NOV (OP/A), CAM (IL/A): NOV upgraded to OP/A, CAM downgraded to IL/A May 16, 2006
We are upgrading National Oilwell Varco (NOV) to OP/A, from IL/A, for 3 key reasons:
(1) We are more confident about execution after solid 1Q and a recent meeting with management;
(2) We think NOV underperformance is overdone. Since we launched coverage (3/28) NOV is up 5% vs CAM +17% and OSX +6%. We now see 28% upside for NOV vs 20% for CAM.
(3) We see ample room for NOV to beat estimates following 1Q as we are 3.6%/7.1% above consensus for ?06/?07. The impact of better pricing should be more explicit on NOV results in 2Q and especially 3Q, which should be the key catalyst. NOV is now our favorite vehicle to play the "backlog" theme with a great combination of visibility and growth. Our downgrade of Cameron International (CAM) to IL/A is purely on valuation after recent outperformance, as our positive views on the company's fundamentals and management execution is unchanged. CAM remains our favorite vehicle to invest in subsea.
RECOMMENDATION UPDATE: NOV IS ONE OF THE BEST STORIES IN OILFIELD SERVICES - With the worldwide fleet of rigs averaging 25 years old, NOV is in a great strategic position being a leading provider of rig capital equipment amidst the largest newbuild cycle in decades. In our view, the recent share price weakness is overdone and valuation is compelling. Currently NOV is trading at an '07 EV-DACF/P-E of 12.1x/14.0x, versus 13.8x/16.9x for FTI and 11.7x/15.2x for CAM, which implies a discount of -12%/-17% versus FTI and +3%/-9% versus CAM. To put this in perspective, historically NOV has traded at an average EV/DACF premium of 13% over CAM/FTI. Looking forward we think the two key catalysts for the stock are: (1) We expect the impact of better pricing (i.e. higher margins) to be more explicit on NOV results in 2Q and especially 3Q, which could lead to significant upwards '06/'07 EPS revisions; and (2) strength in new orders should continue.
RECOMMENDATION UPDATE: DOWNGRADE OF CAM PURELY ON VALUATION; FUNDAMENTALS REMAIN SOLID - Our downgrade of CAM to IL/A, from OP/A, is purely on valuation given the recent stock rally. We continue to think that CAM fundamentals remain strong and management execution is solid. In fact, CAM is still our favorite stock to invest in subsea as valuation is more attractive than FTI's and since we think that there is still more room for positive EPS revisions. However, our fair value of $60 implies 20% upside for CAM shares versus 28% upside for NOV. We are 0.1%/3.4% above '06/'07 EPS consensus and we think that our estimates are still conservative. Looking forward, we think that key drivers for CAM shares include: (1) subsea orders should increase 2H06; and (2) execution of Dresser acquisition and expansion of CCV margins.
3 KEY REASONS TO BUY NOV SHARES:
(I) WE FEEL MORE CONFIDENT ABOUT NOV EXECUTION/MARGIN EXPANSION
* Impact of price increases on margins will be more noticeable in 2Q and especially 3Q06: For "backlog companies" like NOV/CAM/FTI there is always a lag between price increases and impact on margins. In the case of CAM/FTI, 1Q06 results showed significant improvement in margins due to '05 price increases, which resulted in meaningful EPS revisions and strong share price outperformance. In our view, the fact that NOV margin expansion has lagged CAM/FTI is in part attributed to the fact that NOV started to increase prices a bit later than peers towards the end of 2005. Therefore, we expect the impact of better pricing (i.e. better margins) to be more explicit on NOV results in 2Q and especially 3Q. We see upside to management guidance of 15% EBIT margins for the 2Q05 and we are assuming EBIT margins above 16% for 2H06 that we still think are conservative. Each incremental 100 bps in annual Rig Technology margins has a positive impact on '07 EPS of about $0.15.
* Rig Technology incrementals of 22% may be conservative with price increases. NOV management guidance at its Rig Technology division is of about 22% incremental margins, which is consistent with '05 performance (adjusting for 1x items). However, as price increases kick in, we think it is possible for NOV to do better than 22%. We forecast 26.5% incrementals for 2006 and we think there is room for upside.
* Execution is still the key area to monitor, but risks seems lower than in other cycles: Even though execution risk is certainly an area that deserves special attention, we think there are several reasons to believe that this risk is now lower than in the past. First, consolidation lowered the number of suppliers working in each project and reduced compatibility problems. Second, some of the projects today are more standardized which substantially reduces execution risk. Third, with visibility of some projects in some cases stretching out to 2009/2010, NOV has much more time to plan and manage its supply chain. For instance, NOV has been placing purchase orders (at fixed prices) with its suppliers for major components no later than 60-90 days after the company secures an order. And fourth, the smooth integration with Varco and solid operating performance support our view that NOV learned from past experiences. We think that execution so far in this cycle has been solid and recent management statements suggest that they are very confident about execution over the coming quarters.
(II) NOV VALUATION LOOKS COMPELLING AFTER RECENT UNDERPERFORMANCE
* Since we launched coverage on 3/28 NOV shares are up 5%, versus OSX +6% and CAM +17%. We believe that NOV underperformance is overdone and we believe that continued strong orders and improved Rig Technology margins in 2Q/3Q will be the key drivers for the stock.
* The relative valuation between NOV/CAM/FTI has been very volatile over the past few years. Nevertheless on average NOV has historically traded at around a 13% P/E premium over CAM/FTI, compared to a current discount.
* Currently NOV is trading at an '07 EV-DACF/P-E of 12.1x/14.0x, versus 13.8x/16.9x for FTI and 11.7x/15.2x for CAM, which implies a discount of -12%/-17% versus FTI and +3%/-9% versus CAM.
* Our fair value of $83 for NOV implies 28% upside, versus 20% upside for CAM and 11% for FTI.
(III) NOV HAS SUBSTANTIAL ROOM TO BEAT ESTIMATES
* We are 3.6%/7.1% above '06/'07 EPS consensus for NOV, compared to 0.1%/3.4% above for CAM and 5.6%/6.4% above for FTI.
* Besides being above consensus, as we mentioned previously, we also see upside to our own estimates. We think that there is more room for potential margin expansion at the Rig Technology division than baked into our above-consensus estimates.
WE ARE ADJUSTING OUR '06 EPS ESTIMATE FOR NOV TO REFLECT 1Q06 AND CANADIAN BREAKUP:
We are keeping our '07 EPS estimate unchanged at $4.64. However, we are lowering our '06 EPS forecast to $3.32 (from $3.51) primarily to more appropriately capture the 2Q seasonality impact of the Canadian break up in the Petroleum Services and Supply division. Our '06/'07 estimates are 3.6%/7.1% above consensus and we think that there is room for upside in our forecasts.
Each of the analysts named below hereby certifies that, with respect to each subject company and its securities for which the analyst is responsible in this report, (1) all of the views expressed in this report accurately reflect his or her personal views about the subject companies and securities, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report: Daniel Henriques, CFA, and Daniel Boyd, CFA. |
