National Oilwell Varco's at the Center of Several Major Industry Trends

 National Oilwell Varco (NOV) has announced that Pete Miller, Morningstar's 2012 CEO of the Year, intends to step down as CEO to become executive chairman of the distribution business when it is spun off in 2014. Current COO Clay Williams will be elevated to CEO at the time of the spin-off. We expected this transition, as it was well telegraphed at the time of Williams' appointment as COO late last year.

Miller has orchestrated numerous acquisitions that have largely consolidated the equipment market to the firm's benefit. The company also consistently offers some of the best industry commentary on its quarterly calls. We believe Miller and Williams are shrewd judges of value and very good capital allocators. We think the recent deals for Ameron, APL, Wilson, CE Franklin, and NKT expand National Oilwell Varco's footprint in key growth areas and will create shareholder value over the long run.

Miller has had an outstanding tenure at National Oilwell Varco, as evidenced by our award. However, we consider Williams a very capable replacement, and we do not anticipate any significant deviations from what has been a very successful playbook for the firm. Overall, we view National Oilwell Varco as a very well-run company with a thoughtful management team that is focused on creating shareholder value.

FPSO Foray Could Bring Opportunity
National Oilwell Varco's dominant position in rig equipment is secure, in our opinion, and we view its floating, production, storage, and offshore ambitions as achievable and lucrative. We believe an ongoing shift toward equipment replacement demand for jackups and land rigs, FPSO expansion and equipment aftermarket initiatives, and future acquisition activity are attractive growth and profitability drivers, and the firm remains well positioned to capture economic rents. We're pleased to see this happen.

Over the past year, National Oilwell Varco has increasingly struggled with its manufacturing efforts while its competitive position has remained as strong as ever. Broadly, the two halves of its business--North America and offshore--are seeing very different demand levels, creating a suboptimal cost position for the firm. North American equipment plants are underutilized amid a flattish drilling environment and an oversupplied pressure pumping market. On the flip side, offshore plants are running full out and the company is scrambling to add capacity to meet tight delivery schedules, incurring significant additional freight, overtime charges, and plant startup costs. At the same time, more than 80% of its acquisition spending (more than $4 billion) in the past few years has been toward North American assets, where demand is currently weak, further depressing near-term earnings. As a result, although the firm's distribution acquisition-related cost-saving efforts include consolidating a third of its plants, the lower cost structure is not visible in today's earnings.

To rectify the profitability and operational challenges at its rig technology segment, the company has outlined a roadmap to recovery. The efforts include additional training, trimming supply chain costs, boosting prices, and being more assertive around contract terms such as delivery schedules and costing. These self-help initiatives combined with a slowly recovering North American market and still robust offshore demand should lead to a greatly improved National Oilwell Varco in 2014.

Dominance in Rig Equipment Leads to a Wide Moat
National Oilwell Varco is perhaps best known for its rig equipment dominance, particularly in deep-water rigs, which we see as a wide-moat business. Its equipment is on 90% of the world's rigs, and a rig cannot be built in the Western world without using some components from National Oilwell Varco. The firm's commanding position results from its move in the early 2000s to convince shipyards and offshore drillers to use a more standard rig design, which resulted in a more cost-effective model for the equipment supplier, the shipyard, and the driller, while improving rig performance. In the 1980s, drillers preferred heavily customized rigs to differentiate themselves from peers, which created supply chain inefficiencies and caused late deliveries, construction overruns, and inconsistent rig performance. The shift toward a more standard rig design (or an integrated rig) ensured that many components on the rig were the same shape and in the same place, making the entire rig construction, equipment manufacturing, and engineering processes far more efficient.

The change also naturally encouraged the offshore drillers to standardize on National Oilwell Varco, which already had built out a large product portfolio through acquisitions, in order to reap the most benefits from the improvements in rig uptime, as well as lower training, maintenance, and installation costs. As the bulk of today's global rig fleet is well over 20 years old and still using the custom model, National Oilwell Varco is positioned for continued share gains as integrated rigs become the industry standard. Post-Macondo, these trends are accelerating as oil and gas firms want the latest rigs with the best safety equipment. And drillers are increasingly turning to suppliers like National Oilwell Varco for the required aftermarket services, providing a multidecade stream of income.

National Oilwell Varco retains a similar dominant position in land rigs, as it can provide all of the equipment necessary to build a rig with the exception of the engine, but it can also supply the consumables required during the drilling process. The North American land fleet is undergoing a similar transformation to the offshore rig fleet with new AC-powered rigs becoming the standard industry workhorse as the mechanical rigs built in the 1980s can no longer economically drill today's more demanding tight oil and tight gas plays. The equipment needs also have changed. Better measurement-while-drilling sensors are needed along with nonmagnetic drill collars to house them, more powerful drill bits, drilling motors, and mud pumps while the firm is seeing higher demand for internal pipe coating services. Furthermore, drill pipe useful lives are just two to three years in today's more demanding tight oil and gas plays versus four to five years previously. Thus, National Oilwell Varco is benefiting from higher demand for its onshore technology and consumables thanks to the dramatically shorter useful lives because of the market shifts.

The company's latest forays have been toward FPSO equipment with the acquisitions of APL and NKT Flexibles for $1.2 billion. Through these deals, National Oilwell Varco has added turret systems, flexible pipe, and flowlines, bringing its total opportunity per FPSO (where the number of FPSO installations is projected to double by 2016) to more than $100 million from $25 million-$30 million previously. We think NOV sees an opportunity to consolidate and standardize a market around itself where there is no standard equipment supplier and where companies routinely plan 30%-40% downtime due to unreliable equipment. Taking a page out of its rig equipment playbook, the firm has introduced a harsh-environment FPSO design, with plans for other designs in the future, that we think is likely to promise similar levels of performance improvements and cost savings for FPSO owners if they standardize around it. Given the company's record, we think it is unwise to bet against National Oilwell Varco.

Commodity Prices, Acquisitions Hold Risks
National Oilwell Varco is vulnerable to lower commodity prices and changes in customer spending outlooks, which can be driven by global economic worries or an inability to access the capital markets. Rig activity is a key driver for its petroleum services and supplies segment, which was badly affected in 2009. National Oilwell Varco also could struggle with integrating one of its acquisitions or potentially overpay for a deal, despite its stellar record.