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Morningstar's 2012 CEO of the Year Reshaped Oilfield Equipment

Our winner has done a stellar job at capital allocation, identifying major industry trends, investing billions in capital ahead of the shifts, and then executing brilliantly on deals.

Stephen Ellis, 01/03/2013

The oil and gas industry can be deeply unforgiving. Drilling a well can cost tens, if not hundreds, of millions of dollars. Even then, success is not guaranteed. After spending months scrutinizing seismic analyses and well logs, a well can still turn up bereft of commercial quantities of oil and gas. The last things an oil and gas company wants to worry about are whether the rig's equipment is reliable, whether the roughnecks on the rig are familiar with it, and whether the next shipment of drilling consumables will arrive on time.

Morningstar's 2012 CEO of the Year--National Oilwell Varco's NOV Merrill (Pete) Miller Jr.--has successfully minimized those concerns for his customers. Furthermore, he's done a stellar job at capital allocation, correctly identifying several major industry trends, investing billions in capital ahead of the shifts, and then executing brilliantly on deals to ensure National Oilwell Varco stays ahead of its competitors. The degree of difficulty here shouldn't be underestimated. It should be noted that far beyond just a single deal, Miller has pursued an acquisition-heavy strategy that carries the risk of operational miscues in an industry where reliability is prized, and he pulled it off without a hitch. Miller's excellence across all three facets of a CEO's job (strategic insights, capital allocation, and execution) is indeed a rare combination.

For those unfamiliar with National Oilwell Varco, it provides rig equipment for onshore and offshore rigs, products that are consumed during the drilling of a well such as drill bits and drill pipe, as well as oilfield distribution services. Miller first joined National Oilwell Varco in 1996, and was appointed CEO in 2001. After a string of nearly 300 largely Miller-led deals over the past 15 years, National Oilwell Varco's presence over the industry looms so large it is now impossible to build a rig in the Western world without including some components from the firm. In response, many drillers have simply standardized around National Oilwell Varco equipment. It's not a surprise that the firm is widely known as "No Other Vendor."

Another way of viewing Miller's impact on National Oilwell Varco is through Morningstar's moat ratings. Today, National Oilwell Varco is one of the very few companies in our coverage universe with a wide economic moat, a positive economic moat trend, and an exemplary stewardship rating. At Morningstar, we do not award moats based on operational effectiveness or skilled management, but we do acknowledge that they can add to a firm's moat. In this case, Miller's actions, and by extension the rest of his management team, which includes a stellar CFO (now COO) in Clay Williams, have indeed had a tremendous impact on National Oilwell Varco's competitive position by changing the way offshore rigs are built to its benefit, as well as outstanding capital allocation.

With the recent elevation of Williams to the COO position and Miller stepping back from the day-to-day operations of National Oilwell Varco, it's tempting to view the award as recognition for a stellar run at the top of the firm. However, we note Miller has made substantial contributions to National Oilwell Varco over the past year. For example, in the past 18 months, Miller has completed or has pending nearly $6 billion in deals, where we expect the firm to earn 14% after-tax returns on capital. He also raised $3 billion in senior notes at a time when the corporate credit environment is extremely favorable. We think these moves point to substantial value creation for shareholders.

The Beginnings
National Oilwell Varco under Miller's leadership has changed the way that offshore rigs are built, improving the outcomes for the drillers it served while consolidating the industry around itself. In the 1980s, rigs were heavily customized by the drillers as they believed they could differentiate themselves with a unique rig. However, the custom rig process made for a very inefficient supply chain and construction process, which meant that the rigs were typically late and over budget.

In the early 2000s, National Oilwell Varco set out to make changes. The firm first approached KeppelFels, a major Korean shipyard and one of the best at building rigs, about using a more standardized rig design. KeppelFels agreed, and eventually, the drillers agreed to use more standard rigs as well, as they saw the cost benefits (no overruns and delays) as well as more consistent levels of rig uptime. The benefits for National Oilwell Varco were substantial, as routine items such as derricks, rails, top drives, and cabins were specified to be in the same shape and place on all of the rigs, making the equipment model far more cost-effective.

The switch also meant that drillers were highly incentivized to standardize around a single equipment supplier. National Oilwell Varco made things easier for the drillers by completely integrating all of its rig equipment into a single operating system. The driller can then remotely diagnose and solve equipment issues, and control the rig from a single console. The complete integration of all of the rig components on a rig offers savings to the driller in terms of rig weight, reduced rig downtime, and lower installation and training costs. The driller can chose different components if it wishes, as National Oilwell Varco offers more than one option in several product lines. Given National Oilwell Varco's broad rig equipment portfolio, there is less incentive by the drillers to move elsewhere, leading to the drillers' decision to standardize around the firm. Today, the company's opportunity set per ultra-deep-water rig is around $200 million-$300 million out of a $600 million-$650 million rig construction cost, where the remainder goes to the shipyard building the rig.

Stephen Ellis is a senior stock analyst on the Energy Team.
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