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National Oilwell Varco Analysis

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By TMFKitKat
November 9, 2009

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As often happens when you go through a conference call, the comments and insights on the state of the world are just as interesting as the company specifics. National Oilwell Varco has a lot to say about where energy is at and where the opportunities are

Before looking at the company let's look at what they have to say this quarter about the industry in a few areas

Brazil

Petrobras is beginning production in its Santos Basin discoveries. A recent discovery from a fourth well drilled in the BM-S-9 offshore block is estimated at 1.1-2 billion BOE. In case the Santos Basin does not sound familiar, you might have heard of the Tupi field also in the Santos Basin. It is light sweet crude and estimated around 5-8 billion barrels. But its deep at around 7,000 meters.Petrobras is getting a massive amount of funding from China as China unwinds mature US treasuries for commodities. China will initially lend $10 billion. Petrobras estimates they need $174 billion. China will get back 200,000 bb/pd

The Santos field and Petrobras will provide a lot of work in oil services including NOV, FMC, Cameron and Transocean should see revenue.
For NOV recent orders have been frustratingly slow. Long-awaited tenders from Brazil have been slowed by a very tough credit market and rising local content stipulations despite a high level of result by Petrobras following their spectacular deepwater discoveries in the Santos Basin.
However in mid-September, Petrobras formally approved the strategy to build up to 28 new ultra-deepwater rigs and tenders were finally issued for these a week ago, Friday. Specifically, seven drill ships and two semi-submersible tenders were provided to Brazilian shipyards for rigs to be purchased and owned by Petrobras.

Additionally, tenders for new floaters to be purchased and owned by drilling contractors were also sent to 15 companies for new rigs to be predominantly constructed in Brazil. Bids on these were due back to Petrobras late in the first quarter of 2010 and we expect that NOV and/or competitors will begin to see the first contracts flow in backlogs for these tenders sometime in mid-2010, probably beginning in the third quarter.

In general, the evidence of investment in this large basin is an encouraging sign of dollars/reals going into E&P looks good for oil services companies in general and deepwater specialists in particular

Management feels NOV will continue to play an important role in the construction of the necessary tools to develop Brazilian deepwater resources. They are working to expand their in-country presence through a combination of acquisitions and greenfield expansions to supplement existing capabilities

Horizontal Drilling

Horizontal drilling or directional drilling is changing energy production. The reason that horizontal drilling in changing the oil and gas business is that a well drilled sideways through a zone of oil and gas bearing rock, will produce many more times what a vertical well would. This is because a vertical oil or gas well only penetrates a few feet of the oil or gas zone whereas a well drilled horizontally may penetrate several thousand. This also means that previously unproductive rock formations such as the Barnett shale and Bakken oil shale can be productive.

The result is increased production but the technical aspect is difficult and the process is expensive. NOV is continuing to develop expertise in new technologies. Directional drilling is allowing the production of oil and gas from formerly difficult rock formations and has increased estimates of US reserves [especially natural gas] significantly.

Directional drilling now accounts for 62% of the U.S. rig count compared to only 38% five years ago. Bending the drill strength around a 90-degree angle places dramatically higher stresses on the downhole tools and tends to wear them out at a much faster rate. Bits, drilling motors, non-magnetic drill collars, drill pipe, coiled tubing, and all hardware. The result is a well bore that may cost two or three times more than a vertical well, but it can deliver three to five times more oil and gas.

Market Perspective

NOV has been listening to a lot of the drilling contractors' conference calls this past quarter and meeting with them and has the impression there is slow improvement in the jack-up market and some other areas. They are cautiously optimistic about the Gulf of Mexico and see the potential for business to begin to accelerate especially in some of the smaller jack-up arenas.
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The biggest risk is going to be the worldwide economy. The economy and has been crushed globally and that has slowed demand for oil and gas and sent rigs down and cut business for companies like NOV. The speed of recovery for a country's GDP is not going to be uniform and will dictate what happens to the marketplace in the long run. NOV is now cautiously optimistic and believes we have probably hit bottom. That does not mean an instant recovery to high profits but just that the free fall has stopped and as GDPs recover, orders in oil services may start to rise.

Financial

Despite some thawing in credit, E&P customers continue to face difficulties in securing structured financing. Specifically, NOV sees banks requiring much higher levels of equity in projects, typically 25% to 30%, and export and trade financing agencies of many governments are now requiring term contracts from oil and gas companies before issuing guarantees on new rig construction projects. The recovery of the credit markets is proceeding at a decidedly glacial pace, but NOV does notice progress.

Nov is tracking a few positives in financing being done to help E&P with capex investment

In particular there is GIEK, the Norwegian financing group, Export-Import Bank in the United States, the China Development Bank and the Korean Development Bank [Korea Development Bank]. These are all banks that are actively trying to finance projects as long as a lot of the manufacturing is done within those countries [NOV has a presence in those countries as do competitors] NOV has facilities that can hit the local content rules and be able to position them to competitively take advantage of these projects

Overview

National Oilwell Varco -name just rolls off the tongue. It hasn't been around as a corporation all that long. It was incorporated in 1995 but has been around for 140 years. The company has over 40 brands largely as the result of acquisitions

It has been a volatile in its distant past taking 50%-75% drops. Around 2002 it started behaving better and climbed steadily, hitting hyperdrive during those glorious bubble years in 2007-2008. Then it suffered a 90's flashback and dropped 76% --along with most oil services companies [OSCs].

NOV is not just another services company. It has all the accoutrements most OSCs have but also specializes in rigs -both offshore and land

Products are arranged by category and there are too many to mention. They cover just about every area of drilling and production and that has become increasingly important as E&P companies are looking to bundle services and equipment rather than go shopping across a large number of companies.

Business Segments

Rig Technology

A description of Rig segments offerings from the company. Presented here to show the all-inclusive nature of products-important now as E&P companies try to bundle and one-stop shop to get better pricing. NOV does everything from the actual rig to pressure pumping.

Rig Technology segment complete systems for the designs, manufactures, sells and services drilling, completion, and servicing of oil and gas wells. The segment offers a comprehensive line of highly-engineered equipment that automates complex well construction and management operations, such as offshore and onshore drilling rigs; derricks; pipe lifting, racking, rotating and assembly systems; rig instrumentation systems; coiled tubing equipment and pressure pumping units; well workover rigs; wireline winches; wireline trucks; and cranes.

Petroleum Services & Supplies

Petroleum Services & Supplies segment provides a variety of consumable goods and services used to drill, complete, remediate and workover oil and gas wells and service pipelines, flowlines and other oilfield tubular goods. The segment manufactures, rents and sells a variety of products and equipment used to perform drilling operations, including drill pipe, wired drill pipe, transfer pumps, solids control systems, drilling motors, drilling fluids, drill bits, reamers and other downhole tools, and mud pump consumables.

Oilfield tubular services include the provision of inspection and internal coating services and equipment for drill pipe, line pipe, tubing, casing and pipelines; and the design, manufacture and sale of coiled tubing pipe and advanced composite pipe for application in highly corrosive environments. The segment sells its tubular goods and services to oil and gas companies; drilling contractors; pipe distributors, processors and manufacturers; and pipeline operators.

Distribution Services

Distribution Services provides maintenance, repair and operating supplies and spare parts to drill site and production locations worldwide. In addition to its comprehensive network of field locations supporting land drilling operations throughout North America, the segment supports major offshore drilling contractors through locations in Mexico, the Middle East, Europe, Southeast Asia and South America. Distribution Services employs advanced information technologies to provide complete procurement, inventory management and logistics services to its customers around the globe.

Segments as a percentages of revenue

These percentages do not account for the corporate intersegment revenue The totals are more than 100%. Corporate is a negative and brings it back to 100%


[See Post for Tables]

It is clear that increasing business in rigs and keeping backlog high is critical-two things that are not happening at present

As the other two businesses drop off, rig is becoming a larger part of revenue. It is living off backlog and new orders are noticeably slow. Other products don't have the backlog to draw down. They immediately lose revenue as orders drop.


[See Post for Tables]

Since Q3 2008, new orders for rigs are disappearing. The disappearing orders create a disappearing backlog. If orders do not begin to come in over the next few Qs, revenue is going to begin to converge with quarterly orders and at present for the rig segment, that would be $330 million per quarter. This scenario seems unlikely but it does give a sense of how much further things can go down if Petrobras does not come through by 2010 or if the competition gets more than the usual share of the market

New orders Q3 2009

Gross orders were $333 million, which included some jack-up equipment but no floaters. Orders were partly offset by total cancellations out of backlog of $72 million, including some small capital equipment items

Backlog Q3 2009

The backlog for capital equipment sales in Rig Technology declined 15% to $7.3 billion from its June 30 levels

They expect Q4 shipments out of backlog to total about $1.3 billion, down from Q3, which would bring full-year revenues out of backlog to about $6 billion. As of September 30, they had orders scheduled to shift in 2010 totaling about $4.7 billion, and another $1.3 billion scheduled to go out in 2011. 89% of backlog is offshore equipment and 11% is land, which tends to turn much more quickly since it is not gated by hull construction schedules in a shipyard. 93% is for international locations and only 7% is for the U.S.

Overall, they view approximately $334 million of backlog, about 5% is being in arrears and at risk, and a total of $306 million canceled over the past 12 months, about 3% of peak backlog of $11.8 billion a year ago. This compares to gross orders of a little over $2 billion during the past 12 months.

Needless to say, recent orders have been frustratingly slow. Long-awaited tenders from Brazil have proven more languid than we expected when we started the year, stumbling through very tough credit markets and rising local content stipulations despite a high level of result by Petrobras following their spectacular deepwater discoveries in the Santos Basin. But we have good news to report. In mid-September, the executive order Petrobras formally approved the company's strategy to build up to 28 new ultra-deepwater rigs and tenders were finally issued for these a week ago, Friday. Specifically, seven drill ships and two semi-submersible tenders were provided to Brazilian shipyards for rigs to be purchased and owned by Petrobras.

Additionally, tenders for new floaters to be purchased and owned by drilling contractors were also sent to 15 companies for new rigs to be predominantly constructed in Brazil. Bids on these were due back to Petrobras late in the first quarter of 2010 and we expect that NOV and/or our competitors will begin to see the first contracts flow into our backlogs for these tenders sometime in mid-2010, probably beginning in the third quarter.

Although this is later than we expected, and as a result we will fall short of our earlier 2009 order guidance, we are nevertheless very pleased to see concrete progress on this long-awaited event. In the meantime, we continue to pursue booking a handful of orders for other new deepwater rigs for Brazil from the 12 new rigs awarded term contracts in 2008, but these also continue to face financing challenges. We have seen some progress with these and may be able to book some or all of these in the fourth quarter of this year and we'll let you know on an update again in our next call.

We are confident that NOV will continue to play an important role in the construction of the necessary tools to develop Brazilian deepwater resources, and our team is ready to help. We are working to expand our in-country presence through a combination of acquisitions and greenfield expansions to supplement our existing capabilities, which include one of our technical colleges in Macae where we train Brazilian professionals to maintain and to repair sophisticated NOV drilling equipment. We are confident that we will be able to achieve the local content goals of our customers on each projects, which escalate from 20% to 50% through the progression of the new program.


The following are the categories of equipment and services with links just to give an idea of what they look like. It's better than just listing everything.

Down hole -for drilling, completion, repair, service

http://www.nov.com/Downhole.aspx

Drilling

http://www.nov.com/Drilling.aspx

Engineering and project management

http://www.nov.com/Engineering_and_Project_Management.aspx


Lifting and handling

http://www.nov.com/Lifting_and_Handling.aspx

Production

http://www.nov.com/Production.aspx

Supply chain

http://www.nov.com/Supply_Chain.aspx


Tubular and corrosion control

http://www.nov.com/Tubular_and_Corrosion_Control.aspx


Well services and completion

http://www.nov.com/Well_Service_and_Completion.aspx

The global reach is good-NOV is in over 800 locations across six continents. Over the past three years the split has been consistently 57% of revenue is US and 43% is international.


With all the acquisition activity, it's useful to look at return ratios, debt levels and goodwill. Most of NOV's acquisitions are small. There have been two major acquisitions - Varco and Grant Prideco. The company has kept debt low using a combination of cash and equity to fund the acquisitions.

The Varco merger was in 2004. The total purchase price is $2,579.3 million

Nov issued 84 million shares to acquire Varco at $29.99 per share
For $2,518.4 million.

The 2008 Grant Prideco merger total purchase price was $7,199 million,

NOV issued approximately 56.9 million shares at $72.74 per share for
$4,135 million of the purchase price. Cash paid was $23.20 per share for $2,932 million. Total purchase price was $7,199 million

The Grant Prideco merger further strengthened National Oilwell Varco's position as manufacturer to the oilfield. Its drill bits and reamers are being integrated into NOVs offering of drilling motors, non-magnetic drill collars, jars and shock tools, to complement its package of bottomhole assembly tools used to drill complex wellpaths. Complex well paths are becoming increasingly common and this will be an important part of being able to provide comprehensive bundled services.

Additionally, Grant Prideco's drillpipe products are purchased and consumed by the NOVs existing drilling contractor customer base. The consumption of drillpipe per foot of hole drilled, or per rig running, has been increasing due to the rising complexity of wellpath designs. Overall the acquisition better positioned National Oilwell Varco to capitalize on continued application of horizontal, directional and extended-reach drilling, through both drillpipe and drill bit product sales.

The returns on capital and equity have improved through 2007 - confirmation that the company is making good decisions. The ROE is not distorted by outsize debt levels. It has fallen off LTM as revenue and operating income decline.


[See Post for Tables]


They have lots of cash. Total debt has never been much higher than current levels. Shares in 2004 were 171 million and are now 416 million. The increase is 245 million. Of that 141 million were for the two big mergers. Since 2004 approximately 21 million in options have been exercised.

Other acquisitions

Other acquisitions are mostly smaller bolt on types. NOV prefers to buy in cash and the strategy is to grow when the market is down.

2008

In addition to the Grant Prideco Merger, they made nine acquisitions for an aggregate purchase price of $170.7 million net of cash acquired.


  • Welch Power Source, L.L.C., a Louisiana-based manufacturer of power generation equipment.

  • CKS, a France-based solids control company.

  • Mid-South Machine, Inc., a Louisiana-based machine shop.

2007

NOV completed eight acquisitions $286.9 million consisting of cash of $285.8 million and notes payable of $1.1 million. These acquisitions included:

  • Gammaloy Holdings, L.P., a Texas-based manufacturer of downhole tools.

  • Kreiter Geartech, a Texas-based manufacturer of gearing products.

  • Sara Services and Engineers Pvt. Ltd., an India-based manufacturer of oil field equipment.

2006

In December 2006, NOV acquired 87% NQL Energy Services a provider of downhole tools, technology and services used primarily in drilling applications in the oil and gas and utility industries on a worldwide basis, for $253.8 million. The remaining 13% of NQL was acquired in January 2007

There were nine additional acquisitions for $85.3 million consisting of cash of $75.9 million and notes and accrued payables of $9.4 million.
These acquisitions included:

  • Rolligon Ltd., a Texas-based manufacturer of coiled tubing support units and related equipment.

  • Soil Recovery A/S, a Danish-based designer and manufacturer of soil recovery units used to process drilled cuttings for final disposal.


NOV acquires a lot companies but they are small acquisitions for the most part and largely paid in cash. This is how they have built the company. So far it is working. They like to wait for low prices and then strike.

Q3 Consolidated

NOV net income was $385 million or $0.92 per fully diluted share on $3.1 billion in revenue in Q3

Q3 consolidated revenues improved 3% from Q2, but fell 15% from the Q3 2008 when the worldwide rig count was 39% higher.

Operating income was $618 million, excluding $17 million in pretax transaction and restructuring charges in Q3. Operating margins were 20%, up slightly from Q2 pro forma results [excluding charges] and down 2.7% year-over-year.

Softer demand has produced mounting pricing pressures for rig equipment with pricing declines of 10% to 15% for offshore equipment and 15% to 20% for land rigs compared to last year. Better execution and cost experience has enabled NOV to offset some, but not all, of the recent price pressure.

Gross margins were flat with the second quarter at 29.1%. SG&A declined $9 million sequentially to 9.1% of revenues compared to 9.6% in the second quarter. Other expense improved $25 million on lower FX expense, which was a $6 million debit in the third quarter in addition to bank fees and other items on this line, totaling about $7 million in Q3.

The tax rate was 33.2%, slightly above guidance of 32% due to a prior-year return to provision adjustments and other discreet items

CapEx declined again to $43 million, down another $21 million sequentially. CapEx for the full year should end up below $250 million.

Working capital on this basis equaled 17.8% of annualized revenue, down from the second quarter.

Cash flow from operations was $684 million, and less CapEx of $43 million, yielded rough free cash flow for the quarter of $641.

NOV remains exceptionally well-positioned and well-capitalized with $3.2 billion in cash and a $2 billion revolving line of credit

Results by segment

Rig Technology revenues were $2 billion [$3.1 billion consolidated] in the third quarter, up 4% both sequentially and year-over-year. Operating income was $579 million with operating margins of 29%. Incremental leverage or flow-through was 52% from the second quarter and 105% from the third quarter of last year.

Revenue out of backlog was $1.6 billion out of $2 billion total rig revenue. The company is not generating much new business as it has increased its use of backlog -- up nearly 20% over Q3 2008. Backlog use was increased 12% sequentially and 17% year-over-year.

Third quarter aftermarket sales and services, which accounts about 17% of the group's mix, were flat with the second quarter. Small capital equipment sales fell sharply from the second quarter to the third. Approximately 2/3 of the group's aftermarket revenues are derived from offshore markets and 1/3 from land.

Seven new offshore rigs were delivered, bringing the total to 66 delivered so far this cycle.

Pricing pressures are mounting and day-to-day expenditures on both CapEx and OpEx for rigs still remains very tight. Lower demand has reduced production volumes to 50% to 70% of 2008 levels. Underutiilzation at these levels

Rig operating margins have increased with utilization of the contracted backlog at better pricing. NOV says it has not dumped a lot of low margin projects into the backlog just to make it look better in the short-term.This margin performance would tend to support that. It was 26% in Q3 2008 and is at 29% now. The other two segments have dropped margins precipitously

Petroleum services/supplies

Demand for pressure pumping and coiled tubing equipment in North America remains weak, but a handful of international markets like North Africa, India and China appear to be picking up, albeit at lower pricing. Operating margins are at 10% --down from 23% in 2008.


Wireline equipment demand has remained steady for international markets. The group is bidding a number of North Sea platform upgrades and FPSO projects for cranes, riser pull systems offloading a mooring equipment that likely won't be ordered until 2010.

Looking into the fourth quarter, we expect Rig Technology revenues to decline in the high single-digit percent range at higher decrementals, producing operating margins in the mid-20s.

The segment generated total sales of $882 million down 3% from the Q2 2009 and down 33% from Q3 2008. Operating profit was $86 million, [excluding transaction in restructuring charges], down $10 million with operating margins down to 9.8

Sequential decremental leverage or flow-through was 32% and year-over-year decrements ran at 57%

Decremental explained

Decremental margin boils down to this: It is effectively the opposite of operating leverage, or the degree to which each dollar of incremental income adds to profits. Businesses have certain fixed costs necessary for a certain level of sales; when sales are rising, executives ramp up their business to meet new demand, adding workers, production plants and raw materials needed to make the goods. But when sales evaporate, as is happening across so many industries today, companies aren't as adroit at pulling their costs back out of their production process. S&P data indicate that cumulative sales for the S&P 500 companies so far in this quarterly reporting season are down almost 9%.


When incremental dollars are adding to revenue, they are doing it more and more efficiently as fixed costs decline per dollar made. In the reverse, all NOV's fixed costs are making each dollar cost incrementally more, lowering margins and earnings. The company is severely underutilized and the best fix for that would be increase the dollars coming in. Cost cutting helps and preserves margins for awhile and NOV has margins intact in the backlog. But as we work through the backlog, without increased new orders and revenue, expect that decremental margins may hit harder.

Sales of bits and downhole tools improved in North America, but international demand for these fell in Saudi Arabia and Europe, driving sequentially lower results.

Drill pipe revenues were roughly flat with the second quarter, but margins improved due to more favorable mix of premium pipe for new offshore rigs and lower steel costs.

Drill pipe backlog in sales are expected to continue to decline due to the current oversupply, which is not likely to turnaround before the second half of 2010.

Overall, the Petroleum Services & Supplies group generated approximately 42% of its total revenue from North American markets and 58% from international markets. Within the international portion, declining sales to Europe and Russia were offset by growth in the Middle East, Africa and Latin America.

Looking into the fourth quarter of 2009, Petroleum Services & Supplies will decline modestly again as improvements in downhole tool, coiled tubing and other modest products sales increases fail to fully offset expected declines in drill pipe revenues. Margins should stabilize in the high single-digit range.

Distribution Services

Revenue totaled $306 million in Q3, about flat with the second quarter and down 39% from the third quarter of 2008. Operating income was $7 million, down $3 million from the second quarter and operating margins were 2.3%, down 1% from the second quarter. The sequential decline in profitability arose from lower pricing, a decrease in supplier rebates on falling annual sales volumes and lower margins on industrial products and artificial lift. Compared to third quarter of 2008, decremental third quarter leverage was 19% on the 38% sales decline.

Domestic sales were roughly flat sequentially, but Canada increased emerging for seasonal break up at good incrementals. Total North American revenue mix grew slightly overall sequentially to 71% and international sales declined sequentially and accounted for 29% of the group's third quarter revenue.

Pricing pressures appear to be stabilizing across North America but many operators are feeding up much more of their work, which has enabled the group to win some incremental MRO contracts during the quarter. Not surprisingly, unconventional shale plays in the Marcellus, Haynesville and Bakken are some of the most active North American markets, and distribution continues to expand its presence in these areas, as well as expand in Russia. Lift sales in New Mexico are expected to pick up in Q4 after a third quarter pause. Activity in Argentina was hindered by labor issues which affected both Distribution and Petroleum Services & Supplies in the third quarter. For the fourth quarter Distribution Services revenues should improve in the low single-digit percent range at modestly better margins.

Cyclical business and changing drilling environments

This recent downturn follows an extended period of high drilling activity that fueled strong demand for oilfield services between 2003 and 2008.

Incremental drilling activity through the upswing shifted toward harsh environments, employing increasingly sophisticated technology to find and produce reserves. Higher utilization of drilling rigs tested the capability of the world's fleet of rigs, much of which is old and of limited capability. Technology has advanced significantly since most of the existing rig fleet was built.

The industry invested little during the late 1980's and 1990's on new drilling equipment, but drilling technology progressed steadily as oil services companies continued to invest in new and better ways of drilling. As a consequence, the safety, reliability, and efficiency of new, modern rigs surpass the performance of most of the older rigs at work today.

Drilling rigs are now being pushed to drill deeper wells, more complex wells, highly deviated wells and horizontal wells, tasks that require larger rigs with more capabilities. The drilling process effectively consumes the mechanical components of a rig, which wear out and need periodic repair or replacement. This process was accelerated by very high rig utilization and wellbore complexity. Drilling consumes rigs; more complex and challenging drilling consumes rigs faster.

The industry responded by launching high numbers of new rig construction projects since 2005, to retool the existing fleet of jackup rigs (according to ODS, 74 percent of the existing 446 jackup rigs are more than 25 years old); to replace older mechanical and DC electric land rigs with improved AC power, electronic controls, automatic pipe handling and rapid rigup and rigdown technology; and to build out additional deepwater floating drilling rigs, including semisubmersibles and drillships, to employ recent advancements in deepwater drilling to exploit unexplored deepwater basins. Declining dayrates may accelerate the retirement of older rigs raising demand.

As a result of these trends NOV Rig Technology segment grew its backlog of capital equipment orders from $0.9 billion at March 31, 2005, to $11.8 billion at September 30, 2008. However, as a result of the credit crisis and slowing drilling activity, orders have declined below amounts flowing out of backlog as revenue, causing the backlog to decline.

There was huge pent up demand for new rigs that could handle new drilling techniques and new harsh environments like ultra-deepwater. Happily for oil services companies, it coincided with record profits and created more demand than capacity and oil services companies built big backlogs and raised prices. That has effectively evaporated. And that makes NOV a little tricky over the next year or two.

Guidance

There was no actual guidance numbers given

Expect rig operating margins to decline a few percent as less backlog is turned into revenue. The company expects only $1.3 billion will be from backlog in rigs in Q4 compared to $1.6 billion in Q3. With fewer new orders, overall rig revenue has a chance of dropping below $2 billion.

NOV will sell backlog of $1.3 billion in Q4 2009, $4.7 billion in 2010 and $1.3 billion in revenue in 2011. As they win orders in the coming fourth quarter and into 2010, some of that may be revenue in 2010. That may have some upward bias on revenue guidance.

In Q4 2009, Petroleum Services & Supplies revenue will decline modestly again as improvements in downhole tool, coiled tubing and other products sales increases fail to fully offset expected declines in drill pipe revenues. Customers have big backloads of their own in inventory and are not likely to sell those down enough to start buying from NOV in Q4. They expect margins to stabilize in the high single-digit range.

Distribution was not mentioned in guidance other than revenues were expected to improve in the low single-digit percent range at modestly better margins.
There are a few near-term concerns with NOV. Over the long haul this is everything I have ever looked for in an oil services company.

Orders are coming in at a slow pace -- biblically slow to steal a phrase. Slow as the tectonic plate separations. Slow as trying to squeeze frozen honey out of one of those bear dispensers. You get the picture.

While NOV is slated to burn through $6 billion in backlog between now and the end of 2010, new orders this Q were $333 million. Doing some rough math:

There would be $1.3 billion in backlog at the end of 2010

Assume orders in 2010 do not get the benefit of Petrobras and 4 quarters at $340 million is $1.4 billion. Totals at the end worst-case scenario would be a backlog of $2.7 billion - less than the burn rate in 2010 going forward. This seems unrealistically dire

Management is already predicting orders to hit in the third quarter of 2010. There are no estimates yet

The other two segments are slightly down for Petroleum products to slightly up in distribution. There is not enough improvement to offset delayed orders from these smaller units. The first half of 2010 may be especially bleak as backlog could dwindle to $4 billion in the absence of big orders and depending on timing of deliveries. That is down from almost $12 billion in Q3 2008. NOV revenue has not been hit as hard as it could have been as the company lives off previously booked business - like a bear in hibernation.

Estimate for 2009

It would look like the Rig segment could decline below $2 billion in Q4 2009; Petroleum services will be slightly under $882 and Distribution could be a few percent above $306 million. Total revenue might come in around $2.5-$2.8 billion down from $3.08 billion in Q3. If net margins are at 10%, net earnings would be $300 million- $336 million with a predicted EPS of 72¢-81¢--down from Q3 92¢

2009 EPS would be $3.38-$3.29. NOV earned $4.11 in 2008.
Forward PE would be 12.7 at high estimate and a PE of 13 at the low estimate. The company informally guessed they might earn $3.50 in 2009

While this is an incredible company and I wish I would have caught them a few months ago. Most of the oil services sector looks fairly priced and many of them have run up with the price of oil even though most of them are looking at softer pricing, slower orders, delayed projects, and a rig count that is not recovering. In spite of it all, they have appreciated significantly. It's always hard to know how far ahead the market is pricing things. Maybe it's looking out to 2012 and any rough spots in 2010 will be ignored. I tend to think not and as oil services remain slow into 2010, prices may drop to bargain levels again.

In NOV there is a huge amount of uncertainty for me maybe going all the way to 2011. I am absolutely certain this will be an excellent company to hold into the next cycle but at the present price I am wondering if that expectation is already in the price. For now it's a wait and see what happens. I would expect some positive headline boost in price per share in the first half of 2010 when the contractors are awarded the deepwater rigs from Brazil.

A DCF is not a great tool for measuring a cyclic company, but I gave it a shot

[See Post for Tables]

Terminal growth is 2% with lower margins

I used the average capex and cash acquisitions over 5 years. They do use a fair amount of equity to make bigger acquisitions but prefer cash for the smaller buys.

Margins contracted by 2% from Q3 until year 6 then return to 25% EBITDA margins.

Discount rate is 11% and WACC is 10.6%. With ROIC at almost 13% even with decreasing earnings, it still creates a positive spread.

By year 10, revenue has a little more than doubled to $29 billion. It has doubled since 2006. Acquisitions have been a key part of the growth strategy

I usually leave the discount rate around 11%. It makes a big difference where you set it. NOV does not seem sufficiently risky to take it much higher. You cold argue that the cyclical nature makes it more risky and I wouldn't disagree.

At 11% the output looks like this


[See Post for Tables]

The company does not exercise abusive amounts of options. The overhang is 1.9% of total shares.

Finally an interesting exchange between an analyst and the CEO. The first part is an estimation of what Petrobras might add to revenue with just 4 rigs per year.

The last paragraph is the view of the future of deepwater the company sees.

William Herbert

I guess where I'm trying to go is this, I mean Petrobras has come out and again approved, if you will, of the additional 28 rigs that it's going to build. Assuming you get 50% market share plus with regard to those is probably, I do it now, something approaching five Petrobras floaters per year. Let's be conservative and assume, you get one additional floater outside of Petrobras per quarter, so call that four per year, you've got your call it run rate of $300 million to $350 million in non-floater-related orders per quarter that probably moves higher as well. In other words, getting to an environment where you're generating normalized orders, I've call it $3.5 billion per year. That's not necessarily illogical, is it?

Merrill Miller

No, not all. As a matter of fact, I think we'll look back. I mean this has been an abnormal year and it's been an abnormal year, not so much because of the Oil and Gas business as much as robot economy. And I think as you look to the future, I think looking at numbers like that is not abnormal. I think you'd start to throw in land rigs and you start to think about the technological advances on land rigs. You start to take a look at the fact that the clock keeps ticking on rust. And we've said this for a long time and we're adamant about it and I think you're going to see more jackup rigs, there are going to be any, we sold jackup equipment this quarter and the fact of the matter is, that those are not I think abnormal numbers at all to project into the future.

William Herbert

And Clay, when with distill that into -- in earnings number, with PSS improving as well. Conservatively, I don't know, 350 a year in earnings per share, free cash flow, north of $1.5 billion per year something like that?

Clay Williams

The nice thing about is we spent a lot of times sort of mesmerized by this backlog, but the truth is the business is actually much smoother than that. Orders are volatile, as Pete mentioned are subject to cut off, if you look at our earnings and our cash flow because in particular these deepwater rigs are built over two or three or four years, their earnings performance is actually quite level and that makes it a much easier business to run. Bill also, I think it's worth nothing with regards to the deepwater environment a couple of things. First, Petrobras has done an amazing job [indiscernible] on how the drill through a lot of salt. And as the world's population of wells that have successfully penetrated 6,000 feet of salt grows as they continue to drill down there. I think that technology is going to find its way into other basins. So you're effectively opening up new frontiers with that technology. Secondly, as deepwater development progresses, you build out infrastructure, you build out gathering systems such that the incremental costs of new fields in that basin. The economics look that much better because they're not having to carry the expense of line of pipeline all the way to the beach. And so I think those two things along with the other technological advancements in this space mean you are likely to see sort of an acceleration over the coming decade plus of interest in these deepwater environments and that requires a lot of rigs and that's what we're here for.