DRQ - Dril-Quip: Chevron Link And Backlog Acceleration Make It Undervalued

2023-03-09 17:02:29 ET

Summary

• Dril-Quip, Inc. is a manufacturer, designer, and seller of highly complex and engineered products for offshore and onshore platforms.
• Considering the total amount of cash in hand and properties, I believe that Dril-Quip is significantly undervalued. Close to 20% of the total enterprise value is represented by cash.
• I would expect that the guidance given in a recent presentation about backlog increase in 2023 will enhance revenue expectations. In 2022, Dril-Quip, Inc. backlog increased by 15%.

Dril-Quip, Inc. ( DRQ ) saw its revenue accelerating in 2022, and many analysts are expecting significant net income growth in 2023 and 2024. Also, considering that DRQ reported a double-digit backlog increase in 2022 and beneficial expectations in 2023, I would be expecting further revenue growth in the future. Yes, I see many risks from new environmental laws or competitors. However I believe that the Dril-Quip, Inc. stock price could trend higher soon.

Dril-Quip: A Lot Of Properties All Over The World And Reporting Large Clients

Dril-Quip, Inc. is a manufacturer, designer, and seller of highly complex and engineered products for offshore and onshore platforms. Its main products are specialty connectors, marine surface manhole covers, suspension systems for mud lines, drilling systems, safety valves, and other application artifacts. Its products are used by oil and gas extraction companies as well as drilling contractors throughout the world. Dril-Quip also offers advisory services to its customers regarding the application and installation of its products.

The company has developed successful products for underwater use through which it has managed to position its brand as a guarantee of quality and safety in the extraction market and its industries. During 2022, almost 70% of sales were made outside the United States, keeping the percentage similar to the last years of registration.

Dril-Quip's business is divided into three segments that correspond in turn to the geographic areas in which it produces and markets its products. These are the Western Hemisphere, including South America and the United States, based in Texas, the Eastern Hemisphere including Europe and Africa, based in Scotland, and Asia and the Pacific, which includes Oceania and the Asian markets, based in Singapore. The company has production plants in the three geographic segments of operations as well as another plant in Macau, Brazil.

Dril-Quip, Inc.'s income comes from the sale of its products and related services, such as installation and advice, as well as the rental of some elements or tools used to install its products. Almost 66% of the income comes from the sale of its products, 20% from related services, and the rest from its rental offer for the application. The sale of the products is negotiated outside the advisory contracts, regardless of the previous deal with the client

These clients are usually large companies related to the exploitation of gas or oil. During 2022, almost 60% of the income was contributed by contracts and sales to the 15 largest clients, with Chevron Corporation ( CVX ) being the client with the greatest contribution to annual net revenue.

Recent Results Indicated Sales Growth In Services, Leasing, And Sale Of Products

2022 revenue included products of $240.842 million along with services of $79.195 million, leasing close to $42.033 million, and total revenue of $362 million. Product sales, services, and leasing revenue increased. Like other financial analysts, I would be expecting further revenue growth in 2023 and 2024.

The company also reported restructuring of $11.443 million, gain on sale of property of $20.019 million, and operating income of $2.521 million. Finally, the income tax provision stood at $6.327 million with net income of $0.443 million.

Balance Sheet: There Is Plenty Of Cash Outstanding And Property And Equipment

In the last annual report , Dril-Quip, Inc. reported cash of $264.804 million, with short-term investments of $32.232 million, other current assets of $455.552 million, PP&E of $181.270 million, and total assets close to $972.515 million. Considering the total amount of cash in hand and properties, I believe that Dril-Quip is significantly undervalued. Close to 20% of the total enterprise value is represented by cash.

Management does not report debt outstanding. The liabilities include current liabilities of $87.555 million, deferred income taxes of $3.756 million, and other long term liabilities of $6.288 million. In sum, total liabilities are equal to $97 million.

Analysts Expect Double-Digit Sales Growth In 2023 And 2024 Along With Significant Net Income Growth

Market estimates include 2024 net sales of $456 million together with 2024 net sales growth of 14.29%. 2024 EBITDA would stand at $52.5 million, with 2024 EBT of $36 million and net income of $27 million. 2024 net income growth would be close to 107.69%.

It is also worth noting that DRQ noted significant sales growth expectations for 2023 and adjusted EBITDA increases.

Assumptions Under My Model Include Acceleration Of Headcount Growth

I would expect further development and innovation of new products, which bring cost reduction in the short-term and perhaps distribution lines improvements. Management offered a significant amount of commentaries with regard to how much technology is relevant for the company.

Technology is an important component of our business and growth strategy, and our success as a company depends to a significant extent on the development and implementation of new product designs and improvements. Whether we can continue to develop systems and services and related technologies to meet evolving industry requirements and, if so, at prices acceptable to our customers will be significant factors in determining our ability to compete in the industry in which we operate. Source: 10-k

Considering the current amount of cash in hand, I would be expecting more hiring as Dril-Quip, Inc. signs more contracts with clients. DRQ used to report a headcount of more than 2100 employees, and report free cash flow ("FCF") of around $207 million.

The total number of the Company's employees as of December 31, 2022 was 1,356, a 1.0% increase from December 31, 2021. Source: 10-k

In 2022, the number of employees increased a bit. I believe that the upward trend in hiring will likely continue, which may bring free cash flow generation back.

Dril-Quip, Inc. appears to have hired a lot from the year 2000 to 2002, so I believe that hiring employees is somewhat cyclical for management. If management expects significant revenue generation in 2023 and 2024, hiring will likely increase.

With more than $207 million in cash and accelerating revenue, I would also be expecting some acquisition or a smaller competitor. In my opinion, DRQ may not be acquired by other large competitors if it grows quickly through inorganic growth. Management discussed these matters in a recent annual report.

From time to time, we evaluate purchases and sales of assets, businesses or other investments. These transactions may not result in the anticipated realization of savings, creation of efficiencies, offering of new products or services, generation of cash or income or reduction of risk. Source: 10-k

Finally, I would expect that the guidance given in a recent presentation about backlog increase in 2023 will enhance revenue expectations. In 2022, backlog increased by 15%, so I believe that a bet on backlog increase continuation in 2023 does not sound out of the box.

My Cash Flow Model Implied A Valuation Of $40.99 Per Share

I ran a cash flow statement model that includes growing net income in 2023 and 2024 along with declining net income from 2025 to 2033. I also assumed declining stock-based compensation ("SBC"), which would stand at $1.4 million in 2033, growing deferred income taxes, and 2033 restructuring close to $16 million.

Also, with 2033 changes in trade receivables of $51 million, changes in growing unbilled receivables of $174 million, 2033 inventories of $79 million, changes in prepaids close to $6 million, and changes in accounts payable of $40 million, my results would include CFO of $270 million, 2033 capital expenditures of $63 million, and FCF close to $206 million. Note that I expect FCF growth from around $69 million in 2024 to close to $195 million in 2032.

If we also include a WACC of 6.9% and a multiple of 42x FCF, the enterprise value would stand at $1.131 billion with equity of $1.4 billion and a fair price close to $40.99 per share.

Large Competitors And Risks

Dril-Quip, Inc. may suffer from high competition with other multinational producers of elements for extraction and products for the oil market. In most cases, competitors are part of companies with greater resources than Dril-Quip. Some of these are Baker Hughes ( BKR ) Schlumberger Limited ( SLB ), TechnipFMC plc ( FTI ), and Aker Solutions ( AKRTF ). Competitors may provide services or install products without allowing the use of Dril-Quip brand tools, which may lower future FCF expectations from DRQ.

Revenue from DRQ was highly affected by the COVID pandemic, and in the recovery of that process, it also had to amortize a series of complications due to new sanctions and regulations in relation to Russia and the invasion of Ukraine. In this sense, the company is currently affected by variations in the price of oil and the inflationary situation in general, resulting in issues related to the supply of raw materials.

In relation to its operating and sales movements, DRQ could suffer from lack of diversification in its client portfolio. Losing its current contracts with Chevron would most likely lead to significant revenue decreases. The same applies to its 15 largest clients, who contribute almost 65% of total revenue.

Finally, we must add the global trend of adaptation and reduction of emissions and damage to the environment. The oil industry is being highly questioned, and new regulations are made to satisfy these criticisms. In this sense, DRQ's clients reporting operating issues had to change the tools and methods to operate. Resultantly, DRQ could suffer from FCF declines.

Conclusion

With a significant amount of cash and property accumulated in the balance sheet, double digit sales growth in 2022, and promising expectations from analysts, Dril-Quip, Inc. appears a must-follow stock. In my view, with a lot of PP&E, leasing revenue will likely continue to increase in the coming years. Besides, I would assume more hiring like we saw in 2022. Even taking into consideration risks from the dependency to Chevron and other clients as well as the risks from new environmental regulations, in my opinion, Dril-Quip, Inc. could be worth much more.

For further details see: