Shares initially traded in the mid-thirties, but unlike most spin-offs, the ¨separated¨ company has not outperformed the market, as the timing of the spin-off coincided with peak oil prices. After oil prices plunged during the second half of 2014, shares of NOW came under continued pressure, hitting a low of $12 in early 2016, before recovering to current levels of $21.
While I appreciate the reset in the valuation and believe that independently-run companies outperform divisions at large companies, I remain cautious at this point.
What Is NOW?
NOW is a distributor to energy and industrial markets, operating under the brands DistributionNOW and Wilson Export. The company provides simple distribution activities as well as supply chain solutions. While it counts large companies as its customer, the top 20 customers only make up a third of sales. These customers purchase much of their equipment at the company as it has over 300,000 SKUs in inventory. NOW provides goods in the areas of MRO, drilling & production equipment, fittings, valves and pipes.
The company was the product of a series of acquisitions, including the 2012 purchase of Wilson International and CE Franklin. The first was acquired from Schlumberger in an $800 million deal while Canadian CE Franklin was acquired in a $230 million deal. These two deals doubled the size of the company. The company made numerous smaller acquisitions as well over time, in order to benefit from economies of scale in what is still a fragmented market.
On the back of these deals, NOW managed to post revenues of $4.3 billion in 2013 and $4.1 billion a year later. In 2015, the impact of lower oil prices was really felt, as sales fell to $3.0 billion that year. While operating margins came in at 4-5% of sales in the period 2012-2014, NOW was forced to post an operating loss of half a billion in 2015. This loss wiped out years of cumulative profits in one go, but it is important to stress that this was largely the result of a $393 million goodwill impairment charge. If not for this, adjusted losses would have come in at $117 million.
While a normal industrial distribution business is generally somewhat more predictable, this is not the case for NOW which operates in a very cyclical energy industry. Large fluctuations in capital spending and greater exposure to cyclical input costs make it hard to manage the business effectively.
2016, Another Difficult Year
Following a disastrous year in 2015, last year was not easy, even as oil prices have started to recover. First quarter revenues fell another 37% year on year to just $548 million, down 15% on a sequential basis. The company reported a GAAP loss of $63 million and adjusted loss of $38 million, being pretty sizable.
Despite the losses and challenged outlook, NOW announced the acquisition of Power Service during the spring of 2016. No financial details were announced but the purchase looks sizable, as the deal added 400 workers to a workforce of 4,500. The good news is that NOW ended the first quarter with a net cash position of $76 million, giving it a bit of firepower to pursue deals at this favorable point in the cycle.
Second quarter revenues came in at $501 million, down 33% year on year, and down 9% on a sequential basis. Note that the results included a month´s worth of sales of acquired Power Service. While net losses shrank to $44 million, adjusted losses of $44 million were widening compared to Q1. As a result of the acquisition and continued losses, the net cash position from Q1 turned into a net debt load of $44 million.
The third quarter marked a turning point. Revenues came in at $520 million, for sequential growth of 4%, although that was aided by a full quarterly contribution of Power Service of course. Revenues were still down 31% year on year, as revenues are running at just half the levels of 2014. Net losses came in at $56 million, or $36 million on an adjusted basis, which is disappointing as there is no real progress in reducing losses despite sequential improvements in sales.
Strong cash flow management allowed net debt to be down to $14 million.
The reality is that NOW is a $2-$2.5 billion business at a rough point in the cycle, when operating losses approach 10% of sales, for losses of roughly $200 million.
Based on historical data, peak numbers for the business are seen at $4-$5 billion in terms of revenues and margins of 5-7%. If the company does well in integrating past acquisitions, I might perhaps see peak margins another 2 percentage points higher. That suggests potential for operating profits of $270-$360 million at a very good point in the cycle, but the question is if these levels will be seen anytime soon.
Let´s for simplicity sake assume that a cycle takes 10 years, and includes 2 disastrous years, such as 2015 and 2016. In those two years, operating losses could come in at $100-200 million a year. I furthermore assume 4 great years with operating profits of $300 million a year, and 4 medium years in which operating profits come in at $150 million a year. That yields cumulative operating profits of $1.5 billion, or $150 million in an ¨average¨ year. After applying taxes, net earnings are seen at little over a hundred million, or roughly $1 per share. With shares already trading in the low-twenties, I find it hard to see appeal at these levels.
I furthermore note that shares now trade at 1.0 times the current sales rate, while competitor MRC (NYSE:MRC) trades at 0.7 times sales, even as its margins are not as bad at the moment. While it is true that so-called peers Fastenal (NASDAQ:FAST) and W.W. Grainger (NYSE:GWW) trade at nearly 4 and 2 times sales, respectively, these companies are not comparable. Fastenal posts margins of nearly 20% even during challenged points at the cycle.
Envisioning average sales of $3-4 billion across the cycle, and operating profits of $150 million, it will be very hard to justify a current $2.2 billion valuation. After all, it seems that NOW's acquisition track record is not that great. NOW was already a $1.8 billion business in 2011 in terms of sales. Ever since it spent over a billion on deals in 2012 and over $500 million in 2015, it is very hard to argue that these deals have added value, given that the current enterprise valuation stands at just $2.2 billion.
Even if we assume average operating profits of $150 million throughout the cycle, after-tax earnings come in at $110 million if we apply a modest 25% tax rate, for earnings of little over $1 per share. That suggests that shares trade at 20 times earnings, which seems reasonable, yet we are a very long way from posting operating profits of $150 million at this time.
On the bright side, financial concerns are not really existing at this point thanks to the strong balance sheet and cash-flow-generating properties in a downturn. A real recovery is underway as well. The US rig count stood at 522 by the end of the third quarter of 2016, still down 38% year on year. The rig count has already recovered to 658 by the end of 2016, and totals 729 at this moment. This means that the rig count is actually up 27% year on year. If I one-on-one extrapolate the increase in the rig count to revenues, sales are rapidly approaching the $3 billion run rate again, allowing losses to be cut rather dramatically.
I will await the fourth quarter earnings results, to be released halfway February, with great interest. I am mostly interested in the sales leverage and further rebound in sales, cash flow generation, but most of all, the margins. While I am still not really appealed to the shares given the still loss-making operations and the high valuation across the cycle, I am curious to learn how much margin gains can be achieved on the back of great integration of the business.
Upon the release of the fourth quarter results and potential outlook, I would update my neutral stance at this moment.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.