Oil equipment company National Oilwell Varco (NYSE:NOV) reported third-quarter earnings last week, beating analyst estimates as shares shot higher. Revenue grew by 2% year over year, with an EPS of $1.34 beating by $0.02 after adjustments for one-time items. The rig technology backlog grew 9% year over year to a record high of $15.15 billion, displaying strong demand for National Oilwell Varco's products. Let's dig a little deeper into the earnings.
A good problem to have
Reading through the company's conference call transcript, it's clear that National Oilwell Varco's problems are the good kind. Strong demand, and a growing backlog, have put a strain on the company's production facilities. Capacity has been added aggressively over the past few years, but increased outsourcing has led to higher costs and lower margins. Rig tech margins are down from 23.9% in the third quarter of last year to 21.3% in Q3 of this year, and it's certainly not from lack of demand.
One important thing brought up in the conference call was that rigs being delivered now and through the next few years are a new design. As more rigs are built based on this design, production efficiency should improve, as the engineering challenges are largely concentrated at the beginning of production. Management compared the next few years to the 2006-2008 era, a period when the company's operating margin grew from 15.8% to 21.7%. The operating margin was 15% during Q3.
As capacity is increased and efficiency improves, operating margins in the rig tech segment should begin to climb. There has already been some progress, with the rig tech operating margin growing to 21.3% in Q3 from 20.7% in the previous quarter. The company's long-term goal is 24% for the segment, and this could conceivably be achieved by 2015.
Plans for a spinoff
In September, National Oilwell Varco announced plans to spin off its oilfield production equipment distribution business. The new company will represent about 85% of National Oilwell Varco's distribution & transmission segment. There are a couple of reasons why this move is a good idea. First, the new company will have low margins, as the distribution and transmission segment currently has an operating margin of just 5.8%. By separating the low-margin business from the high-margin business, the low-margin business will no longer be competing for finite capital. This will allow the new company to seek out new growth opportunities.
Second, the spinoff will remove conflicts of interest between distribution and National Oilwell Varco's manufacturing competitors. This will allow the new business to sell to the company's competitors, allowing it to expand in a way not possible today.
The spinoff is expected to close by the second quarter of next year, and it should be a positive for shareholders.
Oil services showing strength
National Oilwell Varco is not the only oil support company doing well. Both Baker Hughes (NYSE:BHI) and Schlumberger (NYSE:SLB) recently saw their shares climb as strong demand boosted earnings. Schlumberger's profit grew by 20% year over year, and the company expects double-digit EPS growth to continue into 2014. A seasonal rebound in Canada, along with improvement in Saudi Arabia and Iraq, were the key earnings drivers. Schlumberger derives about two-thirds of its revenue outside of the United States, a mix that is proving very profitable for the company. EPS for the quarter came in at $1.29, beating estimates by $0.04. The stock trades at 15.8 times expected 2014 earnings, so it is significantly more expensive than National Oilwell Varco.
Baker Hughes performed well in the quarter for many of the same reasons cited by Schlumberger. Revenue rose by 8% year over year as the company focused on its global operations. This focus offset low demand for pressure pumping services in North America due to weak natural gas prices. Net income rose 22% year over year as EPS of $0.81 beat estimates by $0.03. Baker Hughes trades at 13.8 times estimates for 2014 earnings, and with similar growth expectations compared to Schlumberger, Baker Hughes looks like the better buy.
The bottom line
National Oilwell Varco is slowly improving its margins as a big backlog and strong demand strains the company's plants. Margins should improve over the next couple of years, and this should lead to solid earnings growth. The spinoff of the distribution business should be a positive for shareholders, and the stock trades at a reasonable valuation given the quality of the company. National Oilwell Varco is a great long-term holding, and it should only get better with time.
Timothy Green owns shares of National Oilwell Varco. The Motley Fool recommends National Oilwell Varco. The Motley Fool owns shares of National Oilwell Varco. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.