Description

 PDF with graphs!: https://www.dropbox.com/s/dqvkuvyixkawvu7/MRC%20Global_v2.14.15.pdf?dl=0

Introduction (Theme)

The following pitch is another thematic play on the potential recovery and stabilization of oil prices. I don’t have much of an opinion on oil prices in the short or medium term, but I believe that prices will stabilize long term at a level in the future where shale oil will exist as the marginal barrel (as shale continues to move down the learning/cost curves). MRC Global is a distributor of pipes, valves, and fittings to the energy and chemical sectors, and as such is indirectly affected by curtailments in capex spending. There have been good write-ups in the past by BTuleda16 and mitch395.

Investment Thesis

MRC Global is the largest distributor of pipes, valves, and fittings (PVF) in the world, with roughly 10% market share globally and ~24% market share in the United States. The Company operates 400 locations and serves over 19,000 customers. 80% of the Company’s revenue is multi-year maintenance, repair, and operating contracts (“MRO”), and the remainder is project-based revenues[1]. The Company breaks its end exposures down as: upstream (47% of revenues), midstream (28%), and downstream (25%). LTM 9/30/2014, MRC generated $5.8 billion of revenue and $410 million of EBITDA, of which a large majority (85% came from North America).

[Chart 1][2]

We believe MRC Global is an interesting investment at the current level (and will perhaps be even better following the Q4’14 earnings call) and has ~100% upside ($29 price target, 17% IRR) over 4-5 years because 1) the current price reflects a substantial loss of upstream revenues in 2015 and we believe the business is more resilient then the market believes, 2) the business has transformed substantially over the past 5 years, with increasingly higher MRO revenues and decreased exposure to volatile, lower margin products 3) the Company generates substantial free cash flow (11% over average last 5 years, 15% ex WC), and has historically released working capital during downturns, and 4) the market is still very fragmented, and acquisition opportunities should be more attractive (vs historical 6-8x) going forward.

The large caveat to wise capital deployment is that management is compensated on EBITDA growth. While acquisitions historically have been okay (not stellar), it does not seem overly likely that the Company will institute a large buyback if shares languish further. Furthermore, while oil demand is most likely going to increase in the next decade, weakness in the global environment could potentially create a protracted period of $50 oil. While we think the business will persist in these conditions, our return forecasts will be wildly overstated.

The Business

MRC Global is the world’s largest pipes, valves, and fittings distributor in the world, and came into existence with the roll up of the McJunkin Corporation and Red Man Pipe & Supply Co. in 2007. Over the past 8 years, the Company has acquired 14 companies representing $1.5bn of revenues. The Company makes money by carrying a massive inventory of SKU’s (230,000), and providing tight, reliable delivery (just in time, or multiple deliveries a day) to end customers. MRC’s service is important as the opportunity costs of downtime are immense, with estimates of refinery (and well) downtimes in the $100k – millions of dollars a day (depending on the cash margin)[3]. In reflection of the persistence in quality of MRC’s product, the Company has achieved 95% renewal rates since 2000 among its top 25 customers.

The PVF market in North America is a $20 bn market and consists of MRC Global (~24% market), Distribution NOW (~19%), Edgen (8%), and thousands of smaller regional or local centers. Globally, the market is $50 billion, and the competitive landscapeis  similarly fragmented. MRC and DNOW are the only two global distributors with presence in 40+ countries.

While I wouldn’t dare to call this a fantastic business given the strength of large IOC customers, we think the company does enjoy some economies of scale. In general, large oil companies outsource certain working capital functions, and MRC is able to generate operational efficiencies by pooling together many customer needs. Our conversations with the Company indicate that MRC is able to pool estimates of supply needs from all its IOC customers, aggregate order forecasts, and give the large order of pooled demand to their selective supplier base (which makes the relationship very sticky). By guaranteeing such large order volumes, MRC can get prices 1-2% lower than even the largest engineering companies who deal directly with suppliers (this is quite significant for a business with 7-8% EBITDA margins). Most of MRC’s small competitors must buy through master distributors, which adds on another layer of cost.

In addition, having large customers makes it possible for MRC to have a minimum level of demand in its serviced regions – it is easier to hold on to existing branches when you have a base level of customer activity from which you can leverage your infrastructure and distribution costs.

1) Attractive Valuation on Normalized Earnings

After achieving $410 million in EBITDA LTM and guiding to $440 million of EBITDA for the year end 2014, the Company currently trades at 6.1x 2014E EBITDA (at steady state, this translates to a 20% FCF yield on today’s trading price[4]). However, this is a pipe dream, and the reality of the major 20-30% capex budget cuts for 2015 will probably dramatically impact 2015 earnings.

I do not know what 2015 revenue numbers are going to be, but we can try to extrapolate some numbers to estimate a downside case, and see whether that provides us with an attractive enough entry point. Below is a chart depicting the relationship of MRC’s upstream earnings with the Baker Hugh’s rig count number  (r=.80). The correlation to midstream and downstream revenues are around .6. However, excluding 2009, the correlation with upstream falls to .45 and is insignificant for both midstream and downstream.

[Chart 2] 

Let us say rig counts fall 35% and stabilize around 1,500 (just a bit above 2009. Rig counts today stand at 1740[5]). Since we all know simple correlations based on 6 years of data is absolutely accurate – we might assume that upstream revenues fall 28% and midstream and downstream fall 21%, resulting in 2015 revenues of $4.5 billion. Applying a 6% EBITDA margin implies EBITDA of $270 million.

The choice of a 6% EBITDA margin is reflective of the margins achieved in 2009. I will later attempt to convince you that EBITDA margins should have a lower “floor” given the changes in the last 5 years.  EBITDA margins were abnormally high in 2008 largely due to a large increase in LIFO reserves that year (the Company removes LIFO affects from adjusted margins). Hence, while gross margins were 18.7% in 2008, adjusted gross margins were 22.1%[6]. This was coupled with vastly increased demand of products, so SG&A as % of revenues fell to 9.2% (vs. 11% since IPO). 

[Chart 3]

In an environment with total revenues down 25%, I believe the Company would dramatically release working capital. In 2009, MRC reduced inventories by $521.6 million and accounts receivable by $311.6 million. Change in working capital unlocked ~$480 million in cash. Working backwards form the S-1 filings, we can roughly predict that inventory was around $1.3 billion and receivables were around $800 million[7]. This compares to September inventory of $1.1 billion and accounts receivable of $1.1 billion. I do not think it will be unlikely that MRC unlocks another $400-500 million of working capital. This would bring net debt down to $900 million - $1bn, and the enterprise value to $2.2-$2.3 billion. MRC would then be trading at 8x to 8.5x EBITDA and 12% FCF yield on today’s valuation.

While this is not cheap, I also think the scenario is somewhat punishing. In addition, the reset in performance should make future growth “easier”, particularly as 1) with strong cash flow, the Company can likely roll up businesses at far lower valuations than the 6-8x that existed in the run-up to 2014[8], and 2) in the longer run (if we are looking at least 2 years out) I believe growth will return to the shale producers as the marginal barrel.

I do not predict to know much about matters of oil (or matters of the heart), but I do believe that shale oil will continue to exist in the future.  Over the past 20+ years, OPEC has consistently supplied 33-37% of global crude oil demand[9]. 

[Chart 4]

During this time, global crude demand has increased from 70 to 92 million barrels a day. The current price volatility is a result of an excess 1.5-2 million barrels a day[10]. Global oil demand has generally grown just shy of 1 million barrels a day over the past decade, and BP predicts that demand will continue to grow at .8% a year, or from 92m to 109 m a day by 2035, driven largely by emerging countries (oil consumption per capita is 7 barrels/day per 1000 people in China, 10 in Brazil, 3 in India, and 18 in Mexico, vs. 25-30 in Europe and >60 in the US)[11]. If OPEC continues to hold 35% of global demand, then 11 million barrels of non-OPEC oil will be required over the next 20 years (~500k/day increase). Similarly, the EIA projects similar short term demand increases (+1 million a day in 2015 and 2016, over 100% from non-OECD countries[12]). Barring any large macro shocks, I think crude oil demand will continue to make a slow and steady climb.

What do we do about the oversupply today? There will be pain in the short run – through 2015/2016, but a correction should be imminent. Today around half of US oil production is tight oil (around ~5.5 million barrels a day)[13],[14]. Tight oil formations generally have extremely high decline rates ranging from 40%-70%, so a decrease in capex will result in rapid correction of tight oil output. For example, there are currently 400 active rigs in the Bakken, but production from new wells of 93k bbl/day is largely offset by 80k bbl/day decline (this is month over month) from legacy production. As a result, oil production is largely flat at 1.3 Mbbl/d with 400 active rigs[15]. The same flat production is witnessed with 250 rigs in the eagle ford[16]. A 30+% decline in active rigs across the United States means (and these are seriously very loose calculations…) means:

• ·         Eagle ford might lose 40k bbl/day production month over month, bringing Eagle Ford production from 1.7 Mbbl/day to 1.2 Mbbl/day
• ·         Bakken might lose 15k bbl/day month over month and bring production from 1.3 billion to 1.1 billion over a year
• ·         Permian will probably be flat, as it is growing quite rapidly right now

In total, it seems that the U.S. could easily lose 1 Mbbl/day + of production in 2016 if capital continues to wither away in 2015. Tied with this global growth of 1.5-2 Mbbl/day over the next 2 years and it seems that the market will balance itself out and “normalize” within 1-2 years. At that point, I believe shale will see a returned inflow of capital, as US shale will be the swing producer at $60-$70 a barrel[17], supplying the 80^th -90^th+ million barrel: 

[Chart 5]

[Chart 6]

In addition, Barclays suggests that there is a pattern of major capex spending rebounds, with sharp increases in spending following years of decline (bars are increase in capex, line is brent crude price movements). 

[Chart 7]

However, there are also some suggestions to the contrary (that shale is actually not such a great asset): http://www.resilience.org/stories/2014-12-16/the-surprising-data-behind-shale-oil

Ultimately this brings us back to valuation. We don’t believe a scenario of 25% decline in revenues and 6% EBITDA margins will materialize, but in the case that it does, we think revenues will stabilize and recover strongly in 2016 and onwards (we also think the midstream and downstream segments should be much more resilient given the nature of chemical capex spending in the U.S.[18]). As such, an 8x trough valuation EBITDA seems fair. If a better scenario materializes, the shares look attractive at current levels.

2.)    The Company has become more resilient

Since the downturn in 2008, we think the Company has become more resilient due to 3 key changes: 1) increased revenue exposure to MRO contracts, 2) product shift to higher margin and less volatile products, and 3) international diversification to lower breakeven oil regions.

Since the downturn in 2008, MRC Global has continued to gain exposure to large IOCs (through frame contracts). The Company’s reported MRO revenues have increased from 66% in 2010 to 80% as of 9/30/2014. Some wins reported in the press over last few years include:

• ·         5 Year contract with midstream supplier Markwest[19]
• ·         Chevron extension into Australia, Kazakhastan, and Thailand, US Gulf Coast
• ·         Renewal of ConocoPhillip’s MRO contract in lower 48 states, and extension into CP’s Canada operations
• ·    5 Year framework agreement with BP International for BP’s Global Projects Organization
• ·    5 Year global enterprise framework (MRC is single source provider for valves, and central distributor for other products) for Shell, with 5 year extension option[20]

While frame agreements necessarily draw lower margins given the bargaining power of large customers, it also makes revenues more predictable and somewhat more stable. MRC’s smaller competitors generally sell to independent E&Ps, the businesses that are most likely to cut back or meet existential crises in the current environment. Smaller businesses with local/regional focus essentially supply to individual rigs that are operating within coverage at any given time. If activity were to slow in the region specifically and rigs are moved away to lower cost shales, these businesses will have dramatically reduced customer bases. MRC’s focus on national (and now global) coverage attempts to diversify away this risk; even though it may incur costs to service areas that might be subscale (i.e. a branch that might service a single customer, as part of a global frame agreement) 

MRC has also gradually reduced its exposure to pipes and tubular products (OCTG, which are consumed during the drilling process). Valves, fittings, and other are now >70% of revenues, vs ~59% in 2009. These products generally carry margins in the low to high 20% gross margins, while pipes carry margins in the single digits. As such, when there is pricing pressure, as happened post-recession, having exposure to low margin products will have a larger impact on the bottom line. Line pipe has been experiencing deflation from 2012 through mid 2014, which has been a pressure on gross margins[21].

[Chart 8] 

Adjusted gross margins bottomed out at 13.5% in 2009, and gradually recovered to 19.3% in 2013. Assuming 10% margins for pipes (tubes) and 20% for valves fittings and other, the mix shift should represent 1.2%+ of gross margin improvement. As such, even in a dramatic downturn, it seems likely that gross margins will fare better than experienced in 2009.

[Chart 9] 

SG&A has picked up in recent years – we think a portion of this is a result of international expansion. Given that MRC is climbing the learning curve as an offshore supplier, the Company should experience operational leverage as it attracts more customers to its global platform. We calculate incremental EBITDA margins to be 10% since 2007, though they have been around 17% in the most recent 3-4 years. Our conversations with the Company indicate incremental EBITDA margins should be 15% up to $7 billion dollars in revenues (this would imply ~9% EBITDA margins), with long term EBITDA margin targets of 10%. We don’t think 10% is likely, but do think 8-9% margins are readily achievable (and was achieved multiple years in the past)

[Chart 10] 

While it may seem silly to buy international businesses at 7-8x EBITDA when it is much cheaper to roll up small domestic players at 4-6x EBITDA, MRC wanted to expand overseas in order to service their existing North American customers (75% of IOC capex spending is made outside North America), and to gain exposure to new businesses, such as Norwegian offshore. As a result, around 15% of revenues today are international, vs 0% during the downturn. Ostensibly, this increases MRC Global’s exposure to areas with lower breakeven oil prices (Norway, for example, at estimated $55), but given the current capex cuts from Statoil, only time will tell whether international revenues prove more resilient. In the long run though, it seems prudent not to have all of one’s revenue reliant on North American tight oil and Canadian oil sands.

[Chart 11] 

3). MRC Generates significant FCF

Since the inception of the Company in 2007, MRC has generated an attractive amount of FCF, as the business is capex light and requires just $15-$20 million of capex a year (versus $97 million of D&A, predominantly the amortization of goodwill and intangibles).

From 2008 to 2013, MRC generated on average $143 million of FCF a year (11% FCF yield), or $193 million a year before working capital changes. Over the past 5 years (from 2010 to 2014E), this number has been $104 million / $187 million (before and post working capital).

 [Chart 12]

In years of strong revenue growth, as experienced in 2014 and 2008, OCF can be flat or negative as the Company invests in inventory and expands into new territories. In years of large revenue declines, such as in 2009/2010, OCF is generally high as the Company draws down working capital. As such, cash flows actually moves inversely to market conditions.

[Chart 13] 

Given the strong growth MRC experienced in 2014 and the lack of FCF generation from ~$240 million net investment into working capital, it seems likely that 2015 will see relatively high FCF generation. I believe longer term, through the cycle, MRC will generate higher FCF than it did through the 2008/2009 boom bust. This is primarily due to the fact that MRC has made $978 million of acquisitions over the time frame. I estimate (roughly, as all my estimates are) based on ~$6 billion of sales in 2014, $3.7 billion in 2009 and $1.2 billion of acquired revenues between 2009 and June 2014, that organic growth might have been around 6% a year since the bottom. While this seems actually quite terrible given we reputedly had a trough year in 2009, I think it bears mentioning that MRC Global’s transition away from selling lower margin pipes (and OCTG) in particular was probably a not insignificant detractor to growth in revenue.

 [Chart 14]

4) Capital Deployment Opportunities

As previously mentioned, MRC Global is extremely acquisitive (for better or worse). It has spent just under a $1 billion (slightly more than the $820 million in FCF it generated) since 2008 acquiring businesses. Using return on gross tangible assets (EBITDA over gross assets), the Company has returned around 8-15% (low teens) over the past 5 years, and is estimated to have a ROGA of ~13% for 2014[22].

The returns generally fall in line with guidance provided by DNOW and MRC that they target acquisitions (domestically) in the 4-6x EBITDA range, and internationally in the 6-8x range (MRC’s international acquisitions in 1H of 2014 seems like they were probably made at exactly the worst time)

[Chart 15] 

I think a low teens return on ROGA is acceptable. Let us imagine a $100 million acquisition (at 8x multiple) in which MRC finances with 60% equity and 40% debt (~3x debt). It will commit $60 million in cash, take on $40 million of debt, and buy $12.5 million in EBITDA. Assuming an interest rate of 5% this results in $2 million of interest and 10.5 million of EBTDA.  In general, around 25% of the purchase price is attributed to intangible assets[23]. This means that the Company will get $25 million of amortization. Assuming that this is amortized over 10 years, the Company will get $2.5 million of tax shield a year. In total, cash earnings will be $7.7 million a year, or 13% after tax ROE. The figure moves up significantly at 6x EBITDA to 17% after tax ROE (more debt can also be taken on to maintain the same leverage ratio)

Especially given the climate following a 50% decline in oil prices, we think valuations will probably head back to the middle or lower part of the spectrum. I think a 13-17% post tax return on equity is quite attractive. I believe MRC might do $1.67 in cash EPS per share in 2015 (on a 16% decline in revenues). Assuming absolutely no organic recovery and simply reinvestment of cash into the business at 15% ROE, the business should trade at 10-11x P/E at a 12% discount rate, which equates to $17-$19 dollars a share.

Of course, a lot of this is really imprecise and stuff, but I think you get my drift. The business isn’t particularly expensive in what I think is a pretty punitive normalization, trades at 11% through the cycle FCF yield, can reinvest at mid-teens ROE, and should see some (potential significant) recovery if oil prices stabilize over the next couple years.

Risks:

·    Debt: MRC has a healthy amount of debt at $1.4 billion (roughly half is a term loan, and the other a revolving facility). While this is only ~3x debt/EBITDA on 2014 metrics, it could easily balloon to a much higher multiple based on 2015 estimated EBITDA. The offset here, is that MRC”s loans do not have any maintenance covenants and so the business can’t violate any leverage ratios (though it is restricted from taking on additional debt, etc.). MRC will also likely draw down working capital and potentially pay down $300-$500 of debt. The term loan matures in late 2019.

·    New Normal: I’ve no idea what price oil should trade at in the long term.I tend to think that shale oil will be a viable swing barrel in the future, but there’s no denying that OPEC has tremendous excess capacity to flood the markets at will[24]

·    Increased Competition: DNOW is now publicly traded and has similar international reach compared with MRC. Potentially the two can begin to butt heads more as DNOW expands outside its core competence (upstream) and more into midstream and downstream. It doesn’t seem likely they will complete too heavily on margins, as DNOW management has publicly stated its 8% EBITDA margin targets

·    Acquisitions: I’m still not convinced that MRC is good at making acquisitions. I think they at best are probably okay at it

·    Management Compensation: I think the salaries are somewhat high and management incentives are sloppy – driven by 70% weight on an absolute EBITDA target, 20% on Return on average net capital employed, and 10% on KPIs. It is no secret why the Company spends every $1 on acquisitions and has not seriously considered a share repurchase plan.

·    Midstream/Downstream: Generally these are somewhat uncorrelated, but there are episodes in the past of random weakness (i.e. 2013 was a very weak year for midstream as the industry consolidated and focused on acquiring rights of ways, etc.)

Valuation

§  Base PT of $28 is based on ~10x 2019E EPS, or 7.5x EBITDA and ~17 % IRR

Ø I first assume upsteam revenues fall by 35% in 2015 while midstream and downstream each fall by 10%. I then have organic revenue growing 4% thereon out (DNOW targets 3-5%, same with MRC). I have EBITDA falling to 6.5% in 2015, and climbing back to 8% in 2019. I have the business generating ~$1.1 billion in FCF over 5 years, and using all of that to acquire companies at 8x EBITDA (12.5% ROGA). I have interest rate going up to just shy of 7% by 2019 and leverage at 2.5x

Ø  Each P/E turn increases IRR by 2.3% (12x P/E exit = 21% IRR)

§  Downside PT of $11 is based on ~7x 2019E EPS, or 5.9x EBITDA and -4% IRR

Ø I assume upstream revenues fall by 50%, downstream and midstream fall by 20%, and never grow organically. I have margins staying at 6.5% and growing to 6.7% by 2019 mostly through higher margin acquisitions. The business spends ~$560 million on businesses (8x EBITDA), and everything else remains the same

 [VALUATION CHARTS]

Catalyst

 2015 GUIDANCE

OIL PRICES STABILIZE??