Source: Offshore Energy Today
I have been bearish cyclical names like Dril-Quip (NYSE:DRQ) for years. I believed the stimulus-driven economy could not prop up oil prices in perpetuity. At some point, demand would have to kick in to support oil prices. The coronavirus practically shut down business activity and caused Q2 GDP to plummet. Oil prices have rebounded from their March lows; supply cuts from Russia, OPEC and certain U.S. oil companies helped. However, at $40 they still may not be robust enough to drive E&P higher.
This could hurt the business prospects of oil services firms like Dril-Quip. The company reported Q2 revenue of $90.45 million, down 6% sequentially and down 13% Y/Y. Dril-Quip has become synonymous with subsea equipment. Subsea generated Q2 revenue of $48 million, down 8% Q/Q and down 23% Y/Y. COVID-19 has negatively impacted production output and customers have requested extensions on their deliveries of equipment.
Subsea still represented over 50% of the company’s Q2 revenue, down from 60% in the year-earlier period. Services represented over 20% of total revenue and it grew in the double-digit percentage range. It could be Dril-Quip’s one remaining catalyst.
The above chart illustrates the company’s Q2 2020 revenue mix. About 53% was derived from subsea technology and another 4% from offshore rig equipment. Dril-Quip is highly-exposed to E&P in sectors that may not generate an acceptable return at current oil prices.
Margins Fell
With revenue falling, particularly in its core subsea segment, Dril-Quip’s margins could come under pressure. Gross margin was 26%, flat versus Q1. On a dollar basis, gross profit of $67 million fell 6% Q/Q. Management has been aggressively cutting costs to better align its cost structure with unfavorable market conditions and volatile oil prices caused by the coronavirus. Dril-Quip incurred $1.6 million in restructuring costs related to workforce reductions. Cost containment measures may not be able to fully offset the company’s loss of scale.
SG&A costs were $23 million, up in the high-single-digit percent range Q/Q, yet flat Y/Y. SG&A was 26% of revenue, up 400 basis points versus Q1. It represents a large pool of costs that management could potentially cut into in the future. The fallout was that EBITDA of $2.8 million fell over 50% Q/Q. EBITDA margin was 3%, down 400 basis points versus Q1. I look for management to cut into operating costs in Q3 to offset declining revenue growth.
The backlog was $322 million in Q2 2019 and fell to $273 million by year-end. It finished at $238 million in Q2 2020, down over 25% Y/Y. Quarterly revenue exceeded new bookings of $67 million. This implies the backlog could continue to erode.
The Valuation Appears Too Robust
The valuations of oil services firms have fallen hard since the pandemic materialized in February. DRQ is down over 45% Y/Y, yet the stock appears overvalued. DRQ has an enterprise value of $609 million and trades at $25x last 12 months (“LTM”) EBITDA. The company has $346 million in cash and no debt. Working capital was $734 million, down from $783 million in the year-earlier period. Its strong balance sheet likely gives it a competitive advantage if oil markets or the economy remain stagnant for an extended period. Management has also proven the ability to cut costs and maximize cash flow amid volatile oil markets. However, DRQ’s valuation likely does not reflect headwinds faced by oil markets and the subsea segment, in particular.
Conclusion
DRQ appears overvalued. Sell the stock.
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