NOW (DNOW) Robert R. Workman on Q4 2015 Results - Earnings Call Transcript

| About: NOW Inc. (DNOW)

NOW, Inc. (NYSE:DNOW)

Q4 2015 Earnings Call

February 23, 2016 9:00 am ET

Executives

Daniel L. Molinaro - Chief Financial Officer & Senior Vice President

Robert R. Workman - President, Chief Executive Officer & Director

David A. Cherechinsky - Chief Accounting Officer

Analysts

David J. Manthey - Robert W. Baird & Co., Inc. (Broker)

Matt Duncan - Stephens, Inc.

Joseph D. Gibney - Capital One Securities, Inc.

Sean C. Meakim - JPMorgan Securities LLC

Ryan Cieslak - KeyBanc Capital Markets, Inc.

James West - Evercore ISI

Charles P. Minervino - Susquehanna Financial Group LLLP

Walter Scott Liptak - Seaport Global Securities LLC

Operator

Welcome to the Fourth Quarter and Full Year 2015 Earnings Conference Call. My name is Paulette, and I will be operator for today's call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session.

I will now turn the call over to Senior Vice President and Chief Financial Officer, Dan Molinaro. Mr. Molinaro, you may begin.

Daniel L. Molinaro - Chief Financial Officer & Senior Vice President

Thank you, Paulette, and welcome, everyone to the NOW, Inc. fourth quarter and year end 2015 earnings conference call. We appreciate you joining us this morning and thanks for your interest in NOW, Inc. With me, this morning is Robert Workman, President and CEO of NOW, Inc.; and Dave Cherechinsky, Corporate Controller and Chief Accounting Officer.

NOW, Inc. operates primarily under the DistributionNOW and Wilson Export brands, and you'll hear us refer to DistributionNOW and DNOW, which is our New York Stock Exchange ticker symbol throughout our conversations this morning. In addition to these brands, we are very excited about new brands added to the DNOW family, including MacLean Electrical, Machine Tools Supply, and Odessa Pump & Equipment, among others.

Before we begin this discussion on NOW, Inc.'s financial results for the fourth quarter and yearend December 31, 2015, please note that some of the statements we make during this call may contain forecasts, projections and estimates, including but not limited to comments about our outlook for the company's business. These are forward-looking statements within the meaning of the U.S. federal securities laws based on limited information as of today, which is subject to change. They are subject to 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.

I refer you to the latest Forms 10-K and 10-Q that NOW, Inc. has on file with the U.S. Securities and Exchange Commission for a more detailed discussion of the major risk factors affecting our business. Further information regarding these as well as supplemental, financial and operating information may be found within our press release, on our website at www.distributionnow.com, or in our filings with the SEC.

As of this morning, the Investor Relations Section of our website contains a supplemental presentation relative to our results and key takeaways, which can assist you in understanding our results.

A replay of today's call will be available on the site for the next 30 days. It also should be noted that we plan to file our 2015 Form 10-K later today and it will also be available on our website. Later on this call, I will discuss our financial performance and we will then answer your questions. But, first, let me turn the call over to Robert.

Robert R. Workman - President, Chief Executive Officer & Director

Thanks, Dan. Welcome to DistributionNOW's Q4 2015 earnings call. As I'm sure everyone on the call is aware, this particular downturn, which will be about the fifth of my career and eighth of my lock time that I can recall, makes others pale in comparison both in severity and longevity. Growing up as a competitive tennis player I'm a big believer in practice makes perfect. However, I feel as though we've had enough downturn practice and while I'm naïve enough to believe this, would welcome a speedy recovery.

We are fortunate to have our amazing group of employees in the DNOW family. I'd like to thank each of them for their loyalty, hard work, and continued success in generating considerable cash in a market contraction. I'd also like to take a moment to recognize Doug Bukowski in Calgary who will soon celebrate his 45th year with DNOW. Doug started with Mid-Continent Supply in Weyburn, Saskatchewan in 1971. Through CE Franklin's acquisition of Mid-Continent Supply, Doug became part of the DistributionNOW family in 2012, after we acquired CE Franklin, and currently provides artificial lift solutions to customers. I'd like to thank Doug for his many decades of committed service and in helping to make DNOW the premiere supply chain provider to the energy industry.

Moving on to the state of the business, today, we reported a net loss for the fourth quarter of 2015 of $249 million, which includes pre-tax charges of a $138 million for non-cash goodwill impairments, $3 million for severance and acquisition costs, $5 million for high steel content, inventory cost adjustments related to falling steel prices, and an after-tax charge of a $129 million related to a deferred tax asset valuation allowance.

Excluding other costs and the impact of steel price deflation, earnings per share for the quarter would be a loss of $0.23. The business generated cash flow from operations of $80 million in the quarter, which brought the cash flow from operations for 2015 to $324 million. The non-cash goodwill impairment charge for the fourth quarter included the remainder of our U.S. goodwill not impaired in the third quarter.

Revenue for the quarter was $644 million, which is $1.3 million for global operating rig or $1 million after removing revenue from acquisitions. Due to the strengthening dollar, revenues were negatively affected by approximately $20 million in the quarter and by approximately $80 million for the full year 2015. Revenue for global operating rig in Q4 2015, less acquisitions, was slightly lower than the $1.1 million produced during the same quarter in 2014 but is still higher than what was produced in the industry downturn of 2009.

We expected, as cannibalization of parts still pervades the industry, that this downward movement in revenue per rig would have come earlier in the down cycle but we attribute our revenue resilience today to market share gains against the backdrop of a bleak energy environment.

Negatively impacting revenue was a reduction in billing days of about 5%, the normal holiday drag on activity and a growing inventory of drilled but uncompleted wells in North America as well as continued destocking as rig counts and E&P activity maintained a persistent decline globally.

Until we reach the bottom of drilling activity, we will continue to face headwinds created by idling equipment with inventories that are redirected to other operating areas. Also, until operators complete all of the wells they drill, we will still experience a lack of pipe, valves and fittings orders that normally accompany the construction of production facilities or tank batteries, as we call them.

As we've discussed previously, our business is impacted almost immediately when the market moves, with over 80% of our revenues tied to the upstream and midstream markets. In a recovery, revenue and margins improve almost immediately, while expense and balance sheet increases lag top-line growth. Achieving expense and balance sheet reductions consistent with revenue declines in this environment, as a distributor as opposed to manufacturer with a backlog, is like trying to catch a falling knife.

As any management team knows, we don't want to cut to the bones and we've tried hard not to so that we can continue to service our customers and gain share from those who are not making the same choices. Unfortunately, because of this unrelenting market, we have already made many significant cuts.

At the end of 2015 and since the end of 2014, we reduced non-acquisition head count by about 1,200 or 23% and have closed or consolidated approximately 46 branches. In addition to these expense reductions, we have added nearly 900 employees in approximately 42 locations through acquisitions in 2015. Additional head count reductions, across the entire business, including within acquired companies of approximately 200 has been completed so far in 2016. We will continue these right-sizing efforts in earnest, as evidenced by the $196 million annualized run rate reduction of non-acquisition fourth quarter 2015 expenses we have eliminated compared to fourth quarter 2014.

Outside of non-cash expenses, we believe we can reach positive EBITDA levels at Q3 2015 revenues of around $750 million or global rig counts between 2,100 and 2,200, which currently stands at about 1,900. As to when activity reaches these levels, it's difficult to predict.

Forecasters and analysts are predicting oil prices to average somewhere between $20 to $65 by the second half of 2016. That's a very wide range and includes rigs to ridges scenarios.

Obviously, rig counts will be drastically different later this year, depending on which firm's model proves to be most accurate and we'll continue to adjust accordingly. We'll maintain our focus on managing the business for the short-term, as we move into unchartered waters for rig count in the U.S. is already down 32% currently when compared to the fourth quarter average and Canada was at its lowest fourth quarter levels since the last century.

We will balance this with preparing for the long term, ensuring that when the market eventually recovers, we are lean and mean, and positioned to leverage our strong balance sheet to seize it.

Regarding our most vulnerable asset, which is inventory, steel process for imported welded pipe continue to fall with mills trying to capture volume due to the lack of OCTG and line pipe orders. Where we were seeing deflation primarily for welded line pipe, we are now seeing deflation in our seamless line pipe products, as both the domestic and import mills struggle with extremely low order volume.

Many manufacturers saw a volume fall-off of 50% to 90% in 2015, with the pipe mills hit the hardest. Many are still working to dispose of high-cost raw materials that accumulated due to the energy sector slowdown. As well, there were numerous pipe distributors buying new raw material for inventory in late 2014 and early 2015 that arrived in Q3 2015, exacerbating an already over-supplied situation. A slowdown in China's economic growth, coupled with increasing steel production levels, is pushing commodity prices lower as steel and metal input costs continue downward. More dumping suits are being filed in an effort to shore up prices in respective markets.

In the fourth quarter, we saw raw material prices for scrap, hot-rolled coil, and most commodities drop further. The steel price drop has moderated some in the U.S. for now, due to the filing of dumping suits and closures of steel capacity. As this downturn continues, we expect to see more closures, possible bankruptcies, consolidations and dumping suits.

Pricing for seamless pipe is now back down to the 2004 levels, and welded pipe back down to the 2003 levels. The lack of volume with manufacturers leads to unpredictability and as steel inputs continue down, we will continue to see inventory cost and price pressures. We will minimize our line pipe inventory risk, both for welded and seamless, having already reduced pipe inventory values by $90 million during 2015.

Diving deeper into the quarter, sequential revenue in the U.S. declined by 13%, in line with rig count. A full quarter of Odessa Pumps and partial quarters of Updike and Challenger added about $17 million of incremental revenue in the quarter to both our energy branch and supply chain units. Strong declines with land rig contractors both for MRO and OEM goods across the U.S. and for electrical products related to new drilling machinery and canceled new rig builds were partially offset by share gains with about a half dozen operators in the Eagle Ford and Bakken shale plays.

Additionally, our new centralized midstream projects team delivered just over $6 million of new line pipe, valves, fittings and meter run orders for Energy Transfer and Howard Energy in South Texas and for ONEOK in the Rockies. This helped soften the impact from large line pipe projects that were either delayed, put on hold or canceled altogether.

For operators that we service through our supply chain group, even though these are some of our largest and most committed relationships, they aren't immune to the commodity price tumble. Large partners such as OXY, Devon and Chevron Gulf of Mexico have curtailed activity and delayed or postponed projects. We're combating these activity-related declines by expanding product lines we provide to these customers, including recently acquired product channels from the Odessa Pumps acquisition.

As for the balance of our supply chain team, the anticipated impact of holidays and fewer billing days produced revenue declines for our downstream, industrial and manufacturer customers. With the weakness in the manufacturing sector, many of our customers encouraged employee time-off during the quarter, further exaggerating the decline.

In Canada, revenue declined sequentially by 16%, while rig counts were down by 9%, and wells spud declined by 26%, all during a timeframe when the Canadian market's seasonality would normally produce increased activity. Project delays and/or shutdowns with major customers, such as CNRL and Progress were responsible for the largest revenue declines. As well, while certain fields that have proved more resilient during the commodity price rout, such as the Montney and Duvernay, continue to be bright spots, others such as the Cardium, Alberta, Viking and Oil Sands are plummeting.

Internationally, increased seasonal activity in the former Soviet Union wasn't nearly large enough to offset lower artificial lift sales in Australia and Indonesia; continued project delays awaiting dispute resolution of the joint operations in the Saudi-Kuwait neutral zone; further stacking of the offshore drilling fleet, affording high levels of inventory available for our customers to redistribute to their own operating floating rigs, which negatively impacts a large share of our International revenue; large valve project declines in most areas outside of the former Soviet Union and Iraq; and across-the-board decline in exports with operators and drilling contractors in all areas of the world except for Europe, where we had a large fourth quarter project; shipment delays at Wheatstone and the completion of the Gladstone LNG project in Australia; and Petrobras cancelling rig contracts or putting them on standby in Brazil.

Looking at market activity moving forward, there's no doubt that we still have some very tough quarters ahead. Continued rig count declines combined with an impending Q2 2016 break-up in Canada will make for a challenging first half of 2016 and possibly beyond.

In the U.S. energy unit, while there are several exciting organic share wins combined with gains from integrating recent acquisitions into our extensive branch and customer network, it will be hard to soften the impact we'll experience from continued deep cuts in operator budgets and the resulting rig count declines. Some of the bright spots include the fact that our DAPL contract with Energy Transfer has started. We opened a dedicated facility in Hamel, Illinois, for the project and product shipments have already begun with orders extending into March.

We expect our recent success in the midstream market, including new meter-run skids and high-pressure actuated valves, will continue to be strong. We have recently received several orders for these two product lines.

While our largest operator supply chain customers will likely continue to reduce activity along with other E&P companies, we have reached agreements with two of them to build dedicated supply chain facilities on their properties in the Rockies and the Permian shale plays.

We also just signed a new supply chain services contract with a very large operator, who currently has a presence in many of the large and very active plays domestically. This deal was just inked last week, so I cannot release the company's name as their current winner base has not been fully informed. I hope to share further details on this implementation in our next call.

Both of these developments will help offset some of the market-driven revenue declines for operator supply chain customers during the second half of the year.

Also within supply chain, we expect to experience modest growth due to increased turnarounds with our downstream customers, new industrial contract wins with Dow and National Grid, and the implementation of our recent manufacturing supply chain contract with Triumph Aerospace. We are hoping to see stabilization with the uncertainties of the general economy to lead to reversals of the current shrinking of the manufacturing market.

In Canada, several recent contract awards with ARC Resources, Encana, Cenovus, Suncor, Husky and Spectra could produce modest organic share gains against further deteriorating E&P budgets. As well in Canada, adoption of our on-site solutions is beginning to gain attraction and is expected to produce share gains throughout the second half of 2016.

Outside of Canada, we expect projects at Wheatstone that were pushed from Q4 2015, as well as increased shipments to BP in Iraq and OXY in Oman, to somewhat hedge continued declines with offshore customers in the North Sea, Latin America, Asia and with our export groups.

Moving to the balance sheet, we continue to generate operating cash flow, as evidenced by the fact that we moved from a net cash position of $6 million to a mere net debt position of $18 million sequentially, even after closing two acquisitions in the quarter. Sequentially, we were able to reduce receivables and inventory by $79 million and $78 million, respectively, yet our working capital as a percent of revenue remained relatively flat at around 38%, or 35% when excluding cash on hand, due to continued revenue declines. For these balance sheet accounts, 2015 proved exceptionally challenging, as bad debt and inventory expenses increased by $69 million year-over-year.

Understanding that our goal is to achieve working capital at 25% of revenue, that still leaves room for continued cash generation in the coming quarters in this current depressed market environment. We recently filed an 8-K relative to an amendment of our credit facility. This was to resolve a technical covenant issue, and Dan will provide more color in his comments. In this business environment, we are pleased to continue to have a $750 million committed credit facility through April 2019.

Capital expenditures grew modestly to $3 million in the quarter, marking the completion of our new, larger distribution center in Dubai. Moving forward, we expect maintenance CapEx to run around $10 million annually.

Turning to corporate development, in Q4 2015, we closed two deals, one of which you are aware of, Challenger, the Northern Rockies (20:18) supplier. Challenger just won an approximate $10 million project for urea fertilizer plant with Dakota Gas that will be completed throughout 2016.

The second deal in Q4 was an Ohio supply chain bolt-on to MTS, the supply chain solutions business we acquired in early 2015. This bolt-on will continue to help us build out our national presence, serving the industrial manufacturing end markets.

We continue to be pleased with the acquired high value-add product lines' performance as their margins have held up nicely in the phase of the surrounding and favorable markets. M&A will continue to be part of our strategic growth plan.

As I said on the Q3 call, we are fortunate to have a strong balance sheet, which aids us in weathering this market and in capitalizing on potential opportunities. Taking into account that we are willing to use our credit line to finance acquisitions, fitting our criteria and the fact that we currently only have $18 million of net debt, we still have a large runway of available credit and more cash to be generated from the balance sheet to allocate towards M&A.

That said, the bid-ask spread between buyers and sellers could widen in this uncertain market. Right now, we are seeing a broad spectrum of sellers from those who would rather wait for an upturn than sell and risk selling below what they value their businesses to be worth to sellers who are fire-selling to avoid declaring bankruptcy.

In between, we are still seeing a few usually product line focused sellers, who are somewhat insulated to the energy markets, are still profitable and are amenable to a sale. In relation to that, for 2016, we're working on a couple larger higher value-add product line transactions and should they move forward, would require regulatory approval. Even if those deals are done, we will continue to be fiscally conservative and refine our models in processes to evaluate and plan for any potential exposure to risk, thus deals may take a little longer to close.

Our focus remains on growing organic market share, decreasing expenses, reducing risk on the balance sheet, generating cash from operations and positioning DNOW to take advantage of an eventual market recovery.

I'd like to thank all of our shareholders, employees and analysts on the call that continue to support DNOW through these challenging times.

And we'll turn the call over to Dan to review the financials.

Daniel L. Molinaro - Chief Financial Officer & Senior Vice President

Thanks, Robert. Well, it's been almost 21 months since we spun off from NOV, and I continue to be proud of the efforts of our wonderful workforce, as we created a world-class provider of products and solutions to energy and industrial markets. I am thankful for our dedicated hard working employees. They are the true assets here at DistributionNOW. I just wish we were enjoying the better market, but our seasoned management team continues to respond to the challenging business environment. We will continue to concentrate on the needs of our customers while focusing on producing long-term value for our stakeholders. Robert discussed our business and I'll touch more on our financials.

NOW, Inc. reported a net loss of $249 million or $2.33 per fully diluted share on a U.S. GAAP basis for the fourth quarter of 2015, on $644 million in revenue. This compares with the net loss of $224 million or $2.09 per fully diluted share on $753 million of revenue in the third quarter of 2015. And both quarters included goodwill impairment and other costs.

While looking at the year-ago quarter, we had net income of $16 million or $0.14 per fully diluted share on revenue of $1.0 billion for the fourth quarter of 2014. Of course, this downturn was just beginning back then.

Other cost for the fourth quarter of 2015 primarily included a pre-tax impairment charge of $138 million associated with the fair value of goodwill and an after-tax $129 million tax valuation allowance. The fourth quarter also included $3 million in pre-tax acquisition related and severance charges, which totaled $20 million for the full year 2015. Excluding these and other costs, our loss was $27 million, or $0.25 per fully diluted share in Q4.

Also included in the fourth quarter ended December 31, 2015 results, but not characterized as other costs was a pre-tax charge of $5 million, approximating $0.02 per share for high steel content inventory cost adjustments relating to falling steel prices. For the year, we've incurred $28 million of these inventory write-downs.

During the quarter ended December 31, 2015, we recognized a pre-tax non-cash loss of $138 million associated with the impairment of goodwill for the remainder of our U.S segment that we didn't impair in Q3 2015.

The impairment charge was predominantly the result of the sustained decline in worldwide oil and gas prices and rig counts, which have adversely impacted, not only our current results, but our future outlook. Including the $255 million impairment taken in the third quarter, we recognized $393 million impairment for the year ended December 31, 2015.

Our remaining goodwill of $205 million resides in our Canada and International units with $88 million and $117 million respectively. Gross margin was 16.5% in Q4 compared with 15.5% in the third quarter of 2015, reflecting reduced inventory cost adjustments and continuing price pressure. Excluding the impairment of goodwill, operating profit was down $10 million sequentially. Fourth quarter EBITDA excluding other costs was a loss of $32 million.

Looking at our operating results for our three geographic segments, revenue in the United States was $433 million in the quarter ended December 31, 2015, down 13% from Q3, which was similar to the decline in the U.S. rig count. Q4 revenue in the U.S. was down 36% from the year ago quarter and strengthened by 2015 acquisitions, the revenue decline was less in the fall in the U.S. rig count.

Fourth quarter operating profit in the U.S., excluding goodwill impairment, was a loss of $45 million compared with $42 million loss in the third quarter 2015, also after goodwill impairment, and a profit of $3 million in Q4 2014, reflecting revenue declines and deflationary pressures at these lower volumes.

In Canada, fourth quarter revenue decreased 16% sequentially to $79 million and down 46% from Q4 2014, reflecting the sharp declines in the Canadian rig count. The Canadian dollar continue to decline relative to the U.S. dollar, which adversely impacts revenue, falling more than 2% in the fourth quarter and 14% for the full year.

For the three months ended December 31, 2015, Canada's operating loss was $1 million compared to a $2 million operating profit in Q3 and operating profit of $15 million in the year ago quarter. The decrease in OP relative to Q4 2014 was essentially due to revenue declines, partially offset by expense reductions.

International operations generated fourth quarter revenue of $132 million, which was down 19% from the third quarter of 2015 and down 10% from the year ago quarter. Additional revenue provided by acquisitions was offset by decreased International rig activity, where we have a heavier customer concentration of offshore drilling contractors.

International operating profit for the fourth quarter 2015 was $3 million, up $2 million over Q3 2015, but down $5 million from the year ago quarter as International activity declined. Revenue channels for the fourth quarter shows 75% through our energy branches or stores as many of us know them, and 25% through our supply chain locations.

Looking at our income statement, warehousing, selling and administrative expenses were down slightly from Q3. These costs include branch and distribution center expenses, as well as corporate costs. It should be remembered that excluding acquisition-related expense, we have reduced our quarterly warehouse, selling and administrative expenses by more than 25%.

The effective tax rate for 2015 was 3%. Based upon the significant level of recent losses in the U.S. driven by goodwill impairment, we recorded a deferred tax asset valuation allowance in the fourth quarter of 2015 totaling $129 million after-tax.

Valuation allowances are recorded per U.S. GAAP when our deferred tax assets may not be realized in future periods, therefore may not reduce our provision for income taxes. As we return to profitability, we would be able to adjust the valuation allowance, thus reducing income tax expense in the future.

Turning to the balance sheet, NOW, Inc. had working capital of $1.0 billion at December 31, 2015, which was 38% of Q4 annualized sales, 35% when cash is excluded. We still strive to get to 25% again. Accounts receivable was $485 million at year end, a reduction of $75 million during the fourth quarter. For the year, we reduced AR approximately $434 million or 51% before the additions from acquisitions.

We continue to be diligent as bankruptcies are on the rise in our energy space. Inventory was $693 million at year-end, or $78 million lower than the end of the third quarter. We have slowed the inventory replenishment process and should continue to show reductions. Excluding the additional inventory from acquisitions, inventory was down $329 million or 35% in 2015. Our current days sales outstanding were 69 days, and we continue to work on improving these results to closer to the 60-day range.

Inventory turns were at 3.1 times. Cash totaled $90 million at December 31, 2015, down $36 million during the quarter. Approximately two-thirds of our cash is located outside the U.S. We ended the year with $108 million borrowed on our credit facility, a net reduction of $12 million during the fourth quarter, a quarter in which we completed two acquisitions totaling $118 million.

We recently amended our $750 million revolving credit facility. We added a minimum asset coverage ratio which requires our eligible assets to be 1.5 times our debt. We also reduced the maximum capitalization ratio from 50% to 45%. We were only 7% at year end 2015. In addition, our borrowing cost increased 75 basis points but remain a very attractive rate, and our commitment fee increased 5 basis points.

In connection with the amendment, we also provide a security interest in essentially all U.S. assets and an approximately 65% of the equity interest in our first tier subsidiary. The total commitments remain at $750 million, but until we comfortably return to profitability, we can borrow up to 75% of this, assuming eligible assets are sufficient.

In the current business climate, this borrowing availability is certainly sufficient. The credit agreement continues to include the $250 million accordion feature and the April 2019 maturity remains.

Capital expenditures during Q4 were $3 million, giving us $11 million spent in 2015. This included $5 million to complete a new distribution center in Dubai, so our maintenance CapEx was $5 million to $6 million in 2015. Free cash flow for the fourth quarter was $77 million and $313 million for the year.

We entered 2016 with the worldwide market continuing in decline. While we look forward to better times, we will continue to focus on serving our customers. We will continue integrating our recent acquisitions and managing costs. We have confidence in our strategy, in our employees, and in our future as we position NOW, Inc. to continue to serve the energy and industrial markets with quality products and solutions. We are an organization with an experienced management team, a strong balance sheet and we believe this current downturn creates new opportunities for us and our shareholders.

With that, Paulette, let's open it up to questions.

Question-and-Answer Session

Operator

Thank you. And our first question comes from David Manthey from Robert W. Baird. Please go ahead.

Robert R. Workman - President, Chief Executive Officer & Director

Hey, Dave.

David J. Manthey - Robert W. Baird & Co., Inc. (Broker)

Good morning. Robert, I believe you mentioned the warehousing and SG&A expense run rate in the fourth quarter 2015 relative to the fourth quarter 2014. What was the – ex acquisitions, what was that decline?

Robert R. Workman - President, Chief Executive Officer & Director

It was $196 million of SG&A reduction less acquisitions on a run rate basis.

David J. Manthey - Robert W. Baird & Co., Inc. (Broker)

Okay. And along with that, I'm trying to understand the footprint here. I know with the IPO you were about 330 locations. You've had a number of acquisitions, today you say about 300. What will that look like over the next few years and in the past Robert, you've mentioned that if you didn't think things were going to get materially better over the next several years, you might redesign the business. Are we there yet? What might that look like and where will we just continue to see these incremental steps between here and there?

Robert R. Workman - President, Chief Executive Officer & Director

Yeah. I don't think anyone out there for at least the people that we follow are forecasting a three year and four year and five year downturn in the U.S. land play. So we're not there yet in the complete redesign of the business, but we'll continue making these expense cuts based on what's going on with drilling activity. Now, as you know, all bets are off, no one ever gets the oil price rig count forecast right. But if we do come to conclusion that this is 2018 event, 2019 event than we'll have to take another look at how we design our supply chain network for our customers.

David J. Manthey - Robert W. Baird & Co., Inc. (Broker)

Okay. And then finally, is there any reason to believe that DNOW's revenues per rig would change in the near future versus the ranges you've seen in the past? And I guess you've been historically thinking about 15% to 20% incremental margins, if things were to turn up here, any change in either of those metrics as you can see?

Robert R. Workman - President, Chief Executive Officer & Director

I don't see any, but I will repeat what I've told you before as well. I'm surprised that it's holding up like it is considering the amount of DUCs, or the drilled uncompleted wells and the amount of destocking that's going on. I fully would have told you a year ago that revenue per rig would be in the $800,000 range, not $1 million less acquisitions.

David J. Manthey - Robert W. Baird & Co., Inc. (Broker)

Right. Okay. Great. Thank you very much.

Operator

And our next question comes from Matt Duncan from Stephens. Please go ahead.

Matt Duncan - Stephens, Inc.

Hey, good morning guys.

Daniel L. Molinaro - Chief Financial Officer & Senior Vice President

Hey, Matt.

Robert R. Workman - President, Chief Executive Officer & Director

Hey, Matt.

Matt Duncan - Stephens, Inc.

So, Robert I want to start by just trying to look forward a little bit here. I mean, since the end of the year, U.S. land rig count is down 27%, 28%. How are you thinking about first quarter revenues relative to 4Q given how rapidly rig count has been declining so far this year?

Robert R. Workman - President, Chief Executive Officer & Director

Well, I think, we've got many, many data points that we provided out there around our revenue per rig. So, depending on what you think rig count is going to do for the rest of the quarter, I think that mass is pretty easy to accomplish.

Matt Duncan - Stephens, Inc.

Okay. So, the Updike acquisition then must be relatively small in terms of revenue contribution?

Robert R. Workman - President, Chief Executive Officer & Director

Yes. It was a very small bolt on.

Matt Duncan - Stephens, Inc.

Okay. Next thing is on gross margin. If I look at it sort of adjusted backing out the inventory adjustments, I think it was 17.7% in the third quarter, 17.2% in the fourth quarter. So down a little bit which would be expected with the sequential revenue decline. Is that a level that you think you can hold give or take depending on what happens with the top line? You talked a little bit about some of the price pressure you're seeing in pipe. Are you seeing that other places, or is this a gross margin level you guys can somewhat maintain depending on what happens with the top line?

Robert R. Workman - President, Chief Executive Officer & Director

Yeah. So, we had a, what I would call, a price pressure event in Q1 of last year which cost us about $11 million of base margin at the time. So far, Q2, Q3 and Q4, that's kind of held flat. So we haven't had any erosion in gross margin that's – as a result of base margin changes. So depending on how we manage all the other buckets that go into the gross margin line, I think that staying where we are generally is probably a reasonable expectation.

Matt Duncan - Stephens, Inc.

Okay. And then given the cost actions you guys built in the fourth quarter and it sounds like you've taken a little bit more of a head count reduction here in the first quarter. How is that going to change that quarterly SG&A expense run rate, Dave or Dan?

Robert R. Workman - President, Chief Executive Officer & Director

Well, I'll answer, Matt. I mean, we've reduced expenses by about $3 million less M&A in Q4 versus Q3. I think we would get something similar, if not a little better, in Q1.

Matt Duncan - Stephens, Inc.

Okay.

David A. Cherechinsky - Chief Accounting Officer

Yeah. Matt, this is Dave. I think the result of the reductions we've made this month would approximate $11 million to $12 million a year. And, of course, we're still resizing all of our businesses. So that number will increase. But going forward, we expect similar down – decrease in expenses are greater.

Matt Duncan - Stephens, Inc.

Okay. So obviously, you get that $11 million or $12 million annualized, plus if revenues are down, you're going to get some decrease in variable comp as well. So it's going to decline probably a little more than $3 million. All right.

David A. Cherechinsky - Chief Accounting Officer

That's right.

Matt Duncan - Stephens, Inc.

And then last thing for me, just on the cash flow side, you guys obviously did a very good job taking working capital out in 2015. It sounds like you do think you've got more to do there. What is a reasonable assumption on how much more you can squeeze out here in 2016 as you think about free cash flow for this year? What should we assume maybe relative to what you did last year? What kind of free cash flow potential do you guys see this year?

Robert R. Workman - President, Chief Executive Officer & Director

We still think, Matt, that we can get the 25% of working capital as a percent of revenue. So we're at 35% right now, if you exclude cash. So that still leaves 10% of revenue on the balance sheet that we're aiming to remove. The percentage doesn't move much when revenue keeps dropping because that's a major component in the calculation. But at some point, when revenues stabilize, we expect to be able to reach 25%. So whatever you're assuming our revenues would be, there is your 10% of that would be the cash we're targeting.

Matt Duncan - Stephens, Inc.

Okay. All right. Very helpful. Thanks guys.

Operator

And our next question comes from Joe Gibney from Capital One. Please go ahead.

Daniel L. Molinaro - Chief Financial Officer & Senior Vice President

Hi, Joe.

Joseph D. Gibney - Capital One Securities, Inc.

Thanks. Good morning. Just a quick one really, I was just curious on the offshore percentage of your mix. Are you going to move away from what's happening on upstream in terms of onshore? Just curious on your offshore percentage of mix within your International component, and then maybe holistically as a total company to be useful just kind of benchmarking as we think about 1Q into 2016 from a revenue perspective?

Robert R. Workman - President, Chief Executive Officer & Director

And just to make sure, you said our International segment?

Joseph D. Gibney - Capital One Securities, Inc.

Yes, and then maybe holistically for your total company as well. Just curious your offshore drilling percentage of the mix, just try and calibrate a little there, it would be helpful? I appreciate it.

Robert R. Workman - President, Chief Executive Officer & Director

Our International segment is our most project-oriented business. So it moves more than you would think. So depending on the number of projects we have with people in Iraq, BP, and companies like that, it could vacillate between a third of our International revenue to some quarters as high as half of our International revenue.

Joseph D. Gibney - Capital One Securities, Inc.

Okay. And then...

Robert R. Workman - President, Chief Executive Officer & Director

And on the rest of the business, it's pretty immaterial. I mean, if you put Canada and the U.S. in with International, it's probably high-single digits today as far as total exposure.

Joseph D. Gibney - Capital One Securities, Inc.

Okay. All right. That's helpful. I appreciate it. I'll turn it back.

Operator

And our next question comes from Sean Meakim from JPMorgan. Please go ahead.

Robert R. Workman - President, Chief Executive Officer & Director

Hi, Sean.

Sean C. Meakim - JPMorgan Securities LLC

Good morning. So you guys know that there's some larger targets out there in terms of M&A. I was just hoping could you give us a little sense of geography meaning. Are we thinking about primarily other sizeable targets in North America or does that kind of leave us mostly internationally focused? Just curious, kind of how to think about, where those types of targets could be located, the types of markets that would have (43:31)

Robert R. Workman - President, Chief Executive Officer & Director

Of the two I mentioned in my commentary. One is very U.S. centric and one is based outside of the U.S. that has revenue all over the world, but has a little bit of revenue in the U.S.

Sean C. Meakim - JPMorgan Securities LLC

Okay. That's helpful. And then just thinking about, at this point in the cycle, is there potential for I guess, these – is stock or stock deals – the main way in which transactions are going to get done here or are there – the types of folks that you're interested in, in acquiring, is anyone willing to take cash at this point in the cycle?

Robert R. Workman - President, Chief Executive Officer & Director

Yeah. So we sell along and it remains to be the case today that we don't want to dilute our shareholders. So, as long as we have available credit, we're sitting at almost net no debt, we'll continue to use cash and we have not had an issue at all in our conversations with target companies in using cash instead of stock.

Sean C. Meakim - JPMorgan Securities LLC

Okay. That's helpful. And then just one last one on gross margin, just curious, if we're still making progress on the supplier side. You noted that – do you think margins are going to continue to hold in gross margins? How are you expecting the suppliers to help you there?

Robert R. Workman - President, Chief Executive Officer & Director

Yeah. So, as I mentioned earlier, our base margins haven't moved any so – well not say any – they have moved very insignificantly. So we're not having any issue on the pricing side because we'd not be getting pricing pressure but we're working it with our suppliers on the cost of goods sold. So we're working that area and we're also working a component of our gross margin, which is our rebates and those are just down because the volume is down. There's not a whole lot we can do about that.

Sean C. Meakim - JPMorgan Securities LLC

Got it. Okay, great. Thank you.

Operator

And our next question comes from Ryan Cieslak from KeyBanc Capital Markets. Please go ahead.

Robert R. Workman - President, Chief Executive Officer & Director

Hey, Ryan.

Daniel L. Molinaro - Chief Financial Officer & Senior Vice President

Hey, Ryan.

Ryan Cieslak - KeyBanc Capital Markets, Inc.

Hey, guys. Good morning. Robert, I think you mentioned on your prepared remarks, a level of rig count where you think you'd eventually get back to positive EBITDA. Could you just refresh us again what you said there?

Robert R. Workman - President, Chief Executive Officer & Director

Yeah. So based on the adjustments we've made in the business to-date we believe we can get to a profitable level between 2,100 rigs and 2,200 rigs, which is where we will – with the rig count and the revenue levels we were in Q3 2015 when I made that statement on the last call. But we're going to continue to right size this business assuming 2,100 rigs and 2,200 rigs are in our foresight anytime soon. So that was just a snapshot on where we sit today and what we think would be breakeven EBITDA today. But that will change as we move forward and continue to right size the business.

Ryan Cieslak - KeyBanc Capital Markets, Inc.

Okay, got you. And then just a question, maybe another way of asking about the margins going into this year – how should we be thinking about the incremental margins if we were to see similar types of top-line declines in 2016. Is there – and actually going to be maybe some additional support be given and all the cost reduction you guys have taking on or just maybe some color around that would be helpful?

Robert R. Workman - President, Chief Executive Officer & Director

Yeah. Our decrementals and – in a recovering market our incrementals would be in the 15% to 20% range until we reach a point where revenue is moving less severe. And then it gets closer to 10%.

Daniel L. Molinaro - Chief Financial Officer & Senior Vice President

And then detrimentals....

Ryan Cieslak - KeyBanc Capital Markets, Inc.

Okay, got you.

Robert R. Workman - President, Chief Executive Officer & Director

Yeah, okay.

Ryan Cieslak - KeyBanc Capital Markets, Inc.

Okay. And then the last one I had is – thinking about the revenue per rig and obviously it seems like you guys continue to execute on the share gains. Robert, can you talk a little bit about maybe the cadence of what you're seeing with share gains? Are they picking up over the last couple of quarters or do you expect that to pick up here going into 2016?

Robert R. Workman - President, Chief Executive Officer & Director

Yeah. In this market, believe it or not, it's easier to go and share in this market than it is a strong market. So we continue to have lots of competitors in all of the major plays in Canada and the U.S. that might have four branches or five branches or six branches that are really struggling that gained customers in a really hot market because customers were only concerned with how fast they could get product, not necessarily what the price of that product was. And in this market, where they are trying to manage their expenses down, they are looking for suppliers that will be here a month or two or three down the road.

There's much fewer players out there that can compete. And so, in this down market where that's kind of evidenced by our revenue per global operating rig, not dropping in the $800,000 ranges or $900,000 ranges is the fact that we're growing share. Sometimes it's coming in small contracts, sometimes it's coming in projects, sometimes it's coming in a large contract to middle contract. So it's kind of across the board.

Ryan Cieslak - KeyBanc Capital Markets, Inc.

Okay. That's good color. And then the last one just really quick, the pricing trends, you gave some color on the pipe side. Just would be curious to know maybe what you're seeing in some of the different product lines, particularly on the valve side into early 2016? Thanks, guys.

Robert R. Workman - President, Chief Executive Officer & Director

Yeah. No problem. Like I said earlier, our product margins or our base margins haven't moved much and it's not really been one product growing, one product declining. It's pretty consistent for the last three quarters. Our margins for our product lines, it's not moved much at all.

Operator

And our next question comes from James West from Evercore ISI. Please go ahead.

Daniel L. Molinaro - Chief Financial Officer & Senior Vice President

Hi, James.

Robert R. Workman - President, Chief Executive Officer & Director

Hi, James.

James West - Evercore ISI

Hi, good morning, guys. Hey, Robert, how do you think about if you go after one of these larger transactions and you are using primarily cash and I'm thinking obviously there's a big elephant in the room right now. But if you were to do something like that, you'd be taking on a lot of debt as well. How do you think about debt to EBITDA or, I guess, debt to capital, or however you guys think about it? Where are you willing to lever up to to do something big?

Robert R. Workman - President, Chief Executive Officer & Director

Yeah. So, I think we've always said we'd be comfortable with 20% to 40% debt to equity, in that range somewhere. One thing we're keeping mindful, though, is that when a market recovery occurs, we're going to need some cash because our receivables and inventory will chew up quite a bit of cash if we have a strong recovery in the market. So, we're definitely taking that into account when we're looking at our debt loads with respect to how far we're willing to go because we don't want to get in a position where we're not able to fund share growth in a recovery.

Daniel L. Molinaro - Chief Financial Officer & Senior Vice President

James, we're at 7% debt-to-cap right now, and that gives us an awful lot of room, and get nowhere near Robert's upper threshold of the 40%. So I think when Michelle and Robert are out looking at deals, I say to them, from a financial standpoint, same thing I used to say to Pete Miller at NOV, I'll be there with the checkbook when you guys find the deal, and I think we're in the same position right now.

James West - Evercore ISI

Okay. And would you be suggesting that even if they did something large that got you towards the upper end of that, you could find additional liquidity at that point to make sure you had cash for the upturn?

Daniel L. Molinaro - Chief Financial Officer & Senior Vice President

Well, I think finding additional liquidity in this market would be difficult. We're a non-investment grade company, and...

James West - Evercore ISI

Sure.

Daniel L. Molinaro - Chief Financial Officer & Senior Vice President

...the capital markets are pretty dry for energy space, although recently there has been some indication it might open up. Someone earlier asked about equity, though, I suppose if we did a real big deal, equity is always a currency we might want to consider later on. During the first two years of our existence, we've been mindful of some NOV issues too with our equity. But if we find a larger deal, we would look at all the options and maybe there'd be some other ways to borrow some more too, but...

James West - Evercore ISI

Are there still any NOV issues with the equity?

Robert R. Workman - President, Chief Executive Officer & Director

Yeah, the...

Daniel L. Molinaro - Chief Financial Officer & Senior Vice President

Well, there is until the end of the two years, which is the end of May.

James West - Evercore ISI

End of May, right, okay.

Daniel L. Molinaro - Chief Financial Officer & Senior Vice President

For the first two years, we have to be careful on how much equity we would throw at a deal, but we've had no equity conversations on any of the deals we've done, not that I'm aware of, Robert. So we've been able to finance them through our balance sheet. And certainly any deal we try to do now, if it was large enough that you needed equity, we wouldn't get it finished before the end of May anyway. So the two-year...

James West - Evercore ISI

Right.

Daniel L. Molinaro - Chief Financial Officer & Senior Vice President

...moratorium will be over anyway.

James West - Evercore ISI

Got you. Okay, great. Thanks, guys.

Operator

And our next question comes from Chuck Minervino from Susquehanna. Please go ahead.

Robert R. Workman - President, Chief Executive Officer & Director

Hey, Chuck.

Daniel L. Molinaro - Chief Financial Officer & Senior Vice President

Hey, Chuck.

Charles P. Minervino - Susquehanna Financial Group LLLP

Hey, guys. Good morning. Just along that similar line of questioning, can you kind of talk a little bit about the pros and cons of large-scale M&A kind of at this point in the cycle? I mean I guess you understand when things are going well, and I guess balancing that with having plenty of capacity internally for some level of an upturn when it comes. So can you talk about what you see there from a benefit perspective of doing it at this point in the cycle, if you're still kind of in this cost reduction, maybe closing of facilities mode as rig count continues to drop?

Robert R. Workman - President, Chief Executive Officer & Director

Yeah. So our philosophy has been the same here as it was when we were at our prior firm. The best time to consolidate is always going to be in a downturn as opposed to when the market's really hot and you're paying 50% to 100% more than you would otherwise. So we see it as an opportunity to make some strategic acquisitions that fit certain holes in our solutions offering or in certain geographies. We think now is the time to do it, especially with our runway of balance sheet room and that's kind of – we're going to continue down that path until such time we feel like that we need to reserve some space on our balance sheet to fund a recovery.

Charles P. Minervino - Susquehanna Financial Group LLLP

Can you talk a little about where you kind of are from a cost perspective kind of set up for the upcoming year? Are you kind of, from a cost basis, set up for a certain level of rig count, whether it be 500 or 600? Are you still kind of managing that as rig count falls further?

Robert R. Workman - President, Chief Executive Officer & Director

Yeah. So global rig count was, what, 3,500, 3,800 or something of that nature about a year ago, and now we're at 1,900. So we've adjusted our cost. At this point, where we feel like we could break even in the 2,100, 2,200 range, which is a huge cut in our expenses and we're going to continue adjusting as the rig count dictates. It's impossible to cut expenses at the same rate the rig count declines. So hitting a bottom and letting revenue flatten out would be a positive step towards making the right amount of adjustments so that we're producing positive EBITDA.

Charles P. Minervino - Susquehanna Financial Group LLLP

I guess kind of along those similar lines, I mean do you feel – I guess it doesn't sound like your M&A strategy has really changed very much. So there's no kind of need to see a trough in rig count or even just some stabilization here before maybe moving further along on some deals?

Robert R. Workman - President, Chief Executive Officer & Director

No, not at this point because we still have so much room left in our balance sheet capacity. And these firms that we're acquiring, whether it's Odessa Pumps or Challenger or MTS or MacLean, those four probably make up 80-plus-% of the acquired revenue so far, are all producing EBITDA that's accretive to where we are, and I don't mean because they lose less, they're making single-digit EBITDA in a horrible market. And so those kinds of investments will always make sense whether in this market or not.

Charles P. Minervino - Susquehanna Financial Group LLLP

Okay. Thank you.

Operator

And our next question comes from Walter Liptak from Seaport Global. Please go ahead.

Robert R. Workman - President, Chief Executive Officer & Director

Hey, Walt.

Daniel L. Molinaro - Chief Financial Officer & Senior Vice President

Hey, Walt.

Walter Scott Liptak - Seaport Global Securities LLC

Hi. Thanks. Good morning, guys. I wanted to ask a follow-on to the M&A question, and just asking about valuation and how you guys are approaching valuation in this market. Are you looking at it like a normalized EBITDA or is it price-to-sales? What metrics are you using?

Robert R. Workman - President, Chief Executive Officer & Director

Before the downturn, we typically look at trailing 12, and we're not looking at that right now. So we're going through it and getting a seller's forecast, and then we're doing our own forecast to see how rosy they're trying to paint a picture. And then once we get comfortable that we can tell how this business looks going forward, we use that model to value the business. And as you can imagine, that creates a lower success rate at us closing these deals. But at the end of the day, it is what it is. I mean, this market's going to be here for an undetermined period of time, and so we're taking a reasonable look at their business or other businesses moving forward as opposed to how they performed in the past.

Walter Scott Liptak - Seaport Global Securities LLC

Okay. Okay, great. And I wanted to ask on the working capital accounts, it's good work on the receivables. But in your commentary, I think you alluded to bankruptcies and maybe some bad debts and trying to improve the DSO. Wonder if you can just give us some color on how bad is it. How much – or did you take any charge-offs for bad debts? Are there some that are at risk as we go forward?

David A. Cherechinsky - Chief Accounting Officer

Yeah. This is Dave. Obviously, we're seeing more bankruptcies among our customer base, and we've taken charges going to $2.5 million in the quarter just for bankruptcies and that doesn't include general bad debt issues we're having as well, which amounted to over $5 million for the quarter. So collections and bad debt issues is an issue. We believe by reducing our DSO, which we've made nice progress on, we can mitigate that somewhat, but now we're in an environment where our customers are having some obvious difficulties.

Walter Scott Liptak - Seaport Global Securities LLC

Okay. And I guess as you're going after market share, credit quality obviously becomes an issue, and I guess with the market share wins that you kind of highlighted, I assume that the terms are normal. I wonder if you can comment on that.

Robert R. Workman - President, Chief Executive Officer & Director

Yeah. We're definitely not making any special terms. Our terms have not changed since the market was hot, and Dan could show you a sheet that he keeps with him and his treasurer as credit group if you want it, but we keep a close eye on everyone that's having covenant issues, are slow paying us or are – other people in the industry are having cash problems. So we keep a close eye on all of our customers well before they get to bankruptcy in trying to forecast who may get in trouble.

Walter Scott Liptak - Seaport Global Securities LLC

Okay. Okay, great. Thank you.

Daniel L. Molinaro - Chief Financial Officer & Senior Vice President

Thanks, Walt.

Operator

We have no further questions at this time. I will now turn the call back over to Robert Workman, President and CEO for closing remarks.

Robert R. Workman - President, Chief Executive Officer & Director

I'd like to thank everyone for their interest in DistributionNOW and we look forward to talking to you about our first quarter 2016 results. Thanks.

Operator

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. And you may now disconnect.

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