Here goes another bloody day for the energy sector. It is a good time to consider Now Inc. (DNOW), which could be one of those babies thrown out with the bath water.
Now Inc. has a wide moat, a strong management, and a material opportunity to consolidate a fragmented industry. Due to the drop in oil price, the stock has sold down to below book value, of which the majority is working capital. We could now be looking at an opportunity that could bring a multi-bagger over the next decade.
The business
Now Inc. (DNOW) is the second-largest distributor to the U.S. oil and gas sector after MRC Global and has some exposure to the international energy market, particularly in Canada. With over 5,000 employees, more than 300 locations worldwide, and a supplier network that consists of thousands of vendors in approximately 40 countries, DNOW stocks and sells a comprehensive offering of products for the upstream, midstream, and downstream and industrial market segments. It offers more than 300,000 stock keeping units, including pipe, valves and valve automation, fittings, instrumentation, mill and industrial supplies, tools, safety supplies, electrical products, drilling and production equipment, fabricated equipment, and industrial paints and coatings. It has operations in more than 20 countries and sells to customers operating in more than 90 countries. Essentially DNOW is the supply and inventory manager of the industry and it is hard to manage this business with a thin margin.
From the company’s 10K in 2014, it states that about half of its revenue is attributable to multi-year MRO (i.e. maintenance, repairs, and operations) arrangements, which are generally repetitive activities such as maintenance and repair. The following has DNOW’s segment information in 2014. Note the revenue has dropped to $3 billion run rate in 2015.
DNOW is a spinoff of National Oilwell Varco (NOV, Financial). NOV traces back all the way to 1841 and evolved in the next 170 years to become one of the largest and best managed companies in the oil industry. In 2012 NOV purchased two oil equipment distribution businesses from Schlumberger, CE Franklin and Wilson. NOV then combined the new businesses of $2.6 billion in revenue (2011) at the time with NOV’s existing distribution business of $1.9 billion in revenue (2011) to create one segment, and spun off the division in May 2014. Now Inc. was born.
DNOW has some good institutional investors. The most interesting ones are First Eagle Investment, which owns almost 8%, and Bruce Berkowitz (Trades, Portfolio)’s Fairholme Capital, who bought 6% of DNOW in Q3 2015. These are good bottom-up fundamental research-based value investors. Fairholme also bought DNOW’s major peer and competitor, MRC Global, although to a lesser extent. On the other hand, the stock has a high short interest ratio, currently at 11% after coming down from north of 30% at the peak. This may be reflecting the extreme pessimistic view on the industry and the company.
The management
DNOW is led by Chairman Pete Miller, who joined NOV in 1996. He had been the chairman and CEO of NOV since the early 2000’s prior to the spinoff of DNOW. Miller gave up running NOV, a $23 billion revenue and $2.3 billion net profit (2013) company to head DNOW, a $4.3 billion revenue and $150 million net profit (2013) company, for $1 base salary. This gave a lot of room for imagination. Over the years of running NOV since 2001, Miller built NOV from a $500 million company in sales with 1,200 employees, to a $20 billion company in sales with more than 60,000 employees. NOV’s book value grew from $5.4 a share in 2001 to the current $48 a share, for a CAGR of 17%. This is impressive even if we consider a lot of the growth is due to a terrific commodity upcycle. Indeed, NOV appeared to have outperformed its peers. Warren Buffett invested in NOV before selling out. This gives Miller and NOV’s management a vote of confidence.
At NOV, Miller succeeded in consolidating a very fragmented industry by aggressively acquiring smaller, specialized component manufactures and integrating them under one umbrella. (Ref: oilpro.com http://oilpro.com/post/692/nov-s-head--heart-the-story-of-merrill-pete-miller--). Since he became CEO in 2001, NOV made over 300 acquisitions. NOV’s EBITDA margin improved from around 10% to over 20%, outperforming its peers.
Miller was a West Point graduate, and holds an MBA from Harvard Business School. He started at Helmerich & Payne before joining National Oilwell in 1996.
The rest of DNOW’s management are all long-term NOV executives. CEO Robert Workman ran the distribution business from 2001 to spinoff. He was with NOV for 23 years. CFO Daniel Molinaro was NOV’s treasure from 1987 to spinoff. The average tenure of senior management at NOV is 28 years.
The management team is compensated on EBITDA, working capital as of revenue, and total shareholder return.
The opportunity
- The return of the cycle:
As oil prices dropped from $100/bbl toward $30/bbl, it is no secret that oil services industry is experiencing the coldest winter. The U.S. rig count has dropped to the lowest level since 2000.
When we compare the U.S. oil and gas production, we can see that the rig count is much more volatile than the production itself. This likely means that the drop in rig count reflects the severe downturn of the industry, but sooner or later, the cap ex would have a sharp rebound as cap ex cannot be delayed forever.
As a result of the severe downturn, which was described by its CEO as the “worst environment since the early 1980s,” DNOW is losing money this year even on the cash basis as the company’s revenue is correlated to the rig count. A drop of rig count from 1929 to the current 664 brought revenue down 50% in the first three quarters in 2015. In the case of a sharp industry downturn, the clients hold on cap ex as low as possible and as long as possible until the tide turns. Sooner or later the margin will return to normal or 5% to 7% EBITDA margin historically.
- Industry consolidation:
The distribution business is a hard business to run with low margins and high requirement for working capital. If we think about Walmart (WMT), Target (TGT), Home Depot (HD), Lowe’s (LOW), as these are essentially distribution businesses, we could visualize how a fragmented distribution business could be consolidated with margin improvement, over many years. Scale is the key to success and the wide moat of the business.
DNOW could repeat NOV’s path as the industry consolidator. The oil equipment distribution industry is very segmented. The combined market share of DNOW and the larger peer, MRC Global, is estimated to be about 40% in the U.S. Other peers all have below 10% market share and are mostly regional or local. There is a large opportunity to consolidate the industry and improve margins. NOV’s only large competitor, MRC Global, has a debt to equity ratio of 100% and is currently running a 7x net debt to EBITDA in this industry downturn. In fact, MRC’s best net debt to EBITDA ratio from 2008 was 2.8x. MRC is not likely to be the consolidator. DNOW, on the other hand, has little debt in the balance sheet and is at the best time shopping due to the severe downturn of the oil industry. In fact, the company clearly stated in the 2014 10K that “current market conditions present a unique opportunity to execute strategic acquisitions.” DNOW completed six acquisitions for $431 million in the first three quarters of 2015. The company is willing to leverage up to 40% net debt to equity or shoulder $600 million in debt if there is no more goodwill impairment going forward after the recent $255 million goodwill write-off.
The risks
Continued downward drifts of energy industry fundamentals could bring further impairment on book value. This includes further impairment to goodwill and write-downs of account receivables and inventory.
The valuation: Already attractive at current price. Assuming U.S. oil and gas industry is going to survive this downturn, maximum downside seems to be at $10.
The recent earnings have been miserable. With earnings tied to rig counts, DNOW is running at a loss as it had to aggressively sell high price inventory on the way down, but the company was able generate significant cash flow through working capital improvement.
Things can get worse. Where is the valuation support? I think downside can go to $10 in an extreme case but a fairly distressed value has achieved. If we believe that the U.S. energy industry is not likely to get worse on a sustainable basis, at the current stock price level of about $14, we get the existing distribution business at a fair price with a free option on one of best management teams in the energy space being able to repeat some of what they did with National Oilwell Varco for the last decade and a half.
1) EV/EBITDA
DNOW is currently recording a loss. The normalized EBITDA margin for a distributor is about 5% to 7% historically (at the spin-off, the management targeted 8%+). The 2015 revenue is about $3 billion with rig count dropped from 1,900 to a little above 600 in a matter of a few months. Consensus forecasts a $2.8 billion revenue for 2016. If about $2.8 billion revenue is sustainable going forward, the business would generate $150 million to $200 million EBITDA. Applying 10x average EV/EBITDA multiples for distributors, the fair price for the existing business should be at $1.5 billion to $2 billion market cap, or $14 to $18 a share given DNOW if there is no hope for an upturn cycle. If we use a trough EV/EBITDA multiple of 7x on the depressed EBITDA for a large scale distribution business, we have $1 billion to $1.4 billion or $10 to $13.
2) EV/Sales
Various distributors seem to have EV/sales troughed at 0.4x. Using $2.8 billion 2016 consensus revenue, the downside value protection seemed to be $1.1 billion market cap or $10 a share.
3) P/B
Current book value is $15.47 per share, tangible book value is $11.32. The tangible book is largely working capital. The management has written down $255 million or $2.4 a share goodwill including a full writing down of all U.S. energy-related goodwill. Raymond James estimates there is $1 goodwill associated the Canadian business. In the worst case scenario, if the working capital needs to be written down 10% and Canadian energy goodwill to be impaired, a good price support for DNOW seems to be at $10 to $13.
Conclusion
As the oil price is dropping day by day, we don’t know where the bottom of the share price would be. But it looks increasingly interesting toward $10 a share, which is more or less supported by the tangible book value. It seems that this is a promising small cap energy stock to own in the small cap space.
