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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.

This shift placed National Oilwell Varco in a powerful position. The resulting economies of scale for National Oilwell Varco led to it typically reporting EBITDA margins of 30%-plus compared with one of its closest peers, LeTourneau (now owned by Cameron CAM), which recently generated single-digit EBITDA margins. The firm's position is powerful enough that even one of the largest deep-water oil and gas firms on the planet, Petrobras PBR, recently chose to use only National Oilwell Varco equipment for seven of its rigs in a record $1.5 billion order. The price tag--$214 million per rig--indicates that National Oilwell Varco didn't bend on price.

A Focus on Expanding Competitive Advantages
We suspect that many executives would be fairly satisfied with this state of affairs. However, if there's one impression that we've obtained from studying Miller's actions over the years, it's that he's always seeking ways to strengthen his firm's competitive advantages. In fact, Miller has correctly predicted several major industry shifts, invested billions in capital to position National Oilwell Varco favorably ahead of them, and then delivered excellent operational performance throughout the entire timeframe without making a misstep.

The first shift is the aging of the global rig fleets. The vast majority of the global rig fleet is well over 20 years of age, and nearing the end of its useful life. Miller made his bet here years before anyone else saw the opportunity. In 2005, National Oilwell acquired Varco for about $2.4 billion in stock, giving rise to the "No Other Vendor" nickname. The merger combined a large capital equipment business with strong rig equipment aftermarket services. This aftermarket income stream (rigs can last for 30 years) becomes far more valuable as the global rig fleet shifts from a "custom" rig to a "standardized" rig. Today, the deal seems obvious, but from 2001-04, only $3.5 billion or so of new rigs were ordered, and Miller made his offer to acquire Varco in August 2004. From 2005-08, $85 billion in new rig orders took place. The increase in oil prices from $20 in 2002 to triple digits in 2008 certainly helped, as day rates and activity levels increased for the offshore drillers. The resulting windfall of cash for fleet reinvestment reversed the perennially cash-starved status of the prior two decades, but neither this shift nor the subsequent industry changes were visible in 2004.

What Miller understood is that the old rigs made in the 1980s generally came from the "custom" era, and it's simply not cost-effective to upgrade them to handle today's more advanced equipment and associated drilling needs. As today's standardized rigs are delivered using a fully integrated approach, we note that National Oilwell Varco's market share has the potential to increase. Currently, we estimate the company's share is around 50%-60%, but for the fully integrated rigs, its market share for rig equipment is closer to 70%-80%. Miller's call here wasn't as obvious as it sounds, because many drillers believed that a policy of keeping the rigs upgraded and well maintained could extend their useful lives beyond the initial 30-year design life. Post-Macondo, where oil and gas companies increasingly want new and upgraded rigs with the best safety equipment and a topnotch crew, those beliefs are looking even more antiquated.

The next major shift was the development of the North American tight oil and gas opportunity. Today, it is generally acknowledged that North America is awash in natural gas, but back in 2007 and 2008, oil and gas companies were anticipating a scarcity of natural gas and were building LNG terminals to import LNG from the Middle East (which are now being redesigned to export LNG). It was during this environment that National Oilwell Varco acquired Grant Prideco for $7.4 billion in cash and stock, adding drill bits and, more importantly, one of the largest global manufacturers of premium drill pipe. The shift toward developing tight gas and oil plays required horizontal wells and meant that stronger drill pipe was needed to better withstand the more extreme drilling angles, well temperatures, and pressures. At the time of the deal, the useful life for drill pipe was generally considered around 4-5 years, but today's tight plays consume the pipe within 2-3 years. Miller's anticipation of the shift in industry trends again created value for shareholders.

The third epochal shift is still in progress, but once again, we think Miller has positioned National Oilwell Varco to benefit. In 2010, Miller acquired Advanced Production and Loading, or APL, for $500 million, which adds key turret mooring systems for floating production storage and offshore (FPSO) units. In 2012, National Oilwell Varco acquired NKT Flexibles, primarily a provider of flowlines for FPSOs and flexible pipe for subsea efforts, for around $670 million. Both deals anticipate the shift toward development efforts from exploratory drilling in the deepwater markets that will very likely take place over the next decade. Indeed, the number of FPSO installations is projected to double by 2016. More FPSOs are needed where pipeline economics do not work out for offshore fields, which should lead to higher demand for FPSO turrets, the flexible flowlines that connects to the turrets, and the flexible pipes that connect the subsea infrastructure. These deals have taken National Oilwell Varco's opportunity set per FPSO to over $100 million per vessel from $25 million to $30 million prior to the APL deal.

However, it's not merely about the market size opportunity for National Oilwell Varco with regards to FPSOs. It's also a chance for the company to replicate its successful rig equipment standardization approach, where its expertise in manufacturing, relationships with shipyards, and experience with the rig building process can also be applied. The FPSO equipment market tends to be characterized by challenges with equipment reliability and cost-effectiveness given the lack of a standard FPSO design. In subsea efforts, companies routinely plan for 30%-40% downtime for projects due to poor equipment reliability. In response, National Oilwell Varco is working on a standard FPSO design in an effort to replicate its success with offshore rigs. We think there is a large opportunity here, as a new FPSO design with standard placement, shape, and size of key pieces of equipment can make the equipment far more cost-effective to engineer and manufacturer, while encouraging vessel owners to standardize around a single supplier to achieve the greatest economic benefits from any improved vessel uptime or lower installation, maintenance, and training costs. Given the company's position within oilfield equipment, we think it is uniquely positioned to execute within the FPSO market.

It's Not Always About the Deals
Given National Oilwell Varco's rather frenetic acquisition pace, we note that Miller takes the time to pursue shareholder-friendly actions. For example, in 2009, when he couldn't find any deals worth pursuing, he paid out a special $1 per share dividend to shareholders. In the same year, he requested that his salary be cut to $800,000 from $950,000 in light of the difficult economic environment. On National Oilwell Varco's conference calls, he takes pains to share insights about where he thinks the market is going over the next few years, and what NOV is doing to position itself. We think Miller avoids the typical song-and-dance routine that executives engage in with analysts and tries to share as much information about his business as possible. Miller also takes the time to thank National Oilwell Varco's employees every call, and the consistency of his praise over the years indicates that he is genuinely grateful to work with them.

Looking over Miller's track record of operational excellence, his astuteness in positioning his firm at the center of the major trends within oil services, and his overall shareholder friendliness, we think he made an easy choice for our CEO of the Year award in 2012.

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