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  • Roger S. Conrad

The Blacklist: Eight Energy Stocks to Avoid in 2017

By Elliott H. Gue on Dec. 24, 2016

Dril-Quip (NYSE: DRQ) manufactures and sells offshore oil and gas drilling and production equipment, including subsea and surface wellheads, trees, subsea control systems and specialty connectors.

The company and its major competitors—Schlumberger’s (NYSE: SLB) OneSubsea, FMC Technologies (NYSE: FTI), Aker Solutions (Oslo: AKSO, OTC: AKRTF) and General Electric Co’s (NYSE: GE) oil and gas division—dominate this market.

Subsea trees are a complex series of valves connectors and control equipment that are installed on a deepwater well to regulate the flow of oil and natural gas. Analysts often view the total number of subsea trees ordered in a given year as an indicator of deepwater drilling and development activity.

With oil prices hovering around $100 per barrel in 2012 and 2013, robust deepwater drilling and development drove an upsurge in subsea tree awards from about 300 in 2011 to a peak of 551 in 2013.

(Click graph to enlarge.)Subsea Trees

However, runaway costs prompted national oil companies and the major integrated oil companies to begin scaling back their capital expenditures in 2014. Tumbling oil prices in 2015 and 2016 sealed the industry’s fate; the total number of subsea trees commissioned in 2016 had plummeted to about 100—a decline of roughly 80 percent from the high.

Dril-Quip’s stock tumbled 27 percent from the end of 2014 through the third quarter of 2016, underperforming the Philadelphia Oil Service Sector Index by about 6 percentage points.

But Dril-Quip’s share price has soared more than 50 percent from its November low to its intraday high in December, outpacing the Philadelphia Oil Service Sector Index’s return by about 15 percentage points.

This sharp rally coincides with improving sentiment toward energy stocks after the US presidential election and OPEC’s agreement to reduce oil production.

We regard the stock’s recent strength as an aberration that disregards the challenges facing Dril-Quip’s underlying business. Unfortunately for the company, most deepwater developments don’t make economic sense when oil fetches about $50 per barrel. In this environment, producers can earn higher returns by pursuing short-cycle onshore projects in prolific shale plays.

Given the uncertain outlook for oil prices, many oil companies balk at committing billions of dollars to a complex development project that involves significant execution risk and will take three to five years to complete.

Oil prices would need to stabilize at $70 per barrel or more to incentivize another wave of spending on new deepwater projects.

Our outlook calls for oil prices to range between $40 and $60 per barrel over the next two to three years, with any breakouts proving to be short-lived. In other words, a recovery in deepwater spending probably wouldn’t take hold until the end of the decade, at the earliest.

Until then, expect a shallow recovery from the 2016 bottom in activity and vicious price competition between the major offshore equipment manufacturers for the small number of new awards.

Dril-Quip’s business is all about the backlog: The company books orders and then fulfills these sales over time. The subsea equipment manufacturer’s backlog peaked at $1.35 billion in 2014 and has shrunk to less than $400 million as of Sept. 30, 2016. Many of these original awards involved favorable terms, so Dril-Quip’s operating margins hovered around 30 percent until mid-2016.

(Click graph to enlarge.)DRQ Backlog and Op Margin

But with the backlog of legacy orders dwindling, Dril-Quip’s profit margins will continue to take a pummeling in coming quarters. And the company also faces challenges covering its fixed costs as orders slow to a trickle and involve less attractive prices.

Dril-Quip’s valuation remains well off its 2014 high. However, trading at 3.6 times trailing sales and 4.2 times forward revenue estimates, the stock is expensive relative to its 2003-04 and 2008-09 trough multiple of 1.5 to 2 times sales.

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