MRC Global: Natural Gas Utility To Provide The Thrust

Summary

• MRC Global is increasing its focus on the natural gas utility business to benefit in the medium-to-long-term.
• The cost reduction efforts and the benefits of the digital supply chain can keep margin steady.
• However, its aggregate revenues can decline in 2021 because the short-term pressure on the energy market has not dissipated.
• Although its net debt is set to reduce, a higher working capital requirement can result in cash burn in 2021.

MRC Builds The Medium-Term Framework

The two crucial markers that underline MRC Global's (NYSE:MRC) shift in strategy are diversification and its leaning on the natural gas utility sector. The company is poised to gain from the secular growth of the natural gas used in utility services. As the pandemic-led downturn begins to tone down, I think the chemical industry will revive because the crack spread has widened in recent times, leading to higher profitability in the industry.

Despite the positives, the upstream and midstream energy markets can remain below the pre-pandemic level, leading to lower revenues in 2021. Its leverage is higher than many of its peers, which can pose financial risks. In Q1, its working capital can increase due to the long lead time related to its inventory, which can lead to a cash burn. Since the stock is reasonably valued, I do not think the investors will see higher returns from the stock in the short-term. Medium-to-long-term investors may want to hold it for higher returns.

An Insight Into Strategy And Challenges

Following the pandemic, MRC's core business has transitioned with a focus on producing higher-margin valve products, reducing exposure to lower margin line pipe. The company expects revenues from Valve, Automation, Measurement & Instrumentation (or VAMI) to double in the next couple of years. On top of that, it has placed greater emphasis on selling through e-commerce channels. I have discussed it in detail in my previous article here. Investors may note that valves are the top-selling product for MRC (40% of the total business). Revenues from the valve engineering and modification center generated ~$50 million in FY2020.

The third leg of the strategy involved increasing expanding sales through regulated gas utilities. The gas utility sector is in long-term secular growth, according to the management. Despite the pandemic-led restrictions, the gas utilities experienced growth of 21% in Q4 2020 compared to Q4 2019. Not only that, the company's emphasis on the downstream and industrial sectors highlights the benefits of revenue diversification, particularly when the upstream production and midstream pipeline sectors have been going through a lean patch. To shift away from energy, MRC is increasingly focusing on chemicals and other industrial sub-sector, which now forms the majority of its downstream sector sales.

Visibility Into The 2021 Outlook

MRC's management expects a seasonal decline in customer budget, particularly in the international segment, resulting in revenues falling by low to mid-single digits in Q1 2021 compared to Q4 2020. The fall in revenue should be nearly uniform across the segments. The adjusted gross margin should be flat to modestly lower in Q1. In Q1 2021, the management does not expect to generate cash due to the higher need for working capital.

In 2021, the company expects US revenues to increase by the upper single digits, while in Canada, it can increase by double digits. However, as many upstream projects came to a stall, the company's revenues from international operations can decline by low single digits. Investors may note that the company expects 2H 2021 to turn out to be much better compared to 1H 2021. Although its large-size customer base can consolidate in line with the energy market transition, the structural cost reductions and debt reduction efforts will allow it to reap the economic recovery benefits. This cost-reduction pursuit yielded positive effects as the gross margin inflated by ten basis points in FY2020 versus the previous year.

On top of that, the company has made structural changes to its cost base by reducing headcount by 19% in 2020. Overall, except for gas utilities, all other end-markets can decline in 2021 compared to 2020. Adjusted gross margin, however, can remain unchanged at ~29%.

The Line Pipe Price Index And Its Implication

Source: FRED Economic Research

The line pipe price index increased by 3.5% in the past year until December, while relative to October, the rate of growth was higher. According to the company's estimates, line pipe pricing historically has experienced the most volatility. I think line pipe prices will continue to rise in the short-term as the hot-rolled coil (or HRC) prices have shot up, which will put pressure on MRC's margin.

Analyzing The Key Indicators

The crude oil price, which had recovered rapidly in Q4, has kept moving upward in Q1. The global economic recovery has resumed as the process of vaccination is in play. The EIA expects the crude oil prices will remain at the current level ($56 per barrel) in Q1 2021 but may decline to $52 during the remainder of the year. The US rig count increased rapidly in Q4 (33% up), although it has decelerated afterward. The company's cost reduction strategy and diversified business model will cushion against any steep fall in the international rig count.

I think this upstream market will be steady in Q1, although it will not show any sharp improvement as the customer budget reset takes place. In Q4, MRC's revenues arising out of the upstream-level customers decreased sharply, by 44% compared to a year ago. The Gas utility sector's revenues bucked the trend in Q4 as many of its utility customers renewed work, which is in line with its current strategy. The company is likely to gain market share in this operation following the signing and renewal of contracts, including one with CenterPoint Energy. The company's revenues from the midstream sector fell by 47% in the past year until Q4 due to the lack of pipeline projects. Since the revenue growth was curtailed, it did not allow cash flows to increase much in 2020.

Cash Flows And Leverage

In FY2020, MRC's cash flow from operations (or CFO) increased by 8% compared to a year ago. It generated a 12% higher free cash flow in FY2020 compared to FY2019. During Q1 2021, its working capital can increase temporarily due to the delivery of long lead time items for 2021 inventory. This requirement will result in a cash burn.

MRC's debt-to-equity ratio (1.09x) (excluding preferred stock) is significantly higher than its peers' average of 0.37x. In FY2020, the company has reduced net debt by $168 million or 36%. It plans to reduce net debt by a further 12% in 2021. The available liquidity of $551 million and positive free cash flow can meet its near-term debt reduction target.

Linear Regression Based Forecast

I have observed a regression equation based on the historical relationship among the crude oil price, the Producer Price Index for step price, 3:2:1 crack spread, and MRC's reported revenues for the past five years. I also observed the previous four-quarter trend. I think the multi-factor trend will affect revenues more than the short-term trend in the next two years. Based on the model, I expect revenues to decrease in the next couple of years. It can recover in 2023 and will stay steady afterward.

Using the average forecast revenues, a simple time-series regression model suggests that its EBITDA will decline in the next two years. In NTM 2023, I think EBITDA will reverse sharply and will keep growing afterward.

Returns potential using the price forecast based on the past average EV/EBITDA multiple (25.3x) is a negative 32%. In comparison, Wall Street's sell-side analysts expect higher returns (1% upside). I think the stock has a negative bias.

Relative Valuation

MRC's forward EV-to-EBITDA multiple contraction versus the adjusted trailing 12-month EV/EBITDA is steeper than peers, which should typically result in a higher EV/EBITDA multiple compared to peers. The company's EV/EBITDA multiple (28.3x) is higher than its peers' (DNOW, FAST, and OIS) average. So, the stock is reasonably valued compared to its peers at this level.

What's The Take On MRC?

Source

In 2020, MRC did well to realize the upstream sector's weaknesses and placed sufficient emphasis on the midstream and downstream sectors. Although the diversification strategy did not pay off entirely due to the pandemic-led demand destruction, I think the chemical industry's revival will justify its efforts in the medium-term. The refining sector will see activity resurface because the rising crack spread can help augment profitability. More importantly, the company is poised to gain from the secular growth of the natural gas being used in utility services, as its recent performance proves. Its focus on higher-margin PVF pipes has helped, reducing operating costs and boosting gross margin in the past year.

On the downside, because of the continued lower energy market activity, the demand for the company's products will not surge anytime soon. The company plans to reduce net debt in 2021. Plus, it has sufficient liquidity and positive free cash flows. However, its leverage is higher than many of its peers, which can pose financial risks. Since the stock is reasonably valued, I think investors may find some upside potential in the medium-to-long-term.

Analyst’s 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.