Description

MRC, a recent GS led IPO, is a very good company trading at a very cheap price.  We believe MRC is misunderstood as street estimates severely under represent the company’s true earnings power. The stock trades at 7x our 2013 CEPS estimate of $2.85 and we expect EPS to grow at a high teens clip for the next several years. Our estimates are far above consensus estimates for reasons we’ll discuss later.

MRC is a category killer with scale advantages in an industry poised for growth. As the largest distributor that connects 12,000 suppliers to 12,000 clients, MRC fills a vital role in the energy equipment food chain.

MRC is the largest distributor of pipes, valves and fittings (PVF) to the energy and industrial sectors.  It serves the upstream (exploration, production and extraction of oil and gas), midstream, (gathering and transmission of oil and gas, gas utilities, and the storage and distribution of oil and gas), and downstream (crude oil refining, petrochemical processing and general industrials) markets.  It came public in April 2012 at $21 (the bottom of a $21-23 range). Various GS Capital Partner funds are the largest shareholders.  MRC now trades 6% below its IPO price (which was priced at low end of $21-23 range).

MRC has good operating momentum - revenue and EPS estimates have been increased since the time the deal was marketed.  In 1Q12, revenue rose 39%, organic growth 34%, and adjusted EBITDA 92%. While analysts project revenue and earnings growth to decelerate, we think estimates are overly conservative as analysts are reluctant to get too far ahead of very conservative management guidance. 

On 5/30, MRC announced a new “Enterprise Framework Agreement” with a key (we believe a top 2) client - Shell. This 5 year contract, which has a 5 year option, may double the size of the present Shell business. We believe Shell related sales are $250m + today. The contract is the largest MRC has ever signed. The size, scope and duration of the contract are unique. The fact that Shell chose MRC underscores MRC’s position as the industry’s leading distributor. We believe other integrated oil companies may follow Shell in outsourcing all or more of their PVF to one key supplier. MRC is best positioned to win this business.

MRC CEO Andy Lane, is excellent. Lane, the former #2 executive and COO at HAL, has upside on over 1 million shares. During Lane’s tenure as HAL COO (2004-2007), revenue rose from $7.4b to $15b and net income tripled. Lane also guided HAL’s KBR unit through 3 major crises and a successful IPO. Andy was the youngest VP in HAL history. His deep relationships in the oil & gas industry have and will continue to help MRC drive organic and inorganic growth.

Excellent business model. 66% of sales are recurring under MRO arrangements. MRC targets 8-10% organic growth, 10-12% total growth and 15-20% adjusted EPS growth. CAPX is just $20m/year or about 4% of 2012 EBITDA.

Upside to EPS estimates. Revenue rose 26% in 2011 and 39% in 1Q12. Yet analysts estimate low single digit growth in 2H12. While compares are tougher in 2H, we believe numbers are too conservative.

There are multiple long term revenue drivers:  We list a few below.

• Upstream 47% of sales– North American shale and unconventional shale drilling is driving increased demand for pipe and drilling supplies. Unconventional activity drives 5-10x the PVF revenue as conventional non shale wells.
• Midstream 26% of sales - growth is driven by increasing CAPX budgets to build out the infrastructure to support and transport oil and gas from numerous new locales such as the Bakken, Eagle Ford, Niobrara Marcellus andUtica. In many locations, oil is being transported via truck due to the absence or lack of pipeline capacity. The Interstate Natural Gas Association of America estimates companies will spend $178 billion to build large, high pressure natural gas pipelines between 2011-2035.  In addition, our pipelines are in need of repair. About 60% of theUSnetwork of natural gas transmission pipeline is at least 40years old. Much of our pipelines need substantial maintenance or replacement. Increased safety and government demands for pipeline integrity have and will continue to accelerate demand for PVF products.
• Downstream 27% of sales growth will be driven by higher refinery maintenance budgets as refineries have deferred maintenance. NewUS based petrochemical plant builds, spurred by low US natural gas prices (a big competitive advantage for US producers), is another important positive in 2013 and beyond.
• M&A – MGMT acquires tuck ins at 3-5x EBITDA in NA (pre synergies) and 6-7x in international markets. It expects to pay 4-6x EBITDA on average. Models exclude M&A

Margins should rise over time as 1. Fixed costs are leveraged 2. More products are sourced from international markets 3. Volume discounts and 4. A richer mix of higher margin products (low margin OCTG are declining as a percentage of sales).

We believe MRC is a misunderstood company. On street estimates, the stock trades at 11.7x 2012 EPS of $1.68 and 9.6x 2013 of $2.04 yet on our numbers, the stock trades at 9x 2012 and 6.9x 2013. We see true earnings power far higher than what the street suggests for several reasons. First, the street expenses ~$50m of amortization which we see as a look through expense.  Other D&A of $18m is roughly comparable to cap X of $20m.  So we add back amortization. Second, the street does not add back the increase to LIFO reserve. In time of rising commodity costs, LIFO shifts more costs to COGS thereby reducing pretax income and taxes. Tax considerations were the key reason why MRC uses LIFO (most companies choose LIFO for the same reason). The LIFO adjustment increased COGS by $6.9m in 1Q and most assume a $28m increase in 2012. These 2 items depress EPS $0.49. Finally, our revenue and EBITDA estimates are above the street as we believe consensus numbers are too conservative. 

 Moreover, in 2013 interest expense should fall dramatically boosting EPS by approximately $0.31/ share. MRC has $1.05b of 9.5% debt that is callable on 12/15/12.  Management believes it can refinance long term at roughly 7% (the yield to maturity is ~7.5%). MRC has an asset based revolving credit facility (ABL) which allows it to borrow short term at rates ranging from Libor + 150 to Libor +200bp depending upon how much is borrowed. MRC is evaluating how much debt it will term out. For now, we assume MRC will term out $800m of debt at 7.5% and $400m will float at 2.5%. Hence, we model interest expense to fall to $70m in 2013 from $125m in 2012. The Street models 2013 interest expense at ~120m. If MRC decides to keep more debt short term and or re-pays debt faster (which is likely), our 2013 EPS will rise even further.

MRC’s financial characteristics are attractive. Management estimates 66% of sales are recurring under MRO (maintenance, repair and operations) arrangements. Since 2000, its retention rate is 95% for MRO contracts. MRO contract durations are typically 3-5 years. As the industry’s largest player it benefits disproportionately as MRO contracts gain favor. MRC targets 8-10% organic revenue growth, 10-12% total growth and 15% incremental EBITDA margins (vs. guidance of 8-8.5% in 2012).  So earnings should grow faster than sales.

We think a multiple of 6.9x 2013 EPS for a company of this caliber with terrific management is far too cheap.  Some suggest that The EV/EBITDA multiples of 6.8x 2012 and 6x 2013 are only modestly inexpensive. However, since CAPX is so low, we think EV/(EBITDA-CAPX) is a far better measure of value. MRC trades at just 7x our 2012 EV/EBITDA – CAPX) estimate and 6.5x 2013.  A summary of our estimates is below.

Catalyst