DRQ - Dril-Quip: New Outlook And Re-Segmentation Could Push The Price Up

2023-08-23 07:38:46 ET

Summary

• Dril-Quip's re-segmentation project and M&A efforts could lead to future FCF growth and expansion of geographic footprint.
• Growth in the carbon capture market and collaboration agreements may serve as revenue catalysts.
• Despite risks from environmental regulations and oil price volatility, Dril-Quip appears undervalued.

Dril-Quip, Inc. (DRQ) recently reported a beneficial outlook and further costs related to the re-segmentation project, which may have a beneficial effect on future FCF growth figures. Besides, taking into account the balance sheet, we could expect M&A efforts to bring expansion of the geographic footprint and scalability opportunities. In my view, the growth of the carbon capture, utilization, and storage market as well as new collaboration agreements with new patterns could serve as a revenue catalyst. Even taking into account risks from laws and regulations on environmental damage or crude oil volatility, I think that DRQ appears undervalued.

New Outlook, New Market Expectations, And My Previous Article

In my previous article about DRQ, I noted that we could expect further revenue growth in the future. Have a look at the following lines.

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. Source: Previous Article

The stock price declined, however, I was not wrong about my revenue expectations. The company recently increased its net sales growth expectations. DRQ expects revenue to show 20% growth over 2022, very decent Adjusted EBITDA margins, and capital expenditures of around $30 million. I used some of these figures in my new financial model, so readers may want to have a look at them.

Market analysts out there seem to be optimistic about the future of Dril-Quip. They expect net sales growth in 2024 and 2025 along with net margin improvement and positive FCF. In 2025, under their expectations, the company would deliver 2025 net sales close to $608 million, 2025 EBITDA of $102 million, EBT of $72 million, net income close to $54 million, and free cash flow worth $37 million.

Business Model

Dril-Quip designs, manufactures, and sells highly engineered services for underwater excavation, harsh environments, and other types of applications. Its main products are subsea and surface wellheads, subsea and surface extraction systems, connectors, pipes and accessories, diverters, and safety valves.

Clients include large companies in the oil and gas arena and independent drilling contractors globally. In addition, the company offers assistance and technical advice for the installation and use of the products as well as maintenance guarantees on the products. In some cases, the products can be rented for application in specific projects.

Operations are divided into three segments: Subsea Products, Subsea Services, and Construction Wells. The subsea products segment is dedicated to the design and manufacture of extractors and related parts, while the services segment offers advisory programs and professional technicians who take care of the installation and fine-tuning of the machinery.

In third place, the construction wells segment deals with the line of completion, casing, and related products. Operations are geographically distributed in three parts: East, West, and Asia-Pacific. During 2022, 66% of the company's revenues came from its international operations, and this statistic remains above this number in recent years.

Balance Sheet

In 2023, the company reported a small amount of total assets increase driven by increases in trade receivables, inventories, and property, plant, and equipment. Cash in hand decreased, however the ratio of current assets/current liabilities and ratio of total assets/total liabilities stand at a solid level. In my view, banks would offer financing if necessary.

In particular, the company reported cash and cash equivalents worth $236 million, short-term investments close to $18 million, trade receivables of about $135 million, and inventories close to $164 million. Also, with total current assets of close to $755 million and property, plant, and equipment worth $185 million, total assets were equal to $979 million.

I would not be worried about the liabilities reported by management. The company does not only report a considerable amount of liquidity, management also does not report debt.

With respect to the list of liabilities, management reported accounts payable worth $54 million, contract liabilities of about $6 million, total current liabilities worth close to $89 million, and total liabilities of about $100 million.

Competitors

The market for oil extraction and marketing projects is highly competitive, and in many cases, competitors have greater resources and capabilities than Dril-Quip. In particular, regarding the sale of equipment to the oil industry, the main competitors are Baker Hughes ( BKR ), Schlumberger, Ltd. ( SLB ), TechnipFMC plc ( FTI ), and Aker Solutions ( OTC:AKRTF ). These competitors report EV/EBITDA, and EV/FCF that seem more expensive than that of Dril-Quip.

To a lesser extent, there are other competitors for specific parts or particular equipment within the scope of the company's development. The relationship between manufacturers and customers is not generally based on long-term contracts. The loss of competitiveness, especially from the price offered for products and services, can represent complications for customer retention in the context of industry consolidation.

Financial Model: M&A, Announced Re-Segmentation Plans, And Growth Of The Carbon Capture Market Could Lead To Fair Price Of $37 Per Share

Under my financial model, I assumed organic growth within the markets, in which the company participates. The company followed an active strategy on possible acquisitions. As management mentioned, I believe that expansion of the geographic footprint, scalability opportunities, and end-market diversification would most likely bring FCF growth in the coming nine to ten years.

Part of the current adaptation this year was to restructure its segment organization and put them based on product type. With this in mind and also considering the restructuring plans and costs noted in the last quarter, I believe that we may see FCF margin expansion in the future.

During the first half of 2023, the Company incurred $1.1 million of additional costs under the global strategic plan. During the second quarter of 2023, as we completed our re-segmentation project and as the 2021 global strategic program comes to a conclusion, the Company reassessed the reasonability of a restructuring liability related to its Well Construction business. During our assessment certain market exit costs became known and the liability was adjusted accordingly, resulting in a release of approximately $2.3 million. Source: 10-Q

In my view, the agreement with Aker Solutions goes along the lines of being able to integrate its technologies and production processes in the manufacture of other products to increase the FCF margin. Taking into account the expected growth of the carbon capture, utilization, and storage market, I believe that the collaboration may accelerate the net sales growth of Dril-Quip.

Dril-Quip entered into a collaboration agreement with Aker Solutions ASA to offer subsea injection systems for carbon capture, utilization and storage projects. Under the agreement, Dril-Quip will provide Aker Solutions with CO2 injection Xmas trees and wellheads that will be fully integrated into a larger subsea injection system to provide customers with market-leading technology purposely designed for the injection and storage of CO2. Source: 10-Q

Carbon capture, utilization, and storage market is projected to hit $7.0 billion by 2030, growing at a CAGR of 13.8% from 2021 to 2030. Source: Carbon Capture, Utilization, and Storage Market Analysis - 2030 .

In my new financial model, I included the previous assumptions. Moreover, my financial figures are not far from figures related to changes in working capital, changes in account payables, changes in inventories, or D&A from the year 2000.

I assumed 2033 net income close to $10 million, depreciation and amortization of $14 million, and stock-based compensation expense worth $15 million. Besides, with changes in trade receivables of close to $80 million, changes in unbilled receivables of -$45 million, and changes in inventories worth -$14 million, I obtained 2033 CFO close to $113 million. Finally, subtracting purchase of property of about -$35 million, 2033 FCF would be about $78 million.

If we assume an EV/FCF ratio of 19x, which I believe is quite conservative, and a WACC of 6.5%, the implied enterprise value would be close to $815 million. Now, with cash and cash equivalents worth $236 million and short-term investments worth $18 million, the implied value would be $1.070 billion. We would be talking about a fair price of $37 per share and an IRR of 3%.

Risks

It is interesting to point out the great concentration in relation to its clients that the company reported for several years. Dril-Quip's top fifteen customers account for about 60% of the company's total revenue, while its top customer, Chevron (CVX), accounts for 10% of annual revenue. The statistics remain similar in the last three years. The loss of one of the significant clients can generate financial complications in the short term.

On the other hand, the number of laws and regulations on environmental damage and reduction obligations in this regard can indirectly affect Dril-Quip. While its products are used in different types of extraction, some of the techniques for these extractions or construction of wells are considered to be highly damaging to the environment. The change in laws at the regional level regarding its clients can indirectly generate adverse effects.

The dependence on oil activity is almost total, and a depreciation in the price of fuels could generate indirect complications for Dril-Quip. In general terms, the risks of the oil industry translate into indirect risk factors for this company. In addition, in this context, the company points out that the failure to comply with technological developments to meet the needs of customers, together with the factor of continuous consolidation that some of its main competitors are experiencing, can configure a great risk in its scope, growth, and competitiveness.

In addition, the risks inherent to the international operation, company's ability to manage its growth, and the application and integration of its acquisition strategy are factors that coexist within the context of transformation of uses and consumption of fossil energies.

Conclusion

Dril-Quip may benefit in the coming years from the current reorganization plans. I think that the expansion of the geographic footprint and scalability opportunities driven by M&A transactions could accelerate FCF growth. Finally, I believe that the growth of the carbon capture, utilization, and storage market and the agreement with Aker Solutions could also serve as a revenue catalyst. Even considering potential risks from laws and regulations on environmental damage or crude oil volatility, Dril-Quip does appear undervalued.

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