Introduction
Within the intricate tapestry of the oilfield services and equipment sector, a distinct pattern is emerging. As I’ve highlighted in past articles (here and here), we’re observing a dichotomy: on one side, a lull in the US drilling activity, and on the other, a robust uptick internationally. This divergence is carving out distinct trajectories for companies, and as it stands, oilfield equipment maker NOV Inc. (NYSE:NOV) is decidedly on the right side. Over six years ago, I wrote about the company during the tumult of an oil price downturn. Yet, even amidst those challenges, I thought NOV exhibited resilience. Today, in a vastly improved environment, NOV has been growing its earnings. Their latest quarterly figures were impressive, and there’s a good chance they’ll sustain this momentum with ongoing revenue and profit growth, better margins, and a potential turnaround in their cash flow situation. It’s a narrative worth diving into.
Earnings Recap
Recently, NOV reported what I think were impressive results for the second quarter, demonstrating both earnings growth and enhanced margins. The company posted revenues totaling $2.09 billion, marking a 21% increase from the same quarter of the previous year and a 7% uptick from the preceding quarter. Each of its three business divisions – Wellbore Technologies (WT), Completion & Production Solutions (C&P), and Rig Technologies (RT) – played a significant role in the sequential and year-over-year growth.
The company’s adjusted EBITDA witnessed a significant leap of 63% year-over-year and 25.6% quarter-over-quarter, culminating in $245 million. This increase was fueled by comprehensive earnings growth across the three segments, notably on a year-over-year basis. WT and C&P showcased robust double-digit increase in earnings both sequentially and year-over-year. On the other hand, RT displayed a 73% annual and an approximately 3% quarter-on-quarter earnings growth.
The adjusted EBITDA margin also underwent a positive shift, reaching 11.7% in Q2 2023, up from 8.7% in Q2 2022 and 9.9% in Q1 2023. This operational excellence translated into a net profit of $0.39 per share, a significant rise from the $0.18 reported the previous year and the $0.32 from the prior quarter.
However, I think it’s essential to highlight one area of concern: NOV’s operating cash flow was reported at a negative $72 million. This setback was primarily propelled by a working capital adjustment to the tune of $300 million. This particular aspect of working capital has been an ongoing financial challenge for the company. Yet, when one excludes the impact of these working capital changes, NOV’s operational cash flow stands at a positive $157 million. After accounting for capital expenditures, which amounted to $76 million, the company’s adjusted free cash flow settles at $81 million, based on this analysis.
In sum, NOV’s pronounced growth in both revenue and profits, accompanied by margin expansion, stands in stark relief against its domestic business climate. This is in contrast to the business environment at home, especially in the onshore market, which remains challenging.
The Environment: Drilling Dynamics
The sector of oilfield services and equipment has been navigating through challenging waters, largely attributed to the reduced drilling momentum in North America. The most recent weekly rig count report from Baker Hughes (BKR) showed another dip in the US’s active oil and gas rigs, bringing the count down to 659 for the week ending on August 4, a decrease from the 664 rigs observed the week prior. This pivotal indicator, often employed to assess the drilling activity, has observed declines 13 times over the recent 14-week span. Year-over-year analysis reveals that drillers have decommissioned 105 rigs, translating to a 14% decrease in the rig count.
The decline in drilling activity is beginning to imprint on the crude oil and condensate production levels in the Lower 48 states where the production remained relatively stable in May compared to April. However, this might be a potential precursor to a production downturn, a shift that usually mirrors the drilling activity trajectory but with a delay of a few months.
This lull in the US onshore market paints a contrasting picture when juxtaposed with the strength observed in the international and offshore markets. It’s noteworthy that while the drilling rig count has fallen sharply on a YoY basis in the US, it has gone up in the international markets. Major players in the international domain, encompassing national giants like Saudi Aramco (ARMCO) and a slew of international oil corporations and independents, have added 128 new oil and gas rigs over the past year, as per data from Baker Hughes. Consequently, regions such as the Middle East and Asia are witnessing a surge in the demand for oilfield services and equipment.
The offshore drilling landscape is undergoing a resurgence, with heightened activity spotted across markets like the North Sea, Brazil, and the Middle East. This revitalization is propelled by a confluence of factors: robust oil price trends, the urgency of energy security, and the growing significance of regionalization. This rise in drilling activity in the international and offshore markets has been underscored multiple times by Schlumberger (SLB), a behemoth in the industry with a stronghold in these territories. This thriving offshore and international drilling activity is the driving force behind NOV’s upward trajectory, compensating for the sluggishness observed domestically.
Positive Outlook
NOV typically gets most of its revenues from international markets, which puts it in a great position to benefit from the increase in drilling activity outside of North America. To put things into perspective, in the initial quarter, a notable 60% of NOV’s revenue was generated from international engagements. This is further bolstered by NOV’s significant footprint in the offshore arena.
In fact, the earnings growth reported by NOV in all of its segments was driven entirely by the strength in the international land and offshore markets, which offset the negative impact of the softness in the US. For instance, the company’s WT segment experienced an upswing in demand, particularly from regions like the Middle East and Africa, and from international and national oil conglomerates venturing into deep-water drilling pursuits. Concurrently, while the C&P arm grappled with a dampened demand in North America, the rise in international and offshore demand ensured NOV’s margin expansion and earnings growth.
The international and national oil companies are ramping up drilling activities across regions such as the Middle East, Asia, West and North Africa, North Sea, Guyana, Brazil, and offshore Mexico. These oil and gas moguls have charted aggressive roadmaps for the upcoming years, a prospect that augurs well for NOV. Such a favorable demand climate has instilled confidence in NOV, hinting at potential price increases that could meaningfully enhance margins.
Additionally, it’s essential to spotlight NOV’s ongoing cost-optimization strategy. This is anticipated to yield annual savings to the tune of $75 million in the next 12 months. Compounding this positive trajectory, NOV is set to transition from previously inked low-margin contracts-borne out of less favorable business climates-to ones promising higher margins. I believe all of this promises a substantive margin escalation in the forthcoming quarters.
However, NOV’s cash flow dynamics experienced turbulence, predominantly due to the pandemic’s ripple effects that led to many foundries ceasing operations. This compelled the company to recalibrate its supply chain and maintain elevated inventory levels, which subsequently impacted its free cash flows. But the silver lining is evident: a transition towards stabilization. As noted in their recent conference call, NOV’s management alluded to the normalization of supplies. While complete rectification of supply chain intricacies might still be on the horizon, the current trajectory suggests an optimistic shift. This alignment is already reflecting positively on NOV’s sales growth and profit margins. Moving forward, this trend will continue and I expect the company to start delivering free cash flows from the near term, possibly from 2024.
Takeaway & Risks
In my opinion, NOV’s foothold in international and offshore markets poises it for continued revenue and earnings growth. Coupled with its ongoing cost cutting efforts, the outlook for margin enhancement remains positive. However, the shadow of supply chain disruptions continues to linger, albeit with expectations of progressive improvement. A fully optimized NOV could soon become a reality, and I expect this to have a positive impact on the company’s shares which should move higher.
NOV stock, however, isn’t looking attractive from a valuation perspective. The company holds a valuation grade of D+ on Seeking Alpha. The company’s shares are trading 14x forward earnings estimates, which shows a 29% premium over the sector median. Due to its weak cash flows which might take some time to improve, its shares are priced 20.4x forward cash flows, a whopping 306% premium over the sector median. I suggest that investors to wait for a dip before buying this stock.
Note that NOV’s investment proposition isn’t devoid of risk. Predominant concerns revolve around the deteriorating US market conditions. Should this downtrend persist or intensify, NOV could witness its robust growth narratives – in revenues, earnings, and margins – coming under pressure. This could not only impede its financial performance but also hurt its stock. Additionally, if cash flow issues persist beyond current projections, it might cast a shadow over its financial health.
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