National Oilwell Varco (NOV) has plunged 43% since last summer, mostly due to the dive in oil prices in the last two months. As a result, the stock is now trading around its nine-year lows. This is a dramatic divergence from the broad market, which stands near all-time high levels. As stocks with such a dramatic underperformance sometimes yield extraordinary returns, the big question is whether National Oilwell Varco has become a bargain.
First of all, the company is expected to post a loss of $0.03 per share this year. While it will be a marginal loss, it will be the fourth consecutive year of losses. Although the price of oil is twice as much as it was at the bottom of the downturn of the oil market, the recovery of National Oilwell Varco has been slow.
However, the company is well positioned to benefit from the ongoing recovery of the energy sector. It generates 67% of its revenues from inland oil production, which is in much better shape than offshore production. Moreover, it generates 46% of its revenues in North America, which enjoys great momentum in its production. To be sure, U.S. oil production has climbed to all-time high levels this year and is expected by EIA to rise to new record levels, around 12.0 M barrels per day, in 2019. As a result, National Oilwell Varco is expected to post a profit of $0.75 per share next year.
Moreover, despite its losses, National Oilwell Varco has posted strong free cash flows in every single year throughout the downturn of the oil market that began in 2014. As it has drastically reduced its capital expenses in recent years, it has posted free cash flows between $640 million and $1.9 billion in each of the last four years.
In addition, the company has maintained a strong balance sheet. It has a current ratio of 3.2 and its net debt currently stands at $2.7 B, which is only about 4 times the free cash flows of last year. Therefore, the company is not likely to have any problem servicing its debt for the foreseeable future.
The great financial shape of National Oilwell Varco is in sharp contrast to the condition of offshore drillers, which have heavy debt loads and poor cash flows and thus need to issue new shares and new debt from time to time. Investors always should check these key factors in order to determine whether a stock can successfully recover from a fierce downturn, such as the recent one in the oil market. Thanks to its strong free cash flows and its healthy balance sheet, National Oilwell Varco can wait patiently until its business recovers toward its pre-crisis level without any casualties (issuance of new shares or high debt). As the demand for oil will continue to rise in coming years, oilfield service providers will see their business rebound at some point in the future. The only challenge for them is to be able to wait without casualties throughout the downturn. National Oilwell Varco certainly can wait without having to issue shares or new debt. Therefore, its shareholders should maintain their patience.
National Oilwell Varco earned $5.82 per share at the peak of the previous cycle of the energy sector. As there has been great technological progress in shale oil production, oil producers can now achieve the same level of output with fewer rigs. Consequently, National Oilwell Varco is not likely to return to its record earnings anytime soon. Ironically, oilfield equipment providers are victims of their own success, as they have enabled oil producers to extract more oil with fewer rigs. On the other hand, as U.S. oil production will continue to rise in coming years, it’s reasonable to expect National Oilwell Varco to achieve earnings per share of at least $2.50 per share in the near future, i.e., less than half of its peak earnings. As the stock is now trading at only 11 times those earnings, it’s certainly cheaply valued. If the valuation of the stock rises to a more reasonable earnings multiple of 15, which corresponds to a stock price of $37.5, the stock will offer a 36% return from its current price. Therefore, its shareholders should wait for the recovery of the stock to unwind.
On the other hand, investors always should remember that cyclical stocks are not buy-and-hold stocks. In cyclical stocks, capital gains of several years can evaporate within a rough year. Therefore, as soon as a cyclical stock offers great returns, investors should be ready to take profits. National Oilwell Varco is not an exception. As soon as it rises to $37.50-$40.00, investors should take those exceptional profits.
To sum up, as the stock of National Oilwell Varco has been beaten to the extreme, it can offer great returns over the next few years, mostly thanks to booming U.S. oil production. Thanks to its solid free cash flows and its healthy balance sheet, the company can easily wait for the recovery of the oil sector to unwind. Therefore, its shareholders should hold the stock until it reverts to a more reasonable valuation level.