NOV Inc. (NOV) Q1 2018 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the National Oilwell Varco First Quarter 2018 Earnings Conference Call. [Operator Instructions]. As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, Mr. Loren Singletary, Chief Investor and Industry Relations Officer. Sir, you may begin.

Welcome, everyone, to National Oilwell Varco's first quarter 2018 earnings conference call. With me today are Clay Williams, our Chairman, President and Chief Executive Officer; and José Bayardo, our Senior Vice President and Chief Financial Officer. Before we begin, I would like to remind you that some of today's comments are forward-looking statements within the meaning of the federal securities laws. They involve risks and uncertainties and actual results may differ materially. No one should assume that these forward-looking statements remain valid later in the quarter or later in the year. For a more detailed discussion of the major risk factors affecting our business, please refer to our latest forms 10-K and 10-Q filed with the Securities and Exchange Commission. Our comments also include non-GAAP measures. Reconciliations to the nearest corresponding GAAP measures are in our earnings release available on our website. On a U.S. GAAP basis for the first quarter of 2018, NOV reported revenues of $1.8 billion and a net loss of $68 million or $0.18 per share. Our use of the term EBITDA throughout this morning's call corresponds with the term adjusted EBITDA as defined in our earnings release. Later in the call, we will host a question and answer session. [Operator Instructions]. Now let me turn the call over to Clay

Thank you, Loren. In the first quarter of 2018, NOV generated $1.8 billion in revenue, a decrease of 9% sequentially, and an increase of 3% year-on-year. EBITDA was $160 million, down $37 million sequentially, representing 21% decremental leverage to our fourth quarter 2017 results. Our performance was disappointing and less than we expected, leading us to announce preliminary results several days ago, specifically calling out some of the challenges we faced in the quarter. While some of these were outside our control, many were not. We were focused intently on improving execution, and this morning, I'm going to go straight into operations to explain what we're seeing and doing in more detail. And importantly, show why despite this slow start, we believe that 2018 is shaping up to be a much stronger year. Wellbore Technologies revenues declined a little less than 1% sequentially in the first quarter, down $4 million to $711 million, but strong Western Hemisphere growth, up 7% sequentially, was obscured by lower drill pipe sales and lower sales in the Eastern Hemisphere. Customers continue to deploy excess drill pipe from stacked rigs to working rigs, which has kept demand low and contributed to drill pipe revenues declining 12% sequentially. However, that may be changing as our first quarter drill pipe book-to-bill exceeded 200%, reaching the highest volumes we've seen since the third quarter of 2015, helped by our new delta proprietary thread design. With more than 1,000 rigs operating in the United States diminishing excess drill pipe inventories and E&P companies beginning to speck our sophisticated thread design. The outlook for drill pipe has begun to brighten. Excluding drill pipe, Wellbore Technologies North American revenues increased 7% sequentially, and Latin American revenues increased 6% sequentially, driven by stronger demand and share gains for downhole tools including bits, MWD kits, drilling motors and related equipment. As we've discussed before, NOV has directed M&A and organic development investments into tools to enable our customers to geosteer their wellbores to the sweet spot within the reservoir, and to drill straighter, lower dogleg well and encounter less vibration, torque and drag. To this end, we're seeing more uptake on our 3 Rotary steerable systems product lines. Our MWD kits, which offer 3 different types of telemetry, were also seeing sharply rising demand. In the second quarter, we expect to run our patent and select shift adjustable downhole bit motor, which may prove to be the next-generation of directional drilling technology beyond rotary steerables. This new technology targets the cost-effective delivery of the perfect wellbore, precisely placed and geosteered to the right spot in the formation. The first quarter saw bits and downhole tools post strong double-digit gains in the Western Hemisphere, where we are benefiting from pricing improvements on certain products. NOV continues to enhance a downhole tool portfolio that can provide higher quality wellbore and more precise wellbore placement, which we see as key differentiators and profitability drivers for E&P companies. We are also seeing steadily rising demand for closed-loop automated drilling optimization services employing heuristic algorithms in our proprietary Wired Drill Pipe. We expect to have 7 jobs running simultaneously soon in the Permian, Oklahoma, Alaska, Norway and Saudi Arabia. Higher levels of demand broadly for Wellbore Technologies and the strong North American market were largely offset by lower international sales sequentially, reflecting hesitancy by some Middle Eastern customers on spending money. Seasonal challenges in Russia and labor and currency devaluation issues in certain other markets. Nevertheless, with oil prices marching upwards, we believe we are seeing international markets slowly recover, and we are very enthusiastic about continued strong growth in the U.S. and higher margins. So to summarize, through the downturn, NOV has a assembled a differentiated portfolio of the most effective downhole directional drilling tools, strong first quarter uptake in the busiest, most sophisticated directional drilling markets indicates we were on the right track. Turning to Completions & Production Solutions segment. Revenues declined 3% from the fourth quarter to the first quarter to $670 million, but decremental EBITDA leverage was held to only 5% due to cost-cutting and the resolution of the subsea flexible pipe issues we discussed last quarter. The segment faced a number of unexpected challenges in the quarter, including the cancellation of a large order for the Ca Rong Do project due to the territorial dispute between China and Vietnam. Ex this cancellation, book-to-bill for the segment was 90% with most businesses reporting strong book-to-bills exceeding 100%, offset by very weak flexible pipe demand. Consequently, our flexible pipe revenues declined sequentially partly due to sluggish orders and partly because we ended up with pipe on the keyside that our customer didn't pick up by the end of the quarter, thereby deferring revenues into the second quarter. Importantly, the business successfully solved the technical torsion challenges that we described to you last quarter. Nevertheless, for the offshore products across the Completions & Production Solutions segment generally remain challenged, but higher oil prices and significant reengineering and cost reductions set the stage, we believe, for offshore FIDs to creep higher in 2018, which should lead to higher demand for our offshore products. First quarter revenue for stimulation in fracking equipment declined as well due to the lull we mentioned last quarter of customers slowing buying on the change in environment standards related to Tier 4 emissions and to customers not taking delivery of equipment by the end of the quarter. The logistical challenges in certain shale basins around labor, trucking, rail, proppant and general congestion are well documented. We believe that some of our customers are slow-rolling equipment deliveries because they may not have the cruise and logistical infrastructure fully in place to launch these new assets just yet. This is transitory, much of this equipment has already been delivered to the first few weeks of the second quarter, and our outlook remains strong as the business posted a book-to-bill well north of 100%, underpinned by very strong demand for coil tubing equipment. The segment's Fiberglas Pipe business also declined sequentially as a large shipment into West Texas did not quite make it there before the end of the quarter, but it is it there now, so we will be recognized as revenue in the second quarter. Again, this business unit is seeing strong demand, transitory factors like the West Texas order notwithstanding, and it benefited from a book-to-bill well north of 100% in the first quarter too, leading to its highest backlog ever, eclipsing the previous high set in 2014. So to sum it up. The Completion & Production Solutions segment continues to struggle with lower offshore demand, but we believe we will begin to see modest increases in offshore FIDs this year, which will be additive to the strong demand we continue to see in composite pipe, frac equipment, coiled tubing and stimulation equipment. Finally, Rig Technology segment declined 21% sequentially at 19% decremental leverage. Decrementals were limited by continued cost reductions that the segment has underway. Although we guided last quarter down for low double-digit declines for the segment, following a 20% sequential growth in this -- in the fourth quarter, the first quarter results declined even more than we expected for a couple of reasons. First, progress on new offshore rig construction was less than we forecasted. As the offshore newbuild rig market has deteriorated, the execution on certain projects has become more challenging because we rely on our shipyard customers and others to supply key functions to support our own operations. Functions such as rigors and welders, crane support, et cetera. With shipyards under stress near the bottom of the market, we find that sometimes it is more challenging to get the resources that we need. Our business has become bumpier and more difficult to forecast accurately as a result. We've seen this effect throughout the downturn, so this is really nothing new. It's just that we missed the forecast for this quarter. Second, like our other businesses, we also saw customers not pick up equipment by the end of the quarter on items like mobile rigs, which we suspect is related to, again, not yet having cruise and logistical support in place to initiate operations with these new assets. Like our other segments though, we see an awful lot to be encouraged about in Rig Technologies. And while not calling bottom yet, I am convinced the segment is finding firmer footing in a new mix of business that reflects market demands in the coming upturn. For the first time since the downturn began, we saw a book-to-bill above 100%, with nearly 60% of new orders for land markets, including 2 rigs for the Middle East, and excellent uptake on new, organically developed drawworks product that targets the upgrade of the North American land rigs. After a couple of head fakes earlier in the downturn, some key Middle Eastern tenders are moving forward now. And since the close of the quarter, we sold 2 more land rigs into Latin America, where we see more interest for high-spec AC rigs from drillers pursuing unconventional drilling programs. We were also seeing rising levels of demand for upgrade equipment, and potentially for a new super spec rigs for the North American market, which is seeing higher day rates of late. Like our other segments, Rig Technologies has used the downturn to enhance its technologies and products including introductions like our NOVOS control system, which is being specified by several major oil companies now and provides a platform for our Wellbore Technologies segment's closed loop drilling optimization service. The NOVOS systems open architecture facilitated the 15 different third party apps now available for drillers on NOVOS, and more are being written as we speak. We have finalized agreements with offshore drillers for more total cost of ownership contracts built on big data predictive analytics to improve their operational efficiency. And we saw a sharp increase in spare parts orders which may be signaling that contractors are diminishing their stocks of inventories and their cannibalization of idle equipment. Again, I'm not prepared to call bottom, but a 22% sequential increase in spare parts orders is pretty stout. We're also encouraged by the number of special-purpose surveys that we are engaged in is growing in the second quarter and we think because offshore contract velocity is rising as average contract duration has declined. Contractors want to be in the mix to win new contracts and must have the rig certifications up-to-date in order to bid. Overall, with land rig demand beginning to grow in North America underpinned by stronger day rates with new incremental land demand emerging in Latin America and the Middle East, with higher spare parts and aftermarket order levels offshore and with new technologies like NOVOS and actionable predictive analytics products in the field, the Rig Technology segment continues to pivot steadily towards greater levels of prosperity. On a consolidated basis, NOV's first quarter for 2018 was not strong. The first quarter is historically slow for E&P CapEx, and this year's budgeting CapEx felt especially tentative. We completed equipment that we didn't get off of our loading dock by quarter end, but I want to be clear, every quarter, we complete equipment and doesn't ship on time, so that is no excuse. We expect NOV to execute better, and we will, as we for, example, make additional cost adjustments like the closure of 32 more locations in addition to the 376 we have closed so far during the downturn. But my key message this morning is that we made good progress during the first quarter 2018. Just like we've made good progress throughout an extraordinarily challenging downturn to reposition NOV for the inevitable upturn. Within all 3 segments, there is a great deal to be encouraged about. We still have a long way to go and the first quarter results are a reminder that this industry is not yet healed. But the stronger, synchronized global economic growth, with oil inventory levels normalized and still declining, with customers running out of spares and consumables, and with technology proving demonstrably that horizontal drilling and hydraulic fracture stimulation could change the energy equation for the world, NOV is positioned well for the coming upturn and stronger performance as these year progresses. I'm confident our second quarter results will be much better. To our hard-working employees listening, thank you for going the extra mile to take care of our customers. You make NOV special. And Loren, Jose and I appreciate you. Now let me turn it over to Jose for more operational color. Jose?

Thank you, Clay. To quickly recap the quarter, NOV consolidated revenue was $1.8 billion, a decrease of 9% or $174 million sequentially. EBITDA declined $37 million to $160 million as decrementals were limited to 21%. Looking at the line items of the P&L, as anticipated, SG&A increased $10 million sequentially due primarily to the nonrecurrence of certain credits realized in the fourth quarter. Interest expense decreased $1 million due to a full quarter impact from the retirement of our $500 million, 1.35% senior note in December. Equity income increased $3 million, primarily due to rapidly improving results in our post-Alpine joint venture which we realized a 14% revenue growth sequentially. Other expenses increased $40 million, primarily due to losses associated with FX and certain owned assets. We reported a GAAP loss before income taxes of $63 million and tax expense of $3 million. The negative tax rate was a result of the valuation allowances applied to foreign tax credits and an increase in nondeductible expenses associated with the recent tax reform legislation, which prevented our tax benefits from fully offsetting income realized in a number of foreign countries. While we operate at or near breakeven income levels, relatively small changes in income by jurisdiction or discrete items will result in significant volatility in our effective tax rate's from quarter-to-quarter. We anticipated that incentive compensation and income and property tax payments would meaningfully reduce cash flow from operations in the first quarter. However, delayed orders and deferred deliveries further contributed to our increase in working capital resulting in a $129 million net use of cash from operations. As Clay mentioned, inventory that was expected to ship and translate into revenue by quarter end did not make it out the door and remained on our balance sheet in greater quantity than expected. We also invested $75 million in capital expenditures and acquisitions, resulting in cash balances decreasing by $201 million during the first quarter. While we're not pleased with the increase in working capital, we remain confident in our ability to convert our inventory and IRR to cash throughout the course of 2018, and expect our future cash flow generation to better reflect our market-leading positions and capital-light business model. Last quarter, we described our philosophy regarding capital allocation. With the expectation that we will generate cash flow that meaningfully exceeds our near-term organic investment requirements. We highlighted that we would like to return excess capital to shareholders in the event that attractive investment opportunities did not materialize. However, we felt that the M&A environment was constructive, which we still feel is the case today. We expect to close several transactions during the second quarter, and we continue to see other attractive M&A targets in the market. This potential high return M&A opportunities likely differ an increase in return of capital to shareholder, but we will closely monitor cash flow generation and future cash needs. Turning back to results of our operations. For the first quarter of 2018, our Wellbore Technologies segment generated $711 million in revenue, a decrease of $4 million. EBITDA also decreased $4 million to $103 million or 14.5% of sales. Strong momentum resulting from our technologies that helped customers more efficiently and precisely placed low torch velocity horizontal wellbores carry forward in Western Hemisphere during Q1, but this growth was more than offset by various slow start to the year across the Eastern Hemisphere, and the 12% falloff in revenue from our drill pipe business. Segment growth in the U.S. continued to outpace industry activity levels and we also realized strong improvements in certain Latin American operations, particularly in Argentina, which more than offset slowing activity in Brazil and Mexico. Overall, segment revenue increased almost 7% in the Western Hemisphere, led by strong demand for products from our ReedHycalog and downhole business units. No operational highlights of the dichotomy in demand from the 2 hemispheres is better than our downhole tool business, which realized 14% revenue growth in the Western Hemisphere and a 10% decline in the East, but delivered 8% sequential growth overall, with strong incrementals. Robust demand continued through Q1 for our drilling, motor and agitator tools and we saw a 20% step change increase in demand for coiled tubing tools as customers replenished depleted inventories and prepare to ramp completion-related activities. Demand for our drilling motors increased 8% sequentially, driven by the enhanced drilling performance provided by our products. We continue to see customers break drilling records when utilized our latest drilling technologies found in products like our Vector Series 50 drilling motor and ERT power section. These products working in tandem recently helped and operate a deliberate 223-foot per hour average rate of penetration on a 10,000-foot horizontal run in the Williston Basin. We also experienced the 10% improvement in demand for our agitator tools, driven in large part by our new Agitator HD product, which continues to gain greater adoption due to its exceptional performance. We've seen the tool enable operators to reduce weight on debt by up to 50%, while delivering 35% improvements in rate of penetration versus offset wells, less we are and increased speeds contribute to meaningfully reduce the cost of drilling operations. Our ReedHycalog business also demonstrated strong performance, realizing a 4% sequential improvement that was led by our bits and borehole enlargement operation in the U.S., which realized 11% sequential growth. We continue to achieve market share gains with our fixed cutter bits as a result of our ION-shaped cutter technology, which provides superior impact and thermal resistance for greater durability. Additionally, our proprietary-shaped cutter designs increased formation fracture propagation by concentrating more force on a defined point, improving drilling efficiency in tough formations. These designs have also been proven to meaningfully decrease the average size of drill cutting particles, significantly improving fluid dynamics, rate of penetration, bit life and the bit's ability to evacuate cuttings from the wellbore. Our downhole measurement tool offering is also realizing market share gains and posted a 12% sequential increase in worldwide sales. Orders included 1 sale for 16 Tolteq MWD strings for the U.S. as well as orders for our newly introduced I series near-bit subsystem and NXT directional module. The near-bit subsystem places MWD tool between the drill bit and the mud motor to provide near-realtime data that originates inches from the bit. Significantly improving response time and enhancing the ability to stay within the formation's target area. The NXT module provides the ability to capture continuous inclination in azimuth readings. Realtime measurements at annular and internal bore pressure while drilling and stick-slip detection, enabling better drilling performance via realtime optimization. Our eVolve automation and optimization services continue to knock strong 8% sequential growth and received several project bookings, which should drive even stronger growth from Q1 to Q2. And performance of our ReedHycalog and downhole tools businesses is indicative of the success we are realizing from our strategy to provide customers with better physical and digital solutions to more precisely and accurately place low torch horizontal wellbores at lower cost. Our legacy wellsite services businesses posted a 1% sequential increase in revenue. Strong demand for solids control equipment and services from increasing activity in the Permian and Oklahoma resulted in 6% top line improvement in our U.S. operation. This robust growth creates opportunities to begin regaining some pricing power in the U.S. WellSite Services also realized robust sequential improvement in Latin America from increased activity in Argentina as well as from new projects in other countries, which included a pipeline tunneling job that is using Brandt solids controls equipment and our portable power generators to drill 3-meter diameter, 2.5-kilometer long gas pipeline channel north of Mexico. Like our other businesses in the segment, strong results in the Western Hemisphere were mostly offset by challenging conditions in the Eastern Hemisphere and offshore markets, with, Africa and Asia realizing the largest sequential declines. Our Tuboscope operation also experienced similar market conditions as other businesses within the segment. The challenges were further compounded by lost productivity in the U.S. due to weather-related disruptions in January as well as maintenance shutdowns impacted our coating plant in Midland, Texas. As previously described, our drill pipe business experienced another sharp sequential fall off in revenue, but bookings exceeded our expectations, reaching levels not seen since 2015. While customers remain capital constrained, we are growing more confident rapidly improving fundamentals for this business and expect to see a material improvement in revenue during the second quarter. Improve prospects for our drill pipe business will amplify overall segment results, which should also benefit from strong momentum in the U.S. and rebound within certain Eastern Hemisphere countries. As a result, we expect to realize high single-digit percentage top line growth, with strong 40% to 50% incrementals. Our Completions & Production Solutions segment generated $670 million in revenue in the first quarter, a decrease of 3% or $20 million sequentially. EBITDA decrementals were limited to 5% due to cost-reduction initiatives and the resolution of manufacturing challenges that impacted our Subsea Production Systems business unit in the fourth quarter. As a result, EBITDA fell by $1 million to $73 million. As Clay mentioned, bookings were generally solid for the segment, with most businesses reporting book-to-bills in excess of 100%. But weak demand for subsea flexible pipe and the cancellation of the Ca Rong Do project resulted in total net bookings of $324 million or an 84% book-to-bill. Total backlog remained above $1 billion at the end of the quarter. Our Process and Flow Technologies business unit realized a 3% sequential top line improvement, and recorded a second quarter in a row with a book-to-bill greater than 100%. The business is seeing increasing demand for reciprocating pumps and midstream products, including closures and pumps for North America. Additionally, we're seeing growing demand for industrial pumps and mixers. Notwithstanding solid bookings for produced water, sand handling and gas dehydration packages associated with the Johan Castberg and Johan Sverdrup developments, the more offshore-oriented wellstream processing area of this business unit remains challenged. While we are generally seeing improving market fundamentals and an increasing number of FIDs, offshore markets remain challenging and we, therefore, see significant crosscurrents across this segment. As Clay mentioned, our Subsea Production Systems business units saw a sequential decline in revenues and soft orders as projects remain limited and competition is fierce for the limited opportunities that do emerge. A bright spot within this business unit is the success we're seeing with the recent commercialization of our proprietary Seabox subsea seawater treatment system. The initial unit was deployed in Q1, and its performance has exceeded all expectations, garnering additional interest from other potential customers. The system also recently won an Offshore Technology Conference 2018 Spotlight on New Technology award, which recognizes the industry's most advanced technologies. Ones that are poised to dramatically change offshore exploration and help the industry operate more efficiently, safely and sustainably. Another bright spot among our offshore-focused operations was our XL Systems conductor pipe connector business unit. The operation delivered strong sequential revenue growth and solid bookings, driven in large part by ramping activity in Guyana. Our fiberglass systems business unit posted a sequential decline in revenue, primarily due to the delayed delivery mentioned earlier as well as limited market demand in the marine and offshore markets. Notwithstanding the challenges in the offshore area, we anticipate growing demand in the North American and Middle Eastern marketplaces for our corrosion-proof piping systems, more than offset stagnant after demand in the foreseeable future. In the first quarter, Fiberglass Systems posted its third quarter in bookings over $100 million, and book-to-bill of over 100%. The bookings included an order from a customer in West Texas, for whom we will have provided over 70 miles of corrosion-proof pipe for a saltwater gathering and disposal system. As unconventional production rises, so too does the production of brine, enhancing the importance of saltwater gathering and disposal systems. Our corrosion-proof composite pipe offers a compelling long-term cost advantage over steel tubing and we see the oil and gas market steadily converting conventional steel installations to composite pipe for its longer lifespan and higher corrosion resistance. As previously noted, our Intervention & Stimulation Equipment business units saw a sequential decline in revenue, primarily due to deferred deliveries of pressure pumping equipment as well as large wireline equipment deliveries that occurred in Q4 but did not repeat in the first quarter. Regardless of the softness in revenue during the quarter, we remain optimistic regarding the future performance of this business unit after realizing $120 million in bookings, making Q1 the fifth quarter out of the last 6 in which we have posted a book-to-bill in excess of 100%. Notable in the order book was a substantial increase in orders for coil tubing equipment as well as a resumption of orders for pressure pumping equipment after taking a bit of a pause in Q4. Looking at the second quarter, we expect to see a 4% to 5% sequential improvement in segment revenues. Crosscurrents will continue through at least the first half of the year, and we anticipate our pure play offshore business units will partially offset the recovery in our land-oriented operations, limiting operating leverage to around 30%. Our Rig Technology segment generated $483 million in revenue, a decrease of $131 million or 21%. EBITDA declined $25 million to $45 million or 9.3% of sales. Revenues from capital equipment fell by $110 million. In addition to slower-than-anticipated progress on offshore rig construction and deferred deliveries of equipment, we also saw a $23 million net reduction of revenue associated with new revenue recognition standards, which slightly alter the timing of when certain revenue streams are recognized. The changes in timing also resulted in a $110 million upward adjustment to segment's backlog in Q1. Bookings for the quarter were strong, coming in at $201 million. The highest level achieved since the third quarter of 2015 and the first time we exceeded 100% book-to-bill since the second quarter of 2014. Clay touched on several specific highlights from the order book, but I'll provide some additional color on what we're seeing from a customer base. Pent-up demand for more modern land drilling technology is bubbling to the surface with greater frequency. We've seen it in North America over the past 1.5 years in the form of equipment technology upgrade to achieve Tier 1 super spec capabilities. This opportunity continues to evolve and the average project scope is increasing for NOV, and as the easy-to-upgrade rigs have mostly been converted. We now see increasingly complex upgrades, including DC to AC conversions and upgrades that incorporate our newly introduced DSGD 425 drawworks. This dual-speed, gear-driven, 425-ton, 2,000-horsepower system was specifically designed for extended-reach drilling applications in North America. We believe that steadily improving activity levels and corresponding increase in day rates support this more elaborate upgrades and will eventually support more new build opportunities in North America. More importantly, we also believe we are beginning to see the early stages of our larger upgrade cycle in the international markets, particularly in certain Middle Eastern and Latin American countries. Capabilities of the drilling fleets in these markets are 1 to 2 decades behind us commonly found throughout the active rig fleet in North America. As a result, we believe the cycle in international market will be better characterized by newbuild rigs rather than equipment updates. We have long believed there is building pent-up demand for high spec land rigs in the international markets and that our agreement with Aramco to build 50 high spec rigs for the Saudi Arabian marketplace would be the first of many international newbuild opportunities. But such projects have been slow to materialize. While we are not prepared to say that we're at a tipping point, we are seeing more opportunities emerge in the form of tenders and spot rig purchases. As Clay mentioned, we sold 2 rigs just in Middle Eastern in Q1 and booked sales earlier in Q2 for two rigs destined for Latin America. We could also see several additional land rig sales over the remainder of the second quarter. In our aftermarket operations, the seasonal falloff in service and repair-related revenue more than offset a $12 million increase in spare parts sales, which resulted in a $20 million overall decrease in aftermarket revenues. We're encouraged by what we are seeing in demand for spare part bookings, which increased 23% sequentially, and reached levels not seen since Q3 of 2015. While indications are hard that we'll see another sequential increase in spare part bookings in Q2, we're hesitant to call bottom due to the head fake that we saw in 2017. Near-term, we expect the volatility in the segment to continue as we bounce along the bottom of the cycle. The booking-to-revenue conversion cycle, to shorten, as we continue to hold ample inventory for land rigs and equipment; and limited operating leverage, as we reward first-mover customers with discounts and convert to cash the inventory that has been slow to move during this prolonged downturn. Specifically for Q2, we anticipate top line growth of roughly 20%, with incremental margins in the low to mid-teens for our Rig Technology segment. So while we were a little slow getting off the blocks in 2018, this organization has a long history of executing extremely well. And we know we will perform better. While challenges persist, broader market fundamentals continue to improve, creating additional demand for our critical enabling technologies. We are also seeing more and more signs of a nascent recovery in international markets, and in more of our longer cycle product lines including drill pipe and land rigs. Our ability to execute in improving markets give us confidence that we will get back to our prior trajectory during the second quarter. With that, we'll open it up for questions.

[Operator Instructions]. Our first question is from Byron Pope from Tudor, Pickering, Holt.

Just have one question. I tend to think of Wellbore Technologies, many technologies within that portfolio, is being early cycle in nature. And it seems like it's just a matter of time before we see the Eastern Hemisphere come around. So Clay, could you just frame, based on what you're hearing and seeing from customers with regard to inquiries, which regions or countries in the Eastern Hemisphere you would expect to lead the recovery there?

Yes, Byron. We're currently hearing a more interest out of the Middle East. Of course, Middle East, through the downturn, has remained at higher activity levels and seen less of a falloff. But kind of what I'm hearing lately from, in particular, national oil companies across that region is they're looking to the productivity gains that have been made in the Western Hemisphere, and really focus on how to replicate those. And in particular, deliver the sorts of long laterals and highly productive wellbores that have been accomplished here in the United States, and so I think a lot of excitement there. Also encouraged by recent developments in Asia. That region, I think, turned down harder than many others in the downturn, and has been hit particularly hard. But in the last quarter or 2, I think, we're getting some more interest there, so that's encouraging. And then lastly, we kind of referenced this in our prepared remarks, a lot of people are very focused on, in particular the Vaca Muerta shale in Argentina, and recognize that newer and more modern levels of technology need to be brought to bear to that formation I think to achieve the sort of results that our producers in North America have achieved with unconventional. So again, there's a lot to be encouraged about in terms of the uptake for the technology NOV offers.

That's helpful. And then just one follow-up with regard to the North America part of Wellbore Technologies. I assumed, based on what you guys are seeing in terms of footage drilled, even if we were to see the pace of incremental rig adds and based on the Permian slow, the trends that you guys are seeing with regard to footage, horizontal footage drill, I would assume, continue to progress in fairly conservative faction. Would that be a fair way to think about it?

I appreciate you bringing that up, Byron, because as you know, is that Wellbore Technologies is probably more driven by footage drilled than actual well count. And the industry continues to improve productivity per rig. In fact, if you look at just over the long-term the footage drilled per active rig is up fourfold from where it was, say 30, 35 years ago, back in the early '80s, so steady gains being made there. But in a lot of ways, that just means we're consuming tools and rigs faster. It's, as I say with cars, it's not the age, it's the mileage. So that's really what NOV benefits from.

Our next question is from Sean Meakim of JPMorgan.

So maybe given the dichotomy you talked about between hemispheres in wellbore. Can you maybe just give us a little bit more granularity of what drove the decline in Eastern hemisphere? Is it just slow start to budget implementations in those types of markets? You mentioned drill pipe being a source of weakness, was that more weighted towards EH as well where the 2 connected, I guess, maybe the western side seem to make sense as you broke that down for us, which was very helpful. Maybe we could drill a bit more on the eastern sides.

Sure, Sean. It's Jose. And effectively, the primary reason is really the typical slowdown that you see in the Eastern Hemisphere in Q1. So it's certainly not unique to NOV. I think maybe we were a little overly optimistic in terms of what the budgeting cycle might look like in 2018. If you'd recall back in 2017, with a slight improvement in commodity prices, you saw activities sort of continue to carry forward and build. This year, even though we had a better commodity prices and arguably a faster pace of improvement in commodity prices, we went back to sort of a traditional budgeting process, particularly in the Eastern Hemisphere. Let's say that we remain very optimistic about where things are headed in the Eastern Hemisphere, in general, a couple of quarters ago, we started seeing that area of the world come to life a little bit more for us. And that wasn't even a result of improved drilling activity, it was really more a result of the scarcity that just takes place over time as operators and service companies consume the inventories of the product they had on hand. So when people come back with those budgets, we are optimistic about what 2018 will look like as the year unfolds. As it relates to the drill pipe question, it's really, obviously, with the 12% sequential decline, it's pretty bad everywhere. But extremely encouraged about what we're seeing in terms of the bookings that we attained this quarter as well as the continued falloff in customer on pipe that we see within our Tuboscope yard. So feel good about where things are headed.

Got it. Okay. That all makes sense. On Rig Technologies, given some of the issues that you outlined, maybe you can you give us an update on how you see the cadence, what's in there today in terms of backlog? Perhaps maybe what you see as likely what you defined as likely 2019 and beyond? You said that the business has become lumpier in terms of the throughput, so that will be great just to get a little update on kind of how you see that cadence based on what you can see today.

Generally, Sean, and you're very familiar with this, but our -- we've been working down our backlog of newbuild offshore rigs, which we entered the downturn with a lot of projects underway, and so those have sort of been diminishing over time. And as I mentioned, and again, in prepared remarks, maybe subject to a little more drama in terms of getting them completed in a steady fashion and being able to forecast progress and those. And what we're seeing now is the replacement of that with more land rig demand. So almost 60% of this quarter's orders for rig technology were for land rigs and we've got a pretty good start on Q2 with the sale of 2 more land rigs into Latin America, and outlook is brightening for demand there. And so what we see -- how we see that business progressing through the remainder of 2018 is kind of continuing to complete these offshore rigs and then pivoting to the land rig business, which we think is very promising for NOV. I think for next quarter, we are looking for about $260 million or maybe $270 million to come out of the existing backlog. And for the remainder -- or for the full year, I guess, 2018...

900

About $900 million to flow out as kind of the current -- currently what's in there. But as Jose mentioned, I think there is a lot of sort of building demand for better technology to achieve higher levels of productivity in drilling. And that really rests on a more modern rig fleet. And the rig fleet throughout most of the international markets is still a generation behind, really the super spec AC sort of capabilities that we have here in North America. And that will be the engine that will drive demand and results for rig technology.

Our next question is from James West with Evercore ISI.

Clay, I wanted to dig in a little bit more on NOVOS. This is something you've been highlighting more and more. I got a chance to spend some time with your guys that have developed this, and I'm hearing from a lot of the -- at least several of the drilling joint contractors that they were very happy with the software. Could you just talk about maybe the penetration that you guys have so far with NOVOS? And then also, I'm curious of the 15 apps that have been developed and more that are being written right now, is there any types of trends that you're seeing with those applications? Or are they kind of all across the drilling spectrum?

Yes, they're really kind of all across the drilling spectrum, James. And coming from all corners of the oil and gas world, so we have drilling contractors that have written apps, we have service companies that have written apps and we have major oil companies that have written apps, and in fact, we had a successful test on an app here in the first quarter from one of the majors that we're very excited about. And so a lot of interest in developing a specific applications that work within our NOVOS environment. And just to explain to listeners who may not be completely familiar, this is -- the NOVOS system is an operating system that operates drilling rigs. And it's an open architecture system that permits third parties to come in and write applications to control the rig in a safe environment, in an envelope that we define to execute their specific operations on the rig. It enables third parties to automate certain steps on the rig. And really what we're trying to accomplish with that software package is to bring more process control and automation to the repetitive actions that are done on rigs. And so there are dozens, if not hundreds, of specific steps in the drilling of a well that are accomplished through a lot of manual steps executed by the driller and the crews. And so in many ways, drillers are really kind of rig drivers. And what we're trying to do is lift that profession up and make that individual more of a process manager and a team leader, less intently focused on driving the rig and more focused on kind of the work environment and the people to think ahead and to let the machines do the repetitive work on the rig. And so it's a really interesting development, I think. And the move here towards effectively sort of crowdsourcing rig activities and doing that in a way that it enables third parties to launch apps that underpin their services or their operations on a rig is pretty interesting. So not surprisingly, I think we're seeing a lot of interest in this and really good adoption. There's 1 large drilling contractor in particular that's been a good partner in this, and then as well as a number of other smaller joint contractors onshore. And now we are migrating this technology offshore this quarter. And there are a number of folks out there. And the last thing I would add on NOVOS, James, is that it's been noticed by the oil companies. And so we're -- I think some drilling contractors are experiencing a lot of pull on this technology and capability from their customers.

That's great to hear. It's very exciting. And just one kind of unrelated follow-up from me. The Middle Eastern tenders that are out there today, which are some pretty big ones, am I correct in thinking that all of them basically spec in this new super spec type of land rigs?

Well, we can always hope but not quite yet. We do have, again, there is a lot of interest overseas for kind of newer, more modern capabilities and technologies. But I would say it's still a mixed bag in terms of [indiscernible] over there. But the good news I think for NOV in the longer-term is [indiscernible] very aware of the technology of new super spec rigs. And so we are seeing some of these standers start to fall that in.

The next question is from Marshall Adkins of Raymond James.

So Clay, I'm sitting here thinking about this, I mean, we got oil up sharply last 9 months, Brent's at 75 today. Every U.S. company we talked to is out of equipment. And most of them have depleted their inventories, and I would assume that's the case for offshore as well. So what am I missing? I mean, Q1 seems to be very transitory in nature, and we should see a meaningful improvement in your business in the back half of '18, and really going into '19 given the later cycle and the lagging part -- the buying phase that you insisted. What's wrong with that logic?

I think that describes it perfectly, Marshall. Obviously, as we mentioned, we are disappointed with Q1 but we do view it as largely transitory. The trends are intact. I -- the only sort of caveat I would make to what you just said is offshore, there are a lot of stacked rigs and so cannibalization continues. We did see a lot of encouragement in the first quarter around spare parts orders that point to maybe we're near the end. So I am a little hesitant to say that our offshore customers are out of spare parts just yet. One quarter doesn't make a trend, but certainly a really strong move on spare parts orders at 22% sequentially in Q1 is pretty solid there. But yes, I think you step back and look at how the company evolves out of this downturn, I think we would have all predicted it would start with consumables and a lot of quick turn items in Wellbore Technologies, which we've seen that pricing leverage would return around those product lines and then a little later in the recovery demand for capital equipment. And so far, we seem to be sort of on that progression.

Are you saying -- with the recent upward surge in the last few months, are you seeing more green shoots across the board in the offshore side? And you mentioned that the parts, but are you seeing more stuff on the consumables offshore, et cetera, et cetera? Has that -- have those discussions changed?

Yes. But what I would add is that they tend to be more conversations and -- we're not seeing the purchase orders falling yet. And so the offshore has lagged, certainly, the North American land market and certain other markets around the globe. But what is encouraging is the number of conversations that we're having, for instance, around our new FPSO topside package initiative appears to be rising. We're getting some feed studies here and there. So yes, I think we are seeing some green shoots and $75 a barrel Brent is precisely the thing that we need to start turning those into purchase orders.

One last quick one for me. Free cash flow of potential seems to be pretty meaningful looking out to later this year and '19. Could you all just comment on your thoughts there?

Sure, Marshall, it's Jose. Yes. So we continue to believe that we will generate an ample amount of free cash flow over the next couple of years. Obviously, Q1 wasn't great from a free cash flow perspective, as we commented. It was anticipated, but also magnified by the fact that inventory stuck around a little bit longer than we had hoped. So we still have the same goals and objectives as it relates to working capital. It is a huge area of emphasis across the organization. As we talked about before, our goal is to get back to historical norms in terms of working capital levels, which we look at as working capital as a percentage of revenue run rate. And what that means is that over the course of call it the next 24 months, we will be able to get back in the vicinity of sort of 35% range for that metric, which, if we do that and if we perform operationally the way we expect to, we'll realize ample amount of free cash flow.

Our next question is from Ken Sill with SunTrust.

Two questions that are kind of minor issues but interesting. Schlumberger is back talking about the rig of the future. They're going to deploy 1 in the U.S. and a couple internationally. Is that a project where they're kind of competing with your designs? Or it's just an alternative to your designs, but they use your parts? It's hard to gauge talking to them what their potential is and I'm just wondering what you guys read on that is.

Ken, being a provider of rig equipment and complete land rig packages, obviously, we've been paying close attention to what they're doing. I think they're probably in a better position to comment on them than we are.

Come on, you know they won't comment on it.

To focus on enhancing our rigs, developing our rigs with features like the NOVOS control system, for instance, we introduced a new drawworks package to upgrade 1,500-horsepower of drawworks to 2,000-horsepower drawworks, which we think is something that is -- we're already finding actually that North American drillers find that attractive. We are kind of focused on our own rigs and rig offerings to the marketplace and can't tell you precisely what they're focused on.

Okay. Another question, obviously, you can't tell us you're working on R&D, but with longer laterals, we're hearing people taking laterals out to well beyond 2 miles now, which inhibits the use of coiled tubing at the far end. Is there anything in the skunk works related to either an enhanced workover rig that's more automated? Or some way to make coiled tubing so it can get further out?

Yes. So larger diameter coiled tubing, higher strength coiled tubing, we've focused on to reach further out. We have completion tools, including sliding sleeves where you can change the way that you access the wellbore further out. We are -- we manufacture well servicing rigs, which you join a pipe to reach out further into the laterals, and we're seeing higher, basically, customer demand for higher mass on well servicing rigs and more pumping capacity and kind of better pipe handling capability driving further demand. So yes, we're kind of all over that trend, including some hybrid units that we're developing to. And so in terms of accessing that wellbore, yes, there are several different ways that NOV is helping customers achieve that. I would add too that in terms of creating that wellbore, you heard on our prepared remarks all the things that we're doing with regards to geosteering, to directional drilling and drilling a straighter wellbore, including Rotary steerable tools and other directional drilling tools because one of the big challenges that E&P company faces, torque and drag is sort of cumulative as that lateral goes longer and longer and longer, so that becomes a problem further out and vibrations, and maintaining oil control and the like. So both the creation and the drilling of that wellbore and also the completion of that wellbore, we have a lot of things going on.

Our next question is from Marc Bianchi with Cowan.

Again Jose, looking at the guidance here for second quarter, I suspect there's some proportion of kind of catch up from what you lost in the first quarter. Is there any way you can help us think about how much of it is just due to the catch up? And then how much is sort of the underlying performance of the business as we try to take a better baseline for modeling beyond second quarter?

Yes, sure, Marc. I can't get into specifics associated with precisely how much slipped from 1 quarter to the next. But there are a couple of elements you got to consider when thinking about the impact to the second quarter and beyond. So certainly we had some of those equipment deliveries get deferred from Q1 to Q2, which will help the revenue in the second quarter. But the other item that corresponded with the deferred deliveries is deferred orders. So orders that took longer to materialize than what we would have otherwise anticipated, meaning a lot of orders came in very, very late in the quarter. So there's a little bit of an element of things slipping from Q1 to Q2, which boost Q2. And then there is another issue associated with timing of those orders that came in late in the quarter which will likely push what we otherwise would have expected in Q2 to take place in Q3. So it's a little bit of a mixed bag there.

Okay. Okay, that's helpful. And I guess, another one for, maybe for Clay. If you guys are talking about the M&A potential now potentially putting on hold and kind of capital return. At the point you do get to thinking about capital return, how do you weigh opportunities for further M&A versus stock buyback versus dividend? And how does the level of stock come into play for that?

That's a great question. And so, as we've mentioned in the past, kind of our hierarchy of attractiveness typically is around organic investment to support our ongoing operations and development of new technologies here internally. And then acquisitions of businesses to sort of enhance our businesses and to deploy capital in new attractive areas. And then the return of excess capital is what we look at and with regards to either through a dividend, special or increasing our regular dividend, or through share buybacks. And so as Jose mentioned in his prepared remarks, we're not prepared yet to increase our capital return to shareholders, but we are in close consultation with our board. And as the year progresses, the way we think we will, will be, I think, probably looking more closely at that, but we will be comparing it to our other potential applications of capital. The company has been busy on the M&A front, and we continue to see a lot of attractive opportunities out there. We had 3 closings in the first quarter and we've got several companies now that we're in the middle of discussions with. And so it continues to be a pretty interesting market for M&A. But basically, to answer your question, we sort of compare application of capital net direction versus either share buyback or an increase in dividend.

Our last question is from Jud Bailey of Wells Fargo.

A question on C&P margins. I appreciate kind of issues going on in the front half of the year in terms of mix, et cetera. How do we think about margins in the back half of the year assuming things progress as you think. Is it reasonable to think we can get back to kind of where you were 2Q, 3Q last year, kind of 14%, 15% type margins in the back half of the year if you start to see decent order flow return? Or help us think about margins in the back half of the year for that segment, if you don't mind.

Hey Jud, it's Jose, I'll start with and Clay will add, if you like. Ultimately, it depended on what the revenue flow and what the opportunity set is. But the thing is, as you know, that's been creating challenges for us on the margin front are the cross currents and the decline in the offshore-related components of that segment. We think we're getting close to a bottom as it relates to those types of issues but we still think over the next quarter or 2 that, that will continue to be a drag on potential incrementals for that segment. With as we get into the back half of the year, certainly expect that business to start generating much more meaningful incremental margin improvements.

Okay. Yes, and my follow-up, I just wanted to circle back on the Rig Systems guide, pretty strong revenue growth but low incrementals. I apologize if I missed the explanation on that. But what's kind of driving the mix there with the lower incrementals relative to pretty strong kind of improvement in the revenue?

Yes, what we try to describe there is a lot of these initial newbuild land rig sales that are going out the door, we have had, as you know, quite a bit of excess inventory sitting in our yards. And also our rewarding first mover customers with some pretty attractive pricing, so here we are in the very initial stages of the recovery of the land markets. We're anticipating less-than-ideal incrementals associated with those but that would be a very short-lived phenomenon.

At this time, I'd like to turn the call over to Mr. Williams for closing remarks.

Thank you all for joining us this morning, and we look forward to sharing our second quarter results with you in July.

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect. Everyone, have a great day.