December 20, 2004
Priti Jain, B.Sc. (Maths Honours)
Research Digest
Ian Madsen, MBA, CFA, Editor, 312.630.9880 x.417
imadsen@zacks.com
www.zackspro.com
National-Oilwell, Inc.
155 North Wacker Drive
(NOI-NYSE)
Chicago, IL 60606
$35.61
Updates from prior report are highlighted
Overview
NOI, based in Houston, Texas, is a worldwide leader in the design, manufacture and sale of
comprehensive systems, components, and products used in oil and gas drilling and production, as well
as in distributing produces and providing supply chain integration services to the upstream oil and gas
industry.
National-Oilwell, like its brethren in the oil services and equipment sector, is dependent on drilling and
production activity and the supply/demand balance of rigs. NOI is generally perceived to be a late-cycle
play. Its earnings are principally generated from new rig construction, refurbishments and upgrades, and
non-capital goods. The non-capital goods earn a much smaller margin and are driven by general drilling
activity. The core of more significant earnings growth comes from new rig construction, followed by
refurbishments and upgrades. New rig construction is dependent on high rig utilization, generally in
excess of 90%, and starts to surface when dayrates increase.
NOI is especially well positioned internationally. National Oilwell has manufacturing facilities in U.S.,
Canada, U.K., France, Norway and China. Saudi Arabia has been a steady market for the company. The
Company has formed a joint venture in China with the largest Chinese rig manufacturer. NOI also has a
team lined up to enter Iraq, and additionally it has considerable activities in Russia, West Africa and
Brazil.
Upgrades and refurbishment activity, and new rigs, are expected to increase as the industry is in the
early stages of a new capital equipment investment cycle. NOI’s earnings are meaningfully leveraged to
its capital equipment sales. With increasing orders and the strengthening pricing environment, the
general opinion of the analysts is highly positive for the upturn in the current cycle.
National-Oilwell and Varco International, Inc. announced that they have entered into a definitive
agreement to merge. Varco shareholders will receive 0.8363 shares of NOI stock in exchange for each
Varco share, resulting in the new company, National-Oilwell Varco, having approximately 168 million
diluted shares outstanding. National-Oilwell and Varco International,Inc merger remains on schedule to
close by the first quarter of 2005.
The key positive and negative arguments are addressed below:



Key Positive Arguments
Positioned for growth (especially for the year 2005) in
the current industry up-cycle having higher orders &
backlog growth rate
Pricing environment strengthening
NOI is the world’s largest drilling rig manufacturer


Key Negative Arguments
Revenues dependent on drilling and production activity
High raw material costs, primarily steel
© Copyright 2003, Zacks Investment Research. All Rights Reserved.
Sales
NOI’s sales are directly related to the level of worldwide oil and gas drilling and production activities.
Third quarter generated revenues of $618 million up 16% sequentially and 24% from 3Q03. Higher sales
volumes from increased demand in both domestic and international drilling markets and better fixed cost
absorption in the company’s manufacturing plants boosted the results. The improved sequential
performance was also due in part to the absence of cost overruns and late delivery penalties that had
plagued the company in the previous quarter. Management expects the revenues in 2005 to be up by
4%-5% and anticipates that revenues from capital equipment business will be up 30% to 50% in 2005
over 2004.
The following table details NOI’s historical and projected sales by segment.
Table updated for Q3
Segment Sales ($ Millions)
Products and Technology
Distribution Services
Eliminations
Consensus Adjustments
Total
1Q04A
305
218
(27)
(0)
496
2Q04A
348
218
(33)
(0)
534
3Q04A
418
233
(33)
4Q04E
426
237
(33)
-
-
619
630
2004E
1,498
906
(125)
(13)
2,266
2005E
1,910
1,022
(131)
00-'03
24.4%
15.0%
23.1%
CAGR
03-04E
13.9%
14.4%
23.1%
04E-05E
27.5%
12.8%
4.8%
20.4%
13.0%
23.6%
-
2,801
Products and Technology (~60% of total sales)
NOI designs, manufactures and sells drilling systems and components for both land and offshore drilling
rigs as well as for complete land drilling and well servicing rigs. The products and technology division of
NOI can be further divided between capital and non-capital goods. Capital goods include complete land
and workover rig packages and offshore rig systems, and other large rig components. Non-capital goods
consist of drilling motors, downhole tools, spare parts, expendable parts and other smaller equipment.
The Products and Technology segment accounts for roughly 60% of company sales and 90% of NOI’s
operating income. Due to the importance of this segment to the bottom line, the analysts focus most of
their attention on it.
In 2003, the majority of NOI’s sales growth was driven by NOI’s acquisitions of Hydrolift, Dec. 2002, and
Mono Pumping Products, Jan. 2003. Hydrolift, acquired for $300 million, strengthened NOI’s position in
the offshore drilling market and helped it gain access to new complementary product lines, particularly
within the FPSO (floating production storage and offloading) market. Mono Pumping, acquired for $87
million, is a manufacturer of power sections for downhole drilling motors and lift pumps, transfer pumps,
grinders and screens. In 2003 revenues were up 43%, primarily due to the above mentioned acquisitions.
Third quarter generated revenues of $418 million up 7% sequentially and 31% from 3Q03. Capital
equipment manufacturing activities recorded revenues of approximately $199 million, or 48% of Product
and Technology revenues. Fifty-two percent of Product and Technology revenues, about $219 million,
were generated from non-capital equipment and system sales during the quarter, up 14% from $192
million sequentially.
Capital equipment orders were up from $185 million in 2Q04 to $333 million in the 3Q04. Backlog also
increased by 30%; as specified in the earlier quarter, the increase to a large extent was contributed due
to Kazakhstan project. The project of Kazakhstan rigs is worth approximately $150 million.The rigs will be
delivered in 2005.
Looking ahead, for the year new, international rig orders should lead to almost 10% revenue growth.
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National-Oilwell continues to see up to 20 rig opportunities, valued between $5 million and $10 million
each in 2005 and into 2006, with most of the international regions (Russia, China, Middle East) coming
up as promising markets. Upgraded equipment for increasingly complex drilling is required. The
accelerating backlog reflects emerging capital spending cycle.
Russia, the Middle East, Southeast Asia, the North Sea, and West Africa are among the strongest
markets. Demand for new land, platform, jack-up rigs or for mud pumps, draw-works, and top drives to
supply rig refurbishment and upgrade programs, is expected to increase (Bear Stearns).
Distribution Services (~40% of sales)
The distribution services segment provides supplies as well as repair and maintenance services through
its network of approximately 150 distribution service centers. The centers stock and sell a variety of
expendable items for oilfield applications and spare parts for NOI’s proprietary equipment.
Like the Products and Technology segment, sales are directly correlated to the general activity level of
E&P activity. Margins are just under 3% and a majority of the sales come from North America. Given the
steady increase in U.S. and Canadian rig counts, revenue and margin growth should be steady to
increasing.
In 2003 sales were up 15%, International growth and Canadian drilling accounted for most of the growth.
Increased drilling activities are expected to lift sales growth by around 12% for the 2004 year.
Third quarter revenues in the distribution business were up 7% sequentially from the previous quarter
and complemented by strong United States performance. Typically, geographical revenue contribution is
50%, 25%, and 25% for U.S, Canada, and the other internationals, respectively.
One analyst (Smith Barney) believes non-capital equipment should grow at least in line with worldwide rig
counts, but Distribution should lag due to NOI’s large exposure to North America.
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Margin
NOI’s historical and near term segment, operating income and operating margins is detailed below.
Tables updated for Q3
Operating Income ($ Millions)
Products and Technology
Distribution Services
Eliminations
1Q04A
23
5
(3)
Consensus Adjustments
Total
Operating Margins
Products and Technology
Distribution Services
2Q04A
35
7
(3)
0
0
26
38
3Q04A
45
8
(4)
4Q04E
49
9
(4)
(14)
(13)
36
41
2004E
153
29
(15)
(33)
2005E
277
36
(17)
00-'03
40.0%
4.0%
3.7%
CAGR
03-04E
-8.5%
101.5%
18.2%
04E-05E
80.7%
22.4%
16.3%
120.2%
-
134
295
39.6%
-21.3%
2003
1Q04A
2Q04A
3Q04A
4Q04E
2004E
2005E
12.73%
1.83%
7.71%
2.52%
10.03%
3.06%
10.80%
3.64%
11.55%
3.71%
10.23%
3.23%
14.50%
3.50%
Products and Technology (~90% of Operating Income)
The mix of capital versus non-capital equipment sold plays a significant role in the operating income of
this segment. Capital goods items generate much larger margins than non-capital goods.
Synergies from the Hydrolift acquisition were expected to generate approximately $10 million in cost
savings. Through the first half of 2003 the company had come up short and margins did not expand as
expected (Lehman). In the third and fourth quarters 2003, margins did improve to about 13.2%, versus
12.4% in the first half, versus almost 14% in 2002. A more favorable product mix was the reason for the
sequential improvement.
The margins though improved sequentially, were low on the year-over-year basis. Similar to the last
quarter the results were adversely impacted as lower-margin projects worked their way out of the
company's backlog. To the extent that future order intake comprises higher profit margin projects – which
is expected over the next 12-18 months - there should be improvement on this front.
NOI is achieving better pricing in its latest backlog additions, suggesting that margins should expand in
2005. The drilling upturn is translating into orders for new rigs and equipment, a trend that may continue
for years (Bear Stearns).
.
Distribution Services (~10% of Operating Income)
Margins have been under 3% in this segment till 1Q04. Management specified that several steps are
underway to improve profitability – including review-underperforming facilities, looking for consolidation
opportunities, cutting overheads, and streamlining some processes.
There has been a marked improvement in the sequential margins, in fact above the expectations of
Management (3.64% above the expected 3.25%).
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Earnings Per Share
Table updated for Q3:
EPS
Consensus
Low
Median
High
# of Estimates
Y-o-Y growth
Quarterly growth
1Q04A
$0.13
-54.3%
2Q04A
$0.25
93.0%
3Q04A
$0.32
27.5%
4Q04E
$0.36
2004E
$1.06
2005E
$2.24
$0.34
$0.36
$0.38
10
$1.04
$1.06
$1.07
11
4.0%
$2.00
$2.23
$2.50
4
111.7%
13.4%
Q3 EPS was in line with the consensus. Some analysts have raised their 2004 EPS estimates based on
increased orders while some have lowered the estimates anticipating weaker returns from Product &
Technology division.
Most of the analysts have maintained their 2005 EPS estimates. The analyst (Goldman Sachs) with the
lowest 2005 EPS estimate lowered its 2005 EPS estimate for NOI (Not Rated) to $1.70 from $1.85
despite higher revenue assumptions due to several factors – higher ’pass-through’ revenues related to
increased integrated project work, a higher mix of activity in logistics intensive foreign markets, and the
volatile raw material cost environment. The higher 2005 EPS estimates providers (Stifel- Nicolaus &
J.P.Morgan) are confident that NOI has strong capital equipment revenues ahead and incremental
increases in capital equipment revenues and margins can add significantly to EPS. Accordingly, given
that the industry is in the early stages of a new capital equipment investment cycle, there is substantial
upside earnings (Stifel Nicolaus).
Target Price/Valuation
With an average target price of $41.12, the target price ranges between $37-$45.
Generally P/E (price-earnings) multiples from 18x - 21x on 2006 earnings and 20x – 24x on 2005
earnings were the most common methodology.
Long-Term Growth
Growth is driven by the level of worldwide oil and gas drilling and production activities. Fundamentals for
an acceleration of capital equipment spending over the near term are generally positive, but this has
been anticipated for some time now and though visibility is improving, hard evidence is only beginning to
emerge. EPS growth over the next few years is significant, and the target prices are based on relatively
high P/Es based on these robust growth expectations.
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Individual Analyst Opinions – Analysts in yellow are updated following Q3 results
POSITIVE RATINGS
Bear Stearns – Outperform ($40): They reiterate their price target and their Outperform rating, believing
that NOI is well positioned for a wave of new investment in drilling assets. They continue to believe that
the merger is positive for NOI shareholders.
First Albany – Buy ($37): They continue to maintain that National-Oilwell is well positioned to benefit
from the strengthening oilfield services capital equipment spending cycle. The pending combination with
Varco International (VRC) will, in their view, further enhance the company's prospects. They reiterate
their Buy recommendation on National-Oilwell shares.
Goldman – Not Rated (Fair value $42): On August 12, they temporarily suspended the investment
rating and price target as the analysts are acting as an advisor in the merger involving NOI and VRC.
They are positive about the merger and are of the opinion that although short-term risks have increased
yet, long term upside has also improved.
Investology Inc – Buy ($39.10): They remain confident that the company has indeed entered a long up
cycle that should result in record revenues and profits in 2005. They reiterate their BUY recommendation
on NOI and maintain their 12-month price target of $39.1.
Raymond James – Strong Buy ($45): They remain very positive on the outlook for National-Oilwell
given the backlog growth and the improved spending by National Oil Companies and rig contractors.
They are maintaining their price target of $45 and Strong Buy rating.
Stifel Nicolaus – Market Outperform ($40): They have been confident for some time that the oilfield
industry is entering the early stages of a new capital equipment cycle. They believe National-Oilwell
management’s optimistic outlook strongly support the expectations. They reiterate their Market
Outperform rating.
J.P. Morgan – Overweight (NA): They believe a strong outlook on capital equipment orders and higher
margins, coupled with attractive relative valuation levels, support their Overweight rating.
Lehman – Overweight ($44): The analyst finds the earnings outlook of NOI as robust given the
company’s growing backlog and dominant rig newbuilding cycle. The stock’s relative valuation should
improve as orders continue to grow and they maintain their Overweight recommendation. The
combination of National Oilwell and Varco International would create a powerhouse in rig equipment and
would be the premier beneficiary of a rig construction cycle.
MSDW – Overweight ($44): They believe the NOI-VRC merger offers the potential for a dominant
position in the capital equipment segment. Both quality and quantity of the backlog is improving with new
orders implying significant earnings improvement for 2005. “Importantly, there is breadth to this cyclical
up turn with new build activity increasing across all segments including land rigs, offshore rigs, and
floating production and storage (FPSO) vessels.” They maintain their Overweight rating and 12-month
price target of $44.
RBC Cap. – Outperform ($37): They believe NOI is already ideally positioned to benefit from a multiyear equipment new build cycle and its competitive position should be enhanced following the completion
of the VRC merger, which they expect to close in early 2005. At about 18x their 2005 EPS estimate, NOI
is one of the more attractively valued stocks in their universe. They reiterate their Outperform rating with
Above Average Risk.
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Smith Barney – Buy-High Risk ($44): Smith Barney increased their price target by $2 to $44. Though
the margins in P&T segment are on the downside but the prices are steadily rising for new projects and
therefore they expect the P&T margins to return to the 12%-13% level in the near-term and rise in 2005.
The new company after merger would be well positioned to capitalize on rising worldwide drilling activity
and capital equipment demand.
NEUTRAL RATINGS
None
NEGATIVE RATINGS
None
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