DNOW Has Moderate Upside For Now
NOW Inc.’s (DNOW) management is smart enough to understand that the energy product distribution business requires structural changes that go beyond short-term corrections necessary in the pandemic situation. So, it has been focusing on pushing e-commerce sales and other digital marketing initiatives to boost the top line. Plus, it will look to further lower the selling and warehousing costs, redesign the supply chain, and consolidate distribution centers to protect operating to the extent possible. The stock outperformed the VanEck Vectors Oil Services ETF (OIH) in the past year. I think it can continue to produce a low but steady return in the short to medium term.
Nonetheless, completion well shut-ins and the company’s closure of sites will not allow revenues to increase in the short term. The company has strong liquidity and zero debt, which can expand its relative valuation multiples in the medium term. I think long-term investors should hold on to the stock.
Strategic Re-focus And Cost Management
DNOW’s strategic focus, following the energy market downturn, has shifted from scaling up growth to one that values efficiency and minimizes costs. In the upstream end market, which continues to account for the majority of its revenues, there is room for further market share gains because the oilfield services market may consolidate. Given the peers’ leveraged balance sheet, NOW is at a relatively higher ground to survive and gain. Also, the company has been diversifying into midstream, downstream, industrial, and alternative energy markets, which are traditionally less volatile. It targets high-margin product lines, which can lead to profitable market share gains.
Earlier in the year, the company initiated an organizational restructuring by closing and consolidating facilities, removing management layers in North America, and renegotiating prices in terms of suppliers. The company looks to push its market-disruptive digital tools platform DigitalNOW. It is leveraging the DigitalNOW technology to funnel more product spend through the platform. It is redesigning its supply chain, finding the optimized hub-and-spoke architecture. To lower costs, it focuses on a centralized structure that will support smaller locations. Also, smaller locations involve less inventory risk. It has significantly lowered the selling and warehousing costs over the past few quarters. I discussed these in detail in my previous article.
As a result of the consistent effort to lower costs, the company’s EBITDA decremental was ~7% in Q2 even though the revenues declined by 39% in Q2 compared to Q1 following a much-depressed energy market. Typically, abrupt revenue declines drive much higher unfavorable decremental because of the effect of cost under-absorption. If the inventory charges are excluded, the company estimates that its EBITDA would have been close to the break-even level.
E-commerce As The New Platform
DNOW’s e-commerce initiatives leverage the brand in the energy and industrial markets, especially after it introduced the DigitalNOW brand to create a unified commerce platform. In Q2, it completed implementation for a new E&P customer. More importantly, it is gaining traction in the midstream market as half of its new implementations in 2020 were in this segment. It has also recently registered two major integrated midstream customers. It has automated over 60 DNOW processes using artificial intelligence, which has pushed the digital initiative boundary. By 2020-end, it plans to complete a new order management system.
Near Term And Medium-Term Outlook
In Q3 2020, DNOW’s revenues will likely remain more subdued than in the recent past because of the persistent weakness in the U.S. In July, the U.S. rig count was 36% lower than the Q2 average, while the completed rig count in the unconventional shales was 80% lower year-over-year so far. Going by the trend, the company forecast its revenues to decrease by the low to mid-teen percentages in Q3. The company also expects warehousing selling and administrative expenses, which were $97 million in Q2, to decline to the high $80s million to low $90 million range.
In this backdrop, like most of the U.S. companies associated with the energy sector, DNOW aims to preserve liquidity while keeping its balance sheet strength in the near term. It plans to make significant cost reductions and change its strategies by combining businesses, centralizing support functions, consolidating distribution centers, and delayering management, as I discussed above in the article.
Analyzing Drivers In The U.S. And The Outlook
As the completions and drilled well counts continued to slip, the company’s revenues from the U.S. decreased by 41% in Q2 over Q1. Since the U.S. accounts for the majority of its top line (70% of the Q2 sales), a weak domestic end-market pulled the entire company down with it. The U.S. supply chain was severely fragile during Q2 after one of its top E&P customers reduced spend by ~80% sequentially. On top of that, a few plant turnaround projects that were scheduled for the year pushed out to 2021, leaving a hole in the company’s U.S. midstream business.
The U.S. Energy Center was nearly as non-productive during the quarter (40% down sequentially) after project deferrals and drilling & completion program suspension affected it adversely. However, the company is optimistic about a near-term revival in this category after it won several project wellhead hookups and tank battery contracts while renewing contracts with some of the upstream players. It the midstream space, it won business at six operating locations by bundling the materials and warehouse management services with the DigitalNOW platform. In U.S. Process Solutions, although revenues declined, there were a few green shoots in the aftermarket services in the downstream sector due to higher part orders and critical field service work.
Margin Level Analysis
In Q2, the company’s gross margin decreased by 100 basis points sequentially (i.e., compared to Q1) to 18.4%. In the U.S. operation, the losses deteriorated to $24 million due primarily to the decline in revenues. Operating earnings deteriorated further in Canada, while it remained steady in the international operations, as I will discuss next in the article.
Canadian and International Markets: Performance And Outlook
In Q2, the average rig count dropped by 87% in Canada, causing DNOW’s revenues from Canada to decrease by 47% compared to Q1. Many of the company’s energy customers canceled projects and delayed unconventional and oil sands activities. The company is making some efforts to reduce dependence on the traditional energy end market as it set up a vendor-managed inventory program with a renewable bio-fuels energy customer during the quarter.
Geographically, DNOW’s revenues were the most resilient in the international operations (19% down sequentially) in Q2. Gross margin, although weak (130 basis points down), held up relatively well due to better product mix. However, higher inventory charges following product line exit reduced the margin in Q2.
The Balance Sheet Is Strong
NOW has set a strategy of reducing working capital as a percentage of revenues. In 1H 2020, its cash flow from operations (or CFO) increased by 51% compared to a year ago. Despite a year-over-year decrease in revenues, the rise in CFO reflects a reduction in working capital requirement due to lower activity levels and the company’s customers conserving cash and delaying deliveries. Since capex is low, its free cash flow (or FCF) also increased handsomely in 1H 2020.
NOW is a zero-debt company, while its peers’ (FAST, MSM, and MRC) average debt-to-equity ratio was 0.39x as of June 30, 2020. Its liquidity was $525 million as of that date. A robust balance sheet and no debt is considered to be hugely beneficial when the economy reflects uncertainty. You can read more on the balance sheet in my previous article.
Linear Regression-Based Forecast
I have observed a regression equation based on the historical relationship among the crude oil price, the completed well count in the U.S. unconventional shales, and DNOW’s reported revenues for the past five years and the previous eight-quarter trend. Based on the model, revenues should decrease in the next twelve months (or NTM). While the top line can remain weak in 2022, I expect it to rebound in 2023.
In the Monte Carlo simulation, after 10,000 iterations, I find that the maximum frequency ranges between $2.6 billion and $3.6 billion. The trailing 12-month (or TTM) revenue falls short of this range. Investors, however, should note that this is only an academic exercise.
Based on a simple regression model using the average forecast revenues, I expect the company’s EBITDA to weaken and turn negative in the next two years. It can then recover sharply in 2023.
I have calculated the EV using DNOW’s past and forward EV/Revenue multiple (since I expect EBITDA to turn negative in NTM 2021, the EV/EBITDA multiple will be meaningless). Returns potential using the forward multiple (0.48x) is higher (41% upside) compared to returns potential using the past average multiple (19% upside). The sell-side analysts, however, expect even higher returns (42.6% downside) from the stock.
What’s The Take On DNOW?
Low upstream capex, hugely depleted completions well count, and rig count hitting a trough, coupled with the company’s closure of sites, will not allow NOW’s top line to take a breather in the short term. So, it looks beyond the traditional sales channel and pushes e-commerce sales and other digital marketing initiatives to boost the top line. With industry consolidation and churning of the high-margin product lines, the company can maintain or gain further market share in the medium to long term. With DigitalNOW as a unified commerce platform, it has registered two major integrated midstream customers in recent times.
The company will continue to lower the selling and warehousing costs to mitigate the margin pressure. Strategically, it has shed the scale-ramping model and adopted a model that focuses on efficiency enhancement, including supply chain redesigning and consolidating distribution centers. Over the medium term, such efforts will protect the margin and will boost it when sales growth returns. The company has strong liquidity and zero debt, which is a big plus in today’s environment. In my opinion, returns from the stock can stay muted in the short term but can increase significantly over the medium to long term.
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.