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We are maintaining our Neutral recommendation on the U.S. equipment supplier Dril-Quip, Inc. (DRQ - Analyst Report).

The company reported impressive second quarter results, fueled by growth in product and service revenues as demand for offshore equipment climbed. Dril-Quip enjoys a favorable position in the industry based on its solid backlog, including an almost debt-free balance sheet.

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 amid the usual fluctuations in commodity prices.

We also expect large orders in the balance of 2012 from the Gulf of Mexico (GoM) and Brazil, with rising demand and activity level in these regions. This gives Dril-Quip the financial flexibility to take advantage of new growth opportunities while returning capital to shareholders.

Increased deepwater activity over the near term, recent capacity additions in Brazil and Singapore, as well as ongoing capacity expansions could prove beneficial for the company over time. Dril-Quip is also pursuing several other large projects – Royal Dutch Shell plc’s (RDS.A - Analyst Report) Malakai tension leg platform (TLP) project, off Malaysia as well as Woodside’s TLP projects in Australia. The award of these contracts is likely to be announced in 2013.

Recently, Dril-Quip clinched a $650 million contract from Brazil’s state-owned energy company Petroleo Brasileiro S.A. or Petrobras (PBR - Analyst Report). The four-year contract was much awaited for Dril-Quip, as it trails the three-year, $180 million contract with Petrobras that concluded in the second quarter of 2012. The planned investment in Petrobras in Brazil’s offshore market over the next five years will likely be beneficial for Dril-Quip, which is well positioned to take advantage of the project.

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

We also remain concerned about the company-specific risk, which include: new product growth challenges, potential backlog losses and high dependency on its top customers. Additionally, delays in deepwater infrastructure awards may also hinder the growth prospect of the company.

Dril-Quip has a Zacks #3 Rank (short-term Hold rating).

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