The Long Case For NOW Inc.

| About: NOW Inc. (DNOW)

Summary

DNOW's stock price has been crippled by the downturn in the oil and gas industry, and as the environment recovers, specifically in the upstream, DNOW will rebound with speed.

It is an industry leader of distribution in the energy markets and has grown during the downturn to occupy greater market share and improved its operational efficiency.

As an industry leader with a clean balance sheet and excellent management, this recovery will grow EPS to $1.57 in 2018, which results in a price target of ~$27.

Target Price and Rationale

The target price for NOW Inc. (DNOW) is $27, a return of around 64% from current prices. I think DNOW can reach this target price due to oil and gas upstream activity recovery seen via increases in capital spending, increasing rig counts, and increase in both completion and drilling of wells. Given DNOW's position as an industry leader with a clean balance sheet and excellent management, this recovery will grow earnings per share to $1.57 in 2018. Using the average P/E ratio of 17.3 of its close competitor, MRC Global (NYSE:MRC), the company will be priced at $27.16.

Relevant Comps

MRC Global, W.W. Grainger Inc. (GWW), Fastenal Company (FAST), MSC Industrial Direct (MSM)

Catalyst

DNOW's stock price has been crippled by the downturn in the oil and gas industry, and as the environment recovers, specifically in the upstream, DNOW will rebound with speed. It is an industry leader of distribution in the energy markets and has grown during the downturn to occupy greater market share and improved its operational efficiency. The downturn since 2014 saw drastic declines in rig counts and capital spending, and rapid accumulation of drilled but uncompleted wells. As oil and gas recovers, these measures that drive DNOW's revenues will improve and rig counts will rise, spending will increase, and more completions will take place. The company, strongly levered toward the upstream, is at the forefront to rally from its low prices today as distributors respond first to industry changes.

NOW Inc. is the second largest global distributor to the oil and gas (O&G) and industrial markets that spun-off from National Oilwell Varco (NYSE:NOV) in 2014. It offers essential products and supply chain solutions for the O&G industry. Supply chain solutions are essential services, such as procurement, inventory and warehouse management, provided to O&G customers. With prices depressed from the O&G industry's downturn, DNOW is well-positioned to capitalize on the mean-reversion in the industry, starting to tap into a large revenue source as completion accelerates on a DUC count that had accumulated from being increasingly inaccessible at previous lower oil prices. As one of the leading distributors, with a clean balance sheet, $1B of liquidity, and low capital requirements led by a management experienced in M&A, DNOW is uniquely positioned for growth with strong risk protection.

Business Overview

NOW Inc.'s products are consumed in all sectors of O&G — upstream drilling and completion, exploration and production (E&P), midstream pipelines, and downstream petroleum refining. The business is more levered to the upstream, specifically to the operators related to well completion. Its products are primarily sold through either Energy Branches, which are brick-and-mortar retail stores supported by distribution centers, or Supply Chain, an integrated on-site model. The latter group also provides supply chain solutions.

Advantages of Scale in Distribution

For distribution businesses, scale provides significant competitive advantage because the distributor can purchase supplies at competitive prices and hold a wide selection of SKUs (stock keeping units), providing a crucial service for their customers and suppliers. This competitive pricing allows large distributors to minimize customers' working capital by lowering their inventory levels. Typically, the products are critical to the customers' operations but are only a small fraction of the total project or facility cost, making these distributors essential for their customers.

As the second largest distributor in the energy distribution market, DNOW had around 16% of market share of the $25B total addressable market before the O&G downturn. This is very fragmented market where the only other competitor of scale is MRC Global, skewed towards the downstream and midstream (all other companies had less than 7% market share). DNOW has 300 branches and operations in over 20 countries, selling to customers operating in around 80 countries. With 300,000 SKUs, it has the depth and breadth of offerings that make it an invaluable part of meeting its customers' diverse and changing local demands.

Resilient Business Growth

Leveraging its scale, and its countercyclical cash flow generating ability as a distribution business, NOW Inc. has positioned itself as a stronger market player than before the downturn through efficiency gains, organic growth, and acquisitions. Oil prices started falling in June of 2014 when low interest rates and breakthrough in shale oil production led to an oversupply of crude oil that sent prices plummeting. Rig counts, the best proxy for DNOW's underlying business growth, fell from a global annual average of 3,578 active rigs in 2014 to 1,594 in 2016. Respectively, revenues for DNOW halved from $4.1B to $2.1B and the stock price fell by 66% from $37.19 in June 2014 to its low of $12.48 in January 2016. MRC also suffered, dropping 69% from $29.20 to $8.94. The entire O&G industry took a brutal beating, with upstream suffering the strongest blows.

This crash coincided with managing expenses incurred from its spin-off. However, by 2Q 2015, DNOW fully integrated prior acquisitions and paid all expenses related to becoming an independent company. The company had consolidated all operations under a single ERP and many duplicate branches and personnel were consolidated or eliminated. By paying these one-off expenses and having adjusted through the downturn, removing over $280M of expenses, DNOW has become much more efficient in managing expenses and more accurate and timely in providing the necessary SKUs to its customers through improved tracking.

In addition to the efficiency gains, the company expanded business with existing customers and contracted new customers. Revenue per operating rig (RPOR) essentially illustrates changing market share. During a downturn, RPOR typically declines from the destocking of wells sustained by increases in drilled but uncompleted wells (DUCs). Furthermore, contracts are renegotiated at lower prices as the distributor is forced to provide price concessions to maintain its market share. DNOW had expected a decline in RPOR, but actually increased it to $1.322M per rig in 2016 from $1.147M in 2014. This growth, despite pricing erosions and destocking of rigs, resulted from share gains attributable to the following: 1) Expansion of supply chain capability globally adding more business per customer as revenues from supply chain management doubled from 18% in 2014 to 36% in 2016. 2) Consolidation of distributors as customers contracted with only the most price competitive ones while expanding internationally and consolidating upstream domestically.

NOW Inc. also developed itself into a stronger position by increasing market shares and strategic reach through acquisitions. Since the mid-2014, the company has completed a total of 12 acquisitions that have filled strategic gaps — both in products and in geography. Specifically, it grew core product lines like valve actuation, artificial lifts, electrical and process equipment, and geographically expanded its customer base. Through acquiring Odessa Pumps and Power Supply, the company has created a new business line, US Process Solutions, which provides the only turnkey battery solution of its scale and quality in the upstream sector. Collectively, these acquisitions added roughly $430M in annualized revenue.

Despite pressures from declining revenues, even after these strategically accretive acquisitions, the company maintains a pristine balance sheet with only $65M borrowed on its credit facility and had $446M in availability. The company holds a total credit facility of $750M with a $250M accordion feature, totaling a borrowing capacity of $1B, and ended 2016 with a net cash position of $41M. Behind these acquisitions is a strong management team with a successful track record of M&A. With an average of 30 years of tenure, management has executed over 40 acquisitions since 1998. With Merrill "Pete" Miller — who grew NOV from a $500M to a $20B company — as DNOW's executive chairman, the company's savvy management and untapped credit gives opportunity for many more future acquisitions.

Recovery in the Oil and Gas Industry

The catalyst that will lead to a repricing of the company's shares is the improvement of the oil and gas industry. More specifically, the growing pile of DUCs, increased upstream capital expenditure, and recovery of rig counts indicate that the company is poised to grow.

The build-up of DUCs during the downturn and the recent growth in completion indicates a large growing potential revenue source is starting to be tapped into. According to the EIA, the US has almost doubled its DUC count in the key producing regions to over 5,500 by the end of March 2017. DUCs are wells that have been drilled, but not yet been made ready for production. These wells have always existed but have ballooned recently, according to the US Energy Information Administration (EIA), to 5,512 in March 2017, up around 33% from 4,138 in June 2014. It has been rising in the downturn because oil prices have been too low. Completion of a well for production is roughly three-quarters of the cost of the entire well, so with declining oil prices, it became uneconomic to complete many of them, especially for the higher cost producers. Since drilling was comparatively much cheaper and there was a substantial cost to cancelling drilling, even though drilling activity declined, it did so more moderately than the rapid drop in completion. With the recovery in oil prices, completed wells has been consistently growing since December 2016, up 42% from 522 to 743 by end of March. This is an exciting opportunity for DNOW as over 50% of North American sales, which are 81% of total revenue, are from operations completing wells. For DNOW, this means there is large revenue potential once the recovery leads to healthier levels of well completion. There is around $1B in additional revenue from completion of the DUCs that DNOW customers hold. As these wells continue to be completed, DNOW will see improvements to its revenue per operating rig.

Other promising metrics in O&G, which are also drivers of DNOW's revenues, have shown substantial improvement. Several changes in the industry illustrate E&P players' confidence in the industry moving forward. After slashing investment by an average of 70% from 2014–2016, based on announced capital spending numbers, 43 E&P firms budgeted a 42% increase. Another projection views US upstream spending to surge 37.8% to $120B, after a 40% plunge in 2016. Upstream capital spending is the primary driver of rig counts, and consequently DNOW's revenue. In addition, rig counts have been showing exciting recovery. The most recent rig count from Baker Hughes shows rig counts currently at 1,899, as of April 21, up 19% from the 2016 average of 1,593. Driving this change was the monumental rise in US rig counts by 68% to 857 in April 21, 2017 from the 2016 average of 510. These are especially exciting developments as 69% of DNOW's sales come from the US; it is uniquely positioned to benefit from the improvements in North American O&G.

Valuation

The base case assumes oil supply and demand will continue to tighten, drawing upon global stock inventories. In such a scenario, this allows room for continued moderate production, projecting an average rig count of 1,900 for 2017 and an increase to average 2,400 for 2018. As for the revenue per operating rig per year, it is expected to increase slightly to $1.4M per rig as DUCs start seeing some completion and production, and orders for the US Process Solutions from 4Q materialize. For 2018, this scenario assumes that the slowly increasing condition starts providing some inflationary pressures on contract pricing and DUC completion accelerates. In this case, EPS is estimated to be $1.57 in 2018. As DNOW only has 3 years of being a public company, with 2 of those years with negative earnings, MRC's P/E ratio offers a better tool in projecting DNOW's prices since it is a close competitor similar in size and business model. Using the historical P/E value of 17.3 (low 10.7, high 23.9), the target price for DNOW in 2018 is $27.16, with an attractive upside of 65%.

In addition to this large potential upside, the downside remains robustly protected as DNOW can generate cash by reducing inventory, has a pristine balance sheet with $41M in net cash and $1B credit facility. Furthermore, the last time the stock was priced at this level, WTI crude oil was priced at a much lower $39/barrel from today's $49.62/barrel and estimated earnings for 2018 shows that the stock is currently trading near historic lows 10.5x P/E.

To summarize, NOW Inc. has strong downside protection with its solid balance sheet and access to $1B in liquidity. As the oil pricing environment mean reverts, DNOW is poised to capitalize on even a modest recovery with its larger market share, more efficient operations, and additional acquisition potential all led by an experienced management team.

(Editor's Note: This is a republication of an entry in the Sohn Investment Idea Contest. All figures are current as of the entry's submission - the contest deadline was April 26, 2017).

Disclosure: I am/we are long DNOW.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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