National Oilwell Varco's Management Needs You to Know This About Falling Oil Prices

By Markets Fool.com

National Oilwell Varco has been around for more than 150 years, so it has seen its fair share of oil price spikes and plunges. This one is really no different than the ones the company has dealt with before, and according to the company's most recent earnings conference call, it already has a game plan in place to deal with it. Let's take a look at what the company is planning for in the future and how dealing with these sorts of oil price swings hasn't really put a dent in NOV's armor in years past.

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Our token take on oil prices
In reality, no one really knows where oil prices will go from here, but it doesn't seem to stop companies from making assumptions based what they are seeing the market. National Oilwell Varco CEO Clay Williams is no different. He believes that the effects of this price plunge will be relatively short-lived, like the last couple times that oil prices plunged:

[W]e do not believe that global excess production capacity is excessive by historical standards.We do not face the kind of structural global overhang the industry faced in 1986, when Saudi Arabian production had been curtailed down to about 4 million barrels of oil per day and spare oil capacity exceeded 15% of demand. We believe that this downturn will be more like 2002 or 2009. In both prior instances, recovery came within about two years.

Luckily for investors, though, the company isn't making any strategic plans based on this idea. Rather, management is taking a "we're going to do what is necessary to get through this as a strong company" approach:

Given our short-term lack of visibility into the timing of the recovery, our approach to 2015 will be to focus on what we can control. We plan to manage NOV to the market, quarter to quarter, in view of near-term orders and activity, while we steadily reduce costs as utilization levels permit, while also continuing to advance the long-term strategic goals we outlined at our investor day.

The industry can cut costs for only so long
Just like how very few of us are driving cars with 700,000 miles on them, there aren't many companies out there that can continue to use the same drilling equipment for decades without getting a few repairs or equipment upgrades from time to time. Even if companies today are looking to cut costs by pulling pieces from idled rigs and drawing down inventory of pipes and other equipment at delayed projects, eventually, new equipment will need to be purchased. When that happens, management believes it will result in a large uptick in orders for National Oilwell Varco's equipment:

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History teaches us to expect this behavior to continue for at least the next couple of quarters, meaning orders will continue to be slow and our book-to-bill in Rig Systems well below 1.

However, this behavior is not sustainable over the long term. Drilling consumes rigs, much like driving consumes your automobile. The rate of consumption of capital equipment and consumables is declining with drilling activity, but customer spending always seems to overreact through cyclical downturns by living off their inventory and postponing maintenance and upgrades wherever they can.

This is just something that happens in all commodity businesses. As commodity prices drop, producers get stingy to maintain certain levels of liquidity and solvency, but once things start to get better, they are forced to repair and replace the equipment they ran into the ground during the down times. NOV's management has seen it happen before, and it's almost certain it will happen again.

Eeking out some cost savings in the downturn
The past few years for National Oilwell Varco have been extremely busy. For several years, the company's equipment manufacturing arms have been working 24 hours a day, seven days a week as well as outsourcing some of its fabrication to subcontractors just to keep pace with all the orders from shipyards. This has resulted in lots of extra labor costs. So as the market starts to decline, and the company doesn't need to operate at breakneck pace, management thinks there could be some significant cost savings:

With regards to the margin, we're probably a little beyond our optimal kind of efficiency, in terms of margin production in the backlog. Meaning,we've had more work. We're relying on graveyard shifts and a lot of overtime and third- and fourth- and fifth-tier suppliers.

I think there is some benefit as volumes start to back off just a little bit, in terms of reducing some overtime, of reverting to our most productive shifts and reverting to our most productive sub-suppliers. That will help on the margin front.

Be reducing heavy overtime costs and trimming down its subcontractor queue, it should help to increase margins and help make up for the smaller amount of revenue coming in the door. It's a great trump card management can play as new orders start to weaken.

Backlog slowly shrinking, but the orders there are definitive
A big fear for a company that generates so much revenue from a backlog of orders is that a downturn will cause some of those customers to back out of orders. Based on National Oilwell Varco's history, though, this doesn't appear likely. Yes, management thinks the backlog will shrink, but it will be a result of the company finishing more orders than new orders coming in the door and not companies canceling their contracts:

Except for minor exceptions, the firm contracts governing our backlog projects do not permit cancellation for convenience. In 2009, we saw about 4% of our backlog evaporate -- not really from cancellations, but rather from customer payment defaults.

We expect it to partly, but not fully, mitigate the effect of lower orders for 2015 on our day-to-day operations in Rig Systems. We foresee revenue out of backlog remaining strong through the first quarter 2015, north of $2 billion, but beginning to decline modestly in the second quarter and more steeply in the third and fourth quarters of 2015. While 2015 orders will be slow, we do continue to see modest demand for certain markets like 20,000 psi deepwater, Middle Eastern land markets, Mexico, and Argentina.

Management believes total backlog will decline by as much as $7 billion from its high late last year until new orders start to outpace production again. This would mean that the company's backlog would remain in excess of $7 billion before the upswing happens again. Leaving plenty of work on the table to keep a steady revenue stream going for several years.

Taking advantage during the downturn
One of National Oilwell Varco's calling cards is using its excess cash flow to acquire smaller manufacturers and fold their products into the NOV drilling package it sells to its customers. This is how the comapany has been able to accumulate a 60% market share in drilling equipment on offshore rigs. With the market in a downswing, and some of those smaller manufacturers struggling financially, CEO Clay Matthews expects to go shopping pretty soon:

We continue to pursue our singles and doubles acquisition strategy, which improves our capabilities in global reach and our technology portfolio. We have seven letters of intent in place and probably triple that in potential prospects.

With more than 20 prospective acquisition targets out there, rest assured that management is looking hard to maintain its market lead in drilling equipment manufacturing.

What a Fool believes
National Oilwell Varco's stock price is down, but it certainly isn't the result of anything that management has done recently. There are still plenty of levers left for management to pull to create value for shareholders, including some of the things mentioned by management on its recent conference call. For investors who may be sweating their investment in this company -- don't. Management is doing exactly what is necessary in these down times... staying the course.

The article National Oilwell Varco's Management Needs You to Know This About Falling Oil Prices originally appeared on Fool.com.

Tyler Crowe owns shares of National Oilwell Varco.You can follow him at Fool.com under the handle TMFDirtyBird, onGoogle +,or on Twitter:@TylerCroweFool. The Motley Fool recommends National Oilwell Varco. The Motley Fool owns shares of National Oilwell Varco. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.