Dril-Quip Upgraded to Neutral

We are upgrading our recommendation on offshore drilling equipment maker Dril-Quip Inc. ( DRQ - Analyst Report ) to Neutral from Underperform.

Dril-Quip’s results are heavily levered with continued strength in global deepwater drilling markets, especially in South America and the Asia-Pacific region. Given the operators’ long-term outlook on these projects, deepwater drilling and other related services will remain relatively stable through the usual fluctuations in commodity prices. The company expects further improvements with increase in capacity and stepped up activities in the Gulf of Mexico (GoM). This will enhance order activity, giving our estimates room for upside, particularly in 2013.

Moreover, recent capacity additions in Brazil and Singapore as well as the ongoing capacity expansion could prove beneficial over time. The company also aims to increase its machinist workforce by 30% in 2012 and is on track to meet this goal.

Moreover, the planned investment of Petróleo Brasileiro S.A. or Petrobras ( PBR - Analyst Report ) in Brazil’s offshore market over the next five years will likely prove beneficial for Dril-Quip given the strong and long-standing association between the companies. Hence, beyond 2012, Dril-Quip remains well suited for Petrobras' planned newbuilds and continued, general secular growth. In particular, Dril-Quip is likely to benefit from the potential renewal of its expiring 3-year, $180 million subsea wellhead contract with Petrobras.

Although Dril-Quip’s backlog experienced a sequential downfall, the company's backlog still remains solid, which provides ample visibility for its earnings growth and cash flow prospects going forward. An almost debt-free balance sheet is an added strength. We also expect large orders in 2012 from the GoM and Brazil, with growing demand and rising activity level in these regions. This gives it the financial flexibility to take advantage of growth opportunities while returning capital to shareholders.

However, in the subsea capital equipment area, Dril-Quip’s competitive position is fairly weak in the more lucrative, large and complex deepwater segment. Despite its continued efforts over the last couple of years, it has made little headway in gaining market share from larger competitors.