For some reason, Wall Street wasn't a fan of National Oilwell Varco's (NYSE:NOV) most recent earnings report, even though it beat earnings. Then again, understanding the logic of the market's daily movements is a futile exercise. If the earnings weren't enough to win Wall Street over, then perhaps there were some signs in the company's conference call that would give investors hope. Here are five key takeaways from management that should help you better understand what's coming for the company.
1. Signs that orders will be coming in soon
National Oilwell Varco has been at this business for a long time now, and so management has a few market indicators that most of us wouldn't really consider. One of those is called rig cannibalization, as CEO Clay Williams explains:
We believe these spending levels are not sustainable because they support ongoing operations by depleting their inventories of consumables and equipment they have on the shelf or by raiding idled rigs for parts, components, and drill pipe. As oilfield service companies gradually de-stock, they will eventually run out of opportunities to cannibalize their existing fleets, and we expect orders to begin to flow again to NOV, given that oil and gas remains a highly capital-intensive undertaking and that NOV is one of its largest capital manufacturers and suppliers of technology.
All of that equipment that deteriorates needs to be replaced, and today much of that equipment is coming off idled rigs. This is a great one-time way to cut costs, but it can only go on for so long until idled rigs are stripped bare and new equipment will need to be ordered. It can also lead to a major ramp-up in orders as some of those stripped rigs needs to go into service on top of the ones already out in the field.
2. There's a big technology turnover going on in drilling today ...
Even though tapping shale reservoirs successfully has been going on for years now, there are still several technological changes hitting the industry today. Onshore oil and gas producers are looking for rigs that are capable of drilling longer horizontal sections at a faster pace and can move quickly from wellbore to wellbore to efficiently tap several layers of shale from the same drilling pad. While there are a decent amount of rigs that can handle these types of jobs, a majority of them can't. That means there's still plenty of work to be done in converting the existing fleet of rigs to these more capable rigs. As Williams explained:
There [are] a lot of conversations under way around land rigs. And I think, generally, our land rig customers are much more optimistic about recovering commodity prices, driving higher levels of activity. And against that, I would add, it's almost unanimous now, the drilling contractors that we speak to all want to convert their fleets to AC-powered Tier 1 rigs. And they recognize we're in a cyclical downturn. It gets tough to do. They're cutting capex budgets. But longer term, they see, "Hey, this is where the market is going." And to be relevant and to remain competitive in that market, they really need to offer the latest and greatest technologies, and it's a way for them to differentiate themselves against smaller competitors that can't afford to write a $20 million check to buy an AC Tier 1 land rig.
It may not be a fast conversion cycle, since overall demand for rigs is weak today, but there is still an immense amount of opportunity for National Oilwell Varco in restocking the world's land-rig fleet with the new technology rigs.
3. ... and it really works in NOV's favor
The conversion to these AC rigs will have a double effect on the company's bottom line. Many of the companies that do have rigs out there drilling are using those advanced rigs, and many of the parts that could be used from the older fleets aren't compatible with the new rigs, which helps business, according to Williams:
This time around, we will be helped by the fact that a lot of new-generation equipment has flowed into the fleet, so the large overhang of mechanical equipment and SCR equipment will be less usable and less relevant on the new tier 1 AC rigs that the industry is migrating to.
As rig owners and oil-services companies can rely less and less on stripping spare parts from SCR rigs, NOV's aftermarket business segment will benefit. This is extremely promising, since rig aftermarket is the company's highest-margin business.
4. Cutting costs effectively
Just like other oil-services companies, National Oilwell Varco is doing everything in its power to cut costs. While the company is enacting some of the things you'd expect a company to do, it's saving money in one way you might not expect: doing more of its own manufacturing. Here's how Williams puts it:
In the second quarter, we reduced SG&A 14% sequentially and 21% since the end of 2014. Within our cost-of-sales structure, we are in-sourcing much more of our work from outside suppliers, seeking to preserve our core NOV employee base and utilize NOV machine shops and fabrication capabilities as much as possible. Our down-hole tools business decreased outsourced manufacturing spend 58% sequentially. Year to date, we've insourced 36,000 hours into one of our large Rig Systems manufacturing plants. By reducing overtime, winning discounts from our suppliers and high-grading our supply chain across the organization, we were able to increase the margins we achieved on existing project work in Rig Systems. The segment posted 120-basis-point margin improvement sequentially despite a 24% sequential reduction in revenues.
Before the recent downturn in the market, NOV had more orders it needed to fill than what it could manufacture in-house. So it contracted out lots of its manufacturing work to stay on schedule. Now that demand is on the decline, it can take a lot of that more costly outsourced work and do it at its own facilities. Not only is that keeping the company's skilled labor force employed as much as possible, 0but it's also helping to reduce costs and maintain margins.
5. Backlog is declining, but there's still a lot of work available
One of the critical factors for National Oilwell Varco is its backlog. It's been a major source of revenue these past couple of quarters, as new orders have dried up. According to Loren Singletary, VP of investor and industry relations, there was a pretty big draw-down this past quarter.
In the second quarter, we received $313 million in new orders resulting in a book-to-bill of 18%, a moderate increase from Q1. We ended the quarter with a backlog of $9 billion, down 13% sequentially. Of the total $9 billion backlog, approximately 91% is offshore and 92% is destined for international markets. ... Turning to our capital equipment orders and resulting backlog for NOV Completion & Production Solutions, the second quarter saw an order intake of $264 million and recognized $538 million of revenue out of backlog resulting in a book-to-bill of 49% and a quarter-ending backlog of $1.2 billion, down 19% sequentially. Orders were down 19% from the $327 million won in Q1, and of the total $1.2 billion backlog, approximately 71% is offshore and 82% is international.
In most cases, we would like to see a book-to-bill ratio of 100%, which means the company generates just as much new work as the amount going out the door in any given quarter. In this case, the company is burning through its backlog. This is expected, considering the conditions of the present market, but luckily for National Oilwell Varco, it had a pretty large backlog in place before the downturn to keep it afloat. It can't keep burning through its backlog as fast as it has in recent quarters, so investors should watch the company's upcoming quarters to see it it can close the gap between orders booked and orders completed.