Is National Oilwell Varco Destined for Greatness?

Every investor can appreciate a stock that consistently beats the Street without getting ahead of its fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with improving financial metrics that support strong price growth. Let's look at what National Oilwell Varco's (NOV -1.51%) recent results tell us about its potential for future gains.

What the numbers tell you
The graphs you're about to see tell Varco's story, and we'll be grading the quality of that story in several ways.

Growth is important on both top and bottom lines, and an improving profit margin is a great sign that a company's become more efficient over time. Since profits may not always be reported at a steady rate, we'll also look at how much Varco's free cash flow has grown in comparison with its net income.

A company that generates more earnings per share over time, regardless of the number of shares outstanding, is heading in the right direction. If Varco's share price has kept pace with its earnings growth, that's another good sign that its stock can move higher.

Is Varco managing its resources well? A company's return on equity should be improving, and its debt-to-equity ratio declining, if it's to earn our approval.

Healthy dividends are always welcome, so we'll also make sure that Varco's dividend payouts are increasing, but at a level that can be sustained by its free cash flow.

By the numbers
Now, let's take a look at Varco's key statistics:

NOV Total Return Price data by YCharts.

Source: YCharts.
*Period begins at end of Q3 2009.

NOV Return on Equity data by YCharts.

Source: YCharts.
*Period begins at end of Q3 2009.

How we got here and where we're going
Varco isn't putting forth a particularly impressive performance here. Its negative free cash flow has dragged down several metrics, and the stock's growth has also begun to outpace earnings per share. Can Varco turn these weaknesses around next time and hopefully earn more than just three out of nine passing grades?

Part of Varco's problem is one endemic to the entire oil and gas industry, which is having a difficult time increasing its output after years of impressive growth in unconventional plays. This is less of a problem for Varco than for most, as it's well positioned in the booming field of offshore drilling. Varco's CFO confirmed the potential here in the company's latest conference call, pointing out that offshore rigs are being embraced more than ever before. ExxonMobil's (XOM -0.73%) projections concur with this shift toward deepwater drilling -- only oil sands are expected to see volume growth to as great a degree as deepwater.

However, that doesn't mean that Varco has a free ride. Declining free cash flow is a worry for any company, and aside from Weatherford International (NYSE: WFT), Varco's free cash flow levels have declined more steeply than almost any other major drilling-services company:

NOV Free Cash Flow TTM data by YCharts.

Halliburton (HAL -1.52%) is neck and neck with Varco in terms of three-year percentage declines, and even giant Schlumberger (SLB -0.56%) has suffered. None of these companies is in as deep a hole as Weatherford, but this chart provides a counterpoint to the claim that any one oilfield-services company is substantially better than its peers.

This is an incomplete counterpoint, however. Varco's acquisition spree has sapped more than $3 billion  from its cash flow over just the past four quarters. Schlumberger's spent less than $1 billion and has taken on far more debt in the same time period. Halliburton has made no acquisitions in the past four quarters. Since Varco's been spending so heavily on new additions, it stands to reason that once this buying spree is over, the company will see a major surge in free cash flow. That will go a long way toward earning Varco some additional passing grades when we examine it next time.

Putting the pieces together
Today, Varco has some of the qualities that make up a great stock, but no stock is truly perfect. Digging deeper can help you uncover the answers you need to make a great buy -- or to stay away from a stock that's going nowhere.