Description

Summary:

MRC Global (MRC) trades at a reasonable valuation based on management’s sandbagged 2022 guidance while offering exposure to the ongoing cyclical recovery in its oil & gas focused business lines as well as a secularly growing natural gas distribution business that is taking market share in a growing pie. I forecast FCF to equity to increase by 150% by 2024 taking MRC’s FCF yield to ~22% with a <1.0x leverage ratio. At $10.50/share, MRC would provide a ~27% IRR based on a target year end 2024 trailing FCF yield of 12%.

Business Overview:

MRC is one of the largest industrial distribution companies in the world. They sell >250,000 SKUs from >10,000 suppliers to >10,000 customers via 210 service locations as well as their proprietary e-commerce platform. ~80% of sales are in the US, 5% in Canada, with the balance in Europe/ME/Australia/NZ.

Distribution is a pretty good business model, especially at MRC’s scale. As the choke point between manufacturers and customers, a large distributor servicing an attractive industry will usually be able to earn a solid ROIC. MRC has meaningful exposure to one “good” industry (natural gas utility; 38% of ’21 sales), one “OK” industry (Downstream/Industrial; 29% of ’21 sales), and one “bad” industry (Upstream/Midstream; 32% of ’21 sales).

Due to their size, MRC is often the largest customer of their suppliers. This buying power allows MRC to extract lower pricing from manufacturers relative to smaller distributors and thus earn a better margin from their customers. MRC’s scale and relative technological sophistication allow them to offer a convenience factor to many customers through either physical proximity, e-commerce optionality, and/or integration of backend systems / ERPs. By providing a demonstrably better service offering, MRC ensures that price is not always the driving factor for their customers’ buying decisions. MRC is also often the largest vendor for their customers. By offering a one stop shop for so many of their customers’ needs, MRC can often deeply integrate themselves into their customer’s supply chain thereby increasing switching costs.

Digital sales through MRC’s e-commerce platform are >40% of sales up from 27% to 29% from 2016-2019. Covid was a driver of the increase; however, it seems that new buying habits have been formed and MRC expects >50% of its sales to run through its e-commerce platform within the next couple of years. MRC’s e-commerce platform is customized for each customer’s contract terms, part numbers, and commonly ordered items. This multi-channel approach with the e-commerce platform and physical service locations provides customers with a highly attractive value proposition. As the range of products that MRC sells varies from highly engineered valves/instrumentation that require significant salesperson expertise to more commodity type items that are more easily added to an online shopping cart, a multi channel sales approach is optimal even necessary to be a one stop shop vendor.

MRC’s target customer base consists of large, complex, multi-site companies in the energy, industrial and gas utilities sectors. Customers include companies like Chevron (largest customer), Shell (2nd largest customer), Marathon, Valero, Exxon, Oxy, Centerpoint, PG&E, NiSource, Atmos, TC Energy, Energy Transfer, and Williams.

As a PVF distributor, MRC’s major product categories include pipe, fittings, and flanges, valves, automation, measurement and instrumentation, gas utility products (pipe, valves, smart meters, etc), stainless steel products among others. All of these products are subject to meaningful inflation right now which is a net positive for MRC’s margins as they are often able to sell existing inventory purchased at lower prices at the new higher prices.

Gas Utility Segment:

The Gas Utility segment is MRC’s best business line. They have grown this segment organically at an 11% CAGR since 2010. It is a very steady grower for MRC where they are taking market share and the overall pie grows almost every year driven by housing starts and large-scale maintenance programs (38% of gas distribution main and service line miles are over 40 years old). Gas Utility customer spending is independent of commodity prices. MRC’s Gas Utility revenue was only marginally affected in 2020 by the pandemic and took a big step up in 2021 as maintenance projects delayed by Covid were released. In 2021, Gas Utility revenue accounted for 38% of MRC’s total revenue, and it is expected to continue to grow ~10%/yr for the next several years as existing gas utility customers increase their spending by 5-7%/year and as MRC continues to win new customer contracts.

My MRC model assumes 10%/yr revenue growth for this segment from 2021 – 2024.

DIET Segment (Downstream/Industrial/Energy Transition):

MRC’s downstream business (DIET) is its second-best business line. This segment accounted for 29% of 2021 revenue. It is split ~1/3 Refining, ~1/3 Chemical plants and ~1/3 General Industrial. 2021 saw minimal contribution from Energy Transition projects; however, management has guided to up to $100mm of 2022 revenue from biodiesel and other renewable energy projects in 2022 (meaningfully above their prior expectations for 2022).

DIET’s business is mostly MRO based and thus is less affected by commodity prices than the Upstream and Midstream segments. However, there is still some commodity price correlation. 2020 and 2021 DIET sales decreased ~30% from 2019 levels as turnaround and upgrade projects were delayed or canceled (partially commodity price driven but also due to Covid restrictions).  In 2022, MRC is seeing meaningful improvement in activity levels as Covid continues to recede and commodity prices improve. MRC expects low double digit sales increases in its legacy refining, chemical, and industrial customers and has stated that Energy transition projects could add another $100mm on top of that in 2022 with more to come thereafter.

My MRC model forecasts a recovery to 2018 revenue levels for this segment by 2024 as turnaround/upgrade project activity reverts to its prior run rate and energy transition projects gain steam.

Upstream and Midstream:

MRC splits out Upstream and Midstream into two segments, but I will combine them here because they have the same drivers: oil and gas prices / well completion activity. These two segments have been crushed since 2018 down a combined 60%. In 2021 they accounted for 33% of MRC’s revenue. MRC is expecting meaningful growth in these segments as we enter the new oil & gas up cycle. This segment’s recovery has somewhat lagged the broader oil & gas industry because they are heavily weighted toward the larger producers that have been slow to increase their budgets in response to higher commodity prices. If you think that those large producers will stay out of the pool forever, then MRC is probably not a bet you want to make. I believe that medium term oil and gas macro has not been this constructive in a generation. Major oil and gas producers will increase their budgets in response to commodity prices over the next 12 to 24 months, and absent a major global recession, will ultimately reach 2018/2019 levels over the next couple of years.

My MRC model forecasts a recovery to 2018 revenue levels for these segments by 2024.

Other Key Forecasting Assumptions:

1.      Gross Margin – 18%. This is slightly better than the trailing 4 year average of 17.6% as I expect the current inflationary environment to attenuate but continue which is a boon to margins. This is roughly in line with management’s commentary (note mgmt. refers to a 20% gross margin figure that adds back D&A and amortization to the gross margin line which does not make any sense to me so I don’t add it back to gross margin in my model).

2.      SG&A – increases from $410mm in 2021 to $450mm in 2022 and to $550mm in 2024 as more service locations and personnel are required to service the increased revenue. Note that the last time MRC revenues approached my 2024 forecasted revenue level was 2015 when SG&A was $607mm. My forecasted $550mm of SG&A takes into account structural cost savings made during both 2016 and 2020/2021 to set up centralized distribution centers, shut down redundant locations, and move more business onto the MRC e-commerce platform.

Risks:

1.      Poor Capital Allocation – MRC was built by acquisition. They have been in survival mode since 2015 paying down debt. They will be in a position to get more aggressive shortly.

a.      Mitigant: A meaningful portion of executive comp is based on relative TSR and a capital efficiency metric. There are also meaningful equity ownership guidelines (5x base salary for CEO and 3x base salary for EVPs and SVPs). These factors should discourage empire building.

2.      Economic recession nips oil & gas recovery in the bud through demand destruction

a.      Mitigant: I want the exposure to oil & gas and am willing to bear this risk; however, it is a hedgeable risk.

 Financial Model:

Catalyst

1. Upstream and Midstream segment cyclical recovery over the next 24 months

2. Continued growth of Gas Utility business