Since some of this equipment has long lead times for NOV to complete, its customers order the equipment far in advance. However, if the downturn is severe enough, the backlog will start to decline.

Strong Backlog
Clay Williams, CFO, provided details on the backlog during the recent conference call:

The backlog term is $1.5 billion for Q4 2008, $5.7 billion in 2009 and $4.6 billion in 2010.
Part of the $2.4 billion in new orders was for contracts for six "deep-water packages".
About 90% of the backlog is directed at international markets, and 66% is directed at new construction of large offshore rigs.

Williams stoutly defended the solid nature of the backlog, and said, "Our backlog contains only contracted work. It does not contain letters of intent for notional projects. Nothing goes into the backlog without a contract. Our contracts on major projects do not permit cancellation for convenience. Our contracts do not allow for cancellation for lack of financing."

The company won’t benefit too much immediately from the fall in the price of steel, which is a major component of equipment that NOV manufactures. Management said that when the company wins an order, it locks in the price of the steel needed to build the equipment. The benefit of falling steel prices will come on new orders.

NOV has an excellent balance sheet with $1.7 billion in cash and debt of approximately $1.5 billion. (Learn more about this financial statement in Reading The Balance Sheet.)

Bottom Line
Since National Oilwell Varco sells capital equipment to its customers, its earnings tend to lag the energy cycle, leading to an anomalous situation where revenues and earnings are still strong even if current business is deteriorating.

By Eric Fox

Eric J. Fox, is the founder of Brittain Capital Management, LLC., which manages the Alesia Fund, LP., a Value oriented long/short investment partnership. You can read more of his views on investments at his blog - Stock Market Prognosticator.

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