A Dominant Company with Perfect Timing
Certain companies are always worth owning. Happily, short-term market anomalies can transform such companies from a good buy into a screaming buy.
Now may be such a screaming-buy time for a certain company in the energy industry.
The demand for crude oil fell in 2009 because of the worldwide recession. But the dip in demand is an aberration. Crude’s longer-term price trend is upward because of a similarly strong upward trend in demand. As China and other emerging-market countries came on the scene, global demand for oil rose to more than 85 million barrels per day in 2007 from 64.8 million barrels per day in 1980.
The recent pullback in worldwide energy use has already begun to turn around. Oil prices have risen to above $80 per barrel from a low of $35 in late 2008 and are now in the $70 range. Analysts expect demand to resume its rise this year by a consensus average of 1.3 million barrels per day. The world is expected to be consuming more than 94 million barrels per day by 2015.
The rebound will be a huge positive to oil and oil-service companies. Many of these companies, having just experienced the worst cyclical downturn in generations, are relatively cheap.
Dresser-Rand (NYSE: DRC) is one of the largest global manufacturers of infrastructure equipment for the oil and gas industry. The Houston-based company makes industrial rotating equipment used to find and refine oil and gas. Dresser operates manufacturing facilities in the United States, France, United Kingdom, Germany, Norway, India and China, and maintains a network of 35 service and support centers covering more than 140 countries.
The company generates about half its revenues from new systems and half from replacement parts on existing equipment, of which it has the largest share, about 40%, of the world’s installed compression equipment. In 2008, revenues were derived from North America (41%), Europe (25%), Asia (12%), Latin America (11%) and the Middle East/Africa (11%).
As worldwide demand for energy has steadily increased during most of the past decade, Dresser’s earnings have been spectacular. Revenues of $915 million in 2004 doubled to about $2.5 billion in 2008. Operating income of $21 million in 2001 increased 16 times over by 2008, to $338 million.
Despite the cyclical downturn, revenues and profits were higher in the first nine months of 2009. One reason is that new systems generally have an order backlog of 12 to 18 months. The other reason is that about one-half of revenue and three-quarters of profits come from the higher-margin replacement parts business, which is relatively steady in good times and bad.
Dresser hasn’t escaped the recession, as new bookings for new systems were -65% lower in the first nine months of 2009 than in the same period a year earlier. Dresser still has a new unit backlog of $1.3 billion (as of 9/30), and replacement parts bookings have been far more steady.
Margins on replacement parts are far higher than on new systems, about 25% versus 6%. While replacement business has only accounted for a little less than half the company’s revenues in the first nine months of 2009, because of the higher margins, it provided 75% of operating income. Because the replacement parts business is less cyclical and more profitable, it serves to keep earnings relatively stable.
Strong Financial Footing
Years of strong earnings have left Dresser with a rock solid balance sheet. The company had just $370 million in debt, compared with $974 in shareholder’s equity. As well, Dresser has about $200 million in cash.
Part of the reason for Dresser’s success is a superior business model. In addition to providing essential machinery for a vital industry, the company keeps cost of capital low and maintains financial flexibility by subcontracting much of the manufacturing. As a result, while a return on equity of 20% is considered excellent, Dresser has a return on equity of more than 28%.
The stock price has shot up +82% during the past year and averaged about +9% in average total return during the past three years, while the S&P 500 averaged -7% per year during the same period. But, DRC is still cheap. The stock is selling at less than twelve times 2009 earnings, well below its five year average of 23.8 times earnings, while the average stock on the S&P 500 is currently selling at well over 20 times earnings.
This is a stellar company with a great business providing infrastructure equipment to a vital industry. Dresser’s earnings and the stock price should be driven higher by increased energy demand in the worldwide recovery. And, the stock is still relatively cheap.
P.S. There are plenty of ways to play oil today. For example, my colleague Amy Calistri discovered how to get her readers safe and steady “oil royalty checks” (without actually owning an oil well) that add up to about 7% of your investment every year. Amy explains everything in her January issue of The Daily Paycheck.