Wednesday, November 05, 1997

Varco International, Inc.
(NYSE: VRC)
Phone: 714-978-1900
Website: http://www.varco.com
Price (11/4/97): $66 3/4

HOW DID IT DOUBLE?

Varco International has had quite a run. This oil services company's stock price has risen 10-fold since early 1995 and has doubled in the past four months.

Varco's share appreciation is the result of its participation in the booming oil services sector. Oil rig utilization is now at 95% leading to plans to build new rigs for the first time in over a decade. Varco generates revenue from these new rigs and from the modification of old rigs to handle deep water drilling.

For the first nine months of 1997, net income increased 99% over the same period from last year. Given the steadily increasing order backlog and a nearly two-fold increase in orders compared to the prior year, this growth rate does not appear to be a fluke.

A stock in a hot industry with outstanding financial performance is a good substrate for a double.

BUSINESS DESCRIPTION

Varco International makes several lines of products for use in the offshore drilling industry. These products include top-drive drilling systems that help in horizontal and deep drilling. They also make a line of tools for use on oil rigs, as well as gauges, recorders, and other instruments used on drilling rigs.

Principal competitors include Maritime Hydraulics, National Oilwell, Tesco Corp., and Smith International.

FINANCIAL FACTS

Income Statement
12-month sales: $480.1 million
12-month income: $40.2 million
12-month EPS: $1.24
Profit Margin: 8.4%
Market Cap: $2174.6 million

Balance Sheet
Cash: $6.8 million
Current Assets: $253.1 million
Current Liabilities: $115.0 million
Long-term Debt: $28.6 million

Ratios
Price-to-earnings: 53.8
Price-to-sales: 4.5

HOW COULD YOU HAVE FOUND THIS DOUBLE?

Unless you've been asleep for the past two years, you have probably noticed there has been consistent good news coming out of the oil and gas industry. The oil drilling sector was the #1 performing sector in 1996. There has been ample reason to consider an investment in this industry as day rates for rigs have exploded and capacity utilization has increased.

Varco has been ranked #1 for timeliness by Value Line for over a year now. If an investor wanted a stock in the oil services business, Value Line is a good place to start. Additionally, an investor using Robert Sheard's (TMF Sheard) Unemotional Growth system would have picked up this stock well before the most recent double.

Varco's March 10-K report showed that the company was hitting on all cylinders with order backlog on the rise and a prodigious growth in reported earnings. The company has bested earnings estimates for the past few quarters as well.

WHERE TO FROM HERE?

Are you a believer? That is the big question for investors in the oil services sector. The argument for these stocks is predicated on the assumption of increasing worldwide demand for oil. If oil prices fall and demand weakens, drilling will dry up and so will profits for Varco. Oil industry experts continue to forecast a bullish scenario for oil service stocks. The typical "boom" cycle for these stocks is three to four years, according to a recent article in Barron's.

As for Varco, it currently trades at 29 times next year's earnings estimates. Five-year projections call for 33% annual earnings growth. With estimates of $2.07 per share for the coming fiscal year, the YPEG valuation is $68. So, while the stock is still trading below "fair value," it doesn't appear to be a screaming bargain.

However, the analysts have consistently underestimated Varco's performance, and they have continued to increase earnings estimates. Taking the most aggressive estimates, the valuation is more like $72, a 20% increase from here.

During the market malaise of late October these shares dipped to $52, clearly a bargain given current estimates. Varco International deserves watching for Foolish investors looking to participate in the oil drilling sector. With the current market volatility, opportunity may knock again.

- Mark Weaver, MD, MWEAV@aol.com

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