3 Reasons National Oilwell Varco's Stock Could Rise

National Oilwell Varco has one thing that hundreds of companies on the market wish they had: the blessing of Warren Buffett as part of his Berkshire Hathaway portfolio. Unlike many of the consumer facing, brand name companies in the Berkshire portfolio, National Oilwell Varco is a company that very few people have heard of, but in the oil and gas industry its name is almost inescapable.

With an almost omnipresent position in the oil and gas industry, there are lots of reasons to believe that NOV's stock will rise over the long term. Let's take a look at three of those reasons and see why National Oilwell Varco should be on your radar.   

1) At the epicenter of major energy industry trends

We are in an extremely interesting time for the oil and gas industry. Over the past decade, we have gone from conventional crude and condensate production being the only game in town to the emergence of tight oil, oil sands, and deepwater production making a significant contribution to global production. Over the next several decades, though, these unconventional sources will become a larger and larger part of the equation. According to ExxonMobil, these sources that were once token players will come to represent over one third of global oil and gas production by 2040.

Source: NOV Investor Presentation

The reason this is so important for National Oilwell Varco is that accessing these unconventional sources of oil and gas require special rigs and equipment. At the same time, many of the onshore and offshore rigs that have been operation for decades are becoming less and less useful. At last count, half of the world's fleet of shallow water jack up drill rigs and 36% of the global deepwater floating drill rig fleets were approaching the end of their economic lives and will ultimately need to be replaced.

When you combine these trends, you get a recipe for incredible growth at National Oilwell Vacro. Why is that? The company happens to be one of the world's largest manufacturers of drilling rigs and equipment. NOV believes that these markets--as well as the market for deepwater infrastructure--will be the key drivers for the company over the next several decades. 

Source: NOV Investor Presentation

2) Building a foundation for decades of sales

One of the most compelling reasons to invest in National Oilwell Varco is its business model. It all starts at the beginning with its rig systems segment where it manufactures the major equipment such as land rigs and offshore drilling packages--the actual drilling equipment on the vessel. National Oilwell Varco has helped many of its customers over the years though the development of standardized designs for these types of equipment. This delivers immense value to customers because it reduces building times and costs as well as reducing maintenance downtime because equipment is interchangeable. 

It's great for customers, but it's even better for NOV because it ensures that customers will keep coming back to it specifically for replacement and aftermarket equipment. Today, the company owns more than 80% of the market for offshore rig drilling packages, and that will continue to grow as new rigs come online and older rigs get retrofitted with modern equipment. These rigs have an average economic life of 30 years or more, and the constant wear and tear of oil & gas drilling will mean customers will keep coming back for more NOV aftermarket equipment.

In fact, the seeds of this movement can be seen in the company's earnings reports already. Since 2011, NOV's rig aftermarket segment has grown sales at an annualized rate greater than 20%. What's even better, though, is that rig aftermarket is the company's highest margin business segment. 

Source: NOV Investor Presentation

Buying big ticket items like new rigs and production infrastructure will always be subject to the up and down cycles of the oil and gas industry, but aftermarket equipment is a much more constant revenue stream because you have to fix and replace broken equipment. With a leading position in the rig market and a highly profitable business selling aftermarket parts, NOV should have decades of revenue growth ahead of it.

3) Generates tons of free cash flow

Sales and business outlook are all well and good, but what really matters is whether a company can translate that into profits for investors. In this regard, National Oilwell Varco not only passes the test, but it blows away the competition. You may not notice the difference between NOV and the other major oil services companies on an earnings margin basis, but when you compare them on a cash flow basis, it doesn't even come close.

Company EBITDA Margin Net Income Margin Free Cash Flow Margin
National Oilwell Vacro 20.95% 10.44% 19.21%
Halliburton 15.6% 9.49% 6.88%
Schlumberger 22.6% 14.03% 12.21%
Cameron International 14.7% 6.98% 4.1%

Source: S&P Cap IQ

This incredible ability to convert sales into cash at a near 20% rate means that management has plenty of excess cash to play with in. Under the helm of recently retired CEO Pete Miller, the company used this excess cash to make strategic acquisitions to increase market share and to diversify into other oil and gas equipment realms. More recently, though, the company is using that excess cash to boost shareholder returns. Since the recent spinoff of its distribution segment into its own company, NOW, NOV management has increased its dividend payment by 77% to a yield of 2.2%, and the amount of cash it generates suggests it could increase it more in the future. 

What a Fool Believes

It's awfully hard to find a reason to not invest in National Oilwell Varco today. Its market leading position in rig equipment manufacturing and its ability to transform those rig customers into lifelong customers through aftermarket parts give it an almost impenetrable economic moat. Add to this that the company can turn those sales into gobs of free cash, and you can see why Berkshire Hathaway loaded up on shares. 

A heads-up to investors, though: This is a company that is operating in a cyclical industry, so it can be subject to periods of feast and famine. So be prepared to ride out the good cycles with the bad while you collect and reinvest those dividends; those who hang on through the good times and bad will be glad they did. 

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