Comeback Seen for Varco International, Knocked for a Loop by 1982-86 Oil Decline

During the last six years, while most county businesses have been booming, oil service companies have taken a big-league beating.

Once-important components of the local economy, two of three major county oil service firms barely pulled through an industry decline that began in 1982 and reached rock bottom in 1986.

Smith International of Newport Beach was forced into Chapter 11 bankruptcy proceedings, while Varco International in Orange survived by laying off 90% of its work force.

The third county company, Baker International, merged with Houston-based Hughes Tool Co. and moved its headquarters to Texas.

Smith, which emerged from bankruptcy Dec. 31, and Varco, which is recovering from its own financial downturn, have survived the dark days.

Analysts are saying both companies are poised for something of a comeback, providing that oil prices don’t go into the tank this year.

Take Varco. The company hasn’t made money since 1981. It lost $9.2 million in 1986, plus another $6 million through the first three quarters of 1987.

The losses resulted in the firing of 225 workers in 1987. Last Spring, shareholders agreed to provide Varco President George Boyadjieff with an interest-free loan of $430,000 to cover personal losses on Varco stock options.

So, why should anyone consider an investment in Varco?

For one thing, there’s a good case to be made that the oil industry as a whole will grow in 1988. Last week, the major oil companies reported improved earnings. Several have also enlisted Japanese investors for exploration ventures.

Russell Hoffman, an oil analyst with Shearson Lehman-E.F. Hutton, expects the majors to increase their exploration and drilling budgets by 10% to 15% over last year’s level. Domestic drilling activity was hardly robust last year, although it was better than in 1986, the worst year ever.

There are already signs that 1988 will be a good year for the industry. Winter is usually the slowest season for Gulf of Mexico drilling, Hoffman said. But so far, contract rates for rigs have increased from $12,000 to $13,000 per day late last year to more than $15,000 per day in January. The same upward price movement holds true for North Sea rigs.

Work by Robert Phaneuf, an oil analyst with Kidder Peabody in Dallas, shows that whenever the after-tax rate of return on oil investments moves to a spread of 4% or more over 15-year Treasury bonds, oil drilling picks up.

Assuming oil prices of about $20 per barrel, Phaneuf is looking for returns on oil investments of about 14% in 1988, contrasted with Treasury rates of 8.75%. Last year, oil investments yielded about 11%, contrasted with Treasury yields of about 7.5%. The widening spread could signal an uptick in drilling.

Phaneuf is predicting that the number of rigs operating nationally will rise to a daily average of 1,100 in 1988, up from 936 last year. In 1981, an average of about 4,000 rigs were operating.

Phaneuf’s 1988 projection would be welcome news for Varco. The company developed and sells “top drive” drill bit units that can cut drilling time by up to 40% over traditional equipment in rocky terrain.

Varco has just delivered 12 of the units and has 28 more drives on order. Each drive sells for $500,000 to $600,000. The company is also preparing to market a new automated pipe handling machine that should help cut drilling labor costs, he added.

The pick-up in business has allowed Varco to reinstate 130 of the 225 jobs the company cut in 1986.

“For the first time in many years, we feel we’re in pretty good shape,” Varco Treasurer Donald Stichler said. “We’re anticipating break-even in the fourth quarter and profitability for the first quarter.”

Varco might not have been around to take advantage of the industry upturn if it hadn’t been for some fancy financial footwork.

The company has gone to great lengths to restructure its balance sheet, Stichler said. Nearly a year ago, the company issued $23 million of convertible bonds with a yield of 10%. Varco set the conversion price at $2.50 a share, slightly below the market price of the company’s common stock at the time. So far, investors have converted nearly $18 million of the bonds into common shares, as Varco’s stock rallied to more than $9 a share before the October collapse.

The financing allowed Varco to reduce its interest expense, to retire $10.4 million of outstanding debt and to set aside some needed cash for working capital.

At the the end of the third quarter, Varco was also able to convert nearly all of its 500,000 shares of preferred stock into common stock by offering investors 3.75 shares of common for each share of preferred.

That freed Varco from its obligation to repay required $2 annual dividends that had been accumulating since preferred share dividends payments were suspended in 1982.

“These steps provided Varco with a very inexpensive way to lower debt and raise equity,” Shearson’s Hoffman said. All in all, the company reduced its debt level from $43.5 million in the first quarter of 1987 to $26.2 million by the third quarter.

Before the October collapse, Varco’s stock price clearly reflected these improvements. The company’s common stock moved from a low of $1.875 per share in 1986 to a high of $9.625 in September of 1987. But the crash collapsed the price to $3, and Varco closed Friday at $4, up 25 cents for the day.

While the company is in much better shape, an investment in Varco today is far from a sure thing. Hoffman said he sees the reduced share price as a buying opportunity. The big question, though, is whether oil prices will remain in a fairly stable range, about $18 to $20 a barrel. If not, all bets are off.

Another key variable is whether the Chevrons and Exxons of the industry will keep spending on drilling and exploration. And that depends in part on the performance of their own stocks. Another serious dip in the stock market could contribute to declining spending on drilling in 1988.

If that doesn’t happen, there could be some compelling reasons to invest in Varco.

Next week, Stock Watch will take a closer look at Smith International.