"Art Of The Deal" Says Dril-Quip Is 15% Overvalued

Ever since oil prices fell from their Q2 2014 peak I have been predicting Dril-Quip's DRQ demise. Offshore E&P has dried up and it will eventually hurt the company's top line. The company generates 69% of its revenue from subsea equipment sales. Q4 revenue from that segment was flat sequentially after having fallen 13% in the previous quarter.

DRQ has not experienced the free fall I have been predicting. The stock is off about 13% over the past year versus a flat return for the S&P 500 SPY. Despite flat to declining revenue Dril-Quip's EBITDA margins have held up well due to management's cost containment efforts. Full-year 2015 revenue was off about 9% Y/Y. However, EBITDA only fell 2% as the company improved margins from 31% in 2014 to 33% in 2015. Otherwise DRQ might have fallen much further. Analysts expect deep water drilling to experience a severe downturn in 2016. Margins might also take a hit due to a loss of scale.

The Model Says $61 However ...

According my bottoms up analysis based on 2015 EBITDA, DRQ is worth $61.

2015 Revenue

2015 revenue is actual full-year revenue for the past year. Revenue fell sharply after Q1 but was flat in the second half of the year. Until actual results come in much lower, one could argue that last year's revenue could be a decent starting point for a valuation.

EBITDA

EBITDA represents actual results for 2015. I expect the company to continue to cut costs in an attempt to maintain margins. Margin erosion could be the one event that causes investors to abandon the stock.

EBITDA Multiple

A multiple of 5.0x to 7.0x is appropriate for an industry leader in a cyclical industry in decline. I awarded Dril-Quip with a valuation at the top end of the range; its revenue and EBITDA have been relatively stable considering the free fall in oil prices and oil & gas capex.

Enterprise Value

The company's enterprise value (equity and debt) would be $2.0 billion.

Equity Value

Including cash of $381 million (Dril-Quip has no debt), I derived an equity value of $2.3 billion.

Per Share Price

I assumed 38.4 million shares outstanding which was sourced from Yahoo. The per share price would be about $61.

The "Art Of The Deal" Says Closer To $50

A analysis based on 2015 actual results delivers a valuation that is probably at the top-end of what DRQ would be worth. Analysts expect the company's Q1 2016 revenue to decline to $167.83 million - down 17% sequentially and 26% Y/Y. If one assumed a 33% EBITDA margin (consistent with Q4 2015 results), Dril-Quip's EBITDA would decline to $56 million or an annual run-rate of $224 million; this margin would be optimistic given the loss of scale.

At 7x forward EBITDA the company's enterprise value would decline to $1.6 billion; its shares would be worth $50 or about 15% less than its current share price. If revenue does fall by double digits as expected, it could be the first quarter that EBITDA margins break support. This is where the "art" comes into play. At a current share price of close to $60 DRQ is overvalued. However, I might have to consider closing my short position once the stock hits $50.

Conclusion

DRQ is worth from $60 - $50 per share. If Q1 2016 results are as bad as expected then $50 could be in the cards. I remain short the stock.