Description

Over the medium term, the world needs more oil and gas production. A meaningful share of future oil and gas production growth will be driven by rigs operating in North America. If those statements are correct, DNOW provides a very attractive risk/reward at $9.20 per share. Based on trailing financials, DNOW does not look cheap, but if the North American rig count continues to increase to support oil and gas production growth then 18 to 24 months from now DNOW could double and still look like reasonable value.

There are two previous VIC write ups on DNOW that provide good background information. They are one of the largest industrial distribution companies in the world with thousands of vendors, thousands customers, and 300,000+ SKUs. Distribution, at scale, is a pretty good business. Typically, this type of two-sided network gives the distributor in the middle solid leverage over both sides to earn a decent return on capital. For reasons discussed below, DNOW has struggled to earn a decent return over the past several years. That is about to change.

DNOW is unique among its publicly traded peers in its concentrated exposure to the upstream oil and gas market in North America. ~85% of their revenue is generated in North America, and the vast majority of that is in the L48. This industry and geographic concentration makes DNOW’s business significantly more cyclical than its industrial distribution peers. Demand for DNOW’s bread and butter product offering (pipe, valves, fittings, flanges, gaskets, fasteners, electrical, instrumentation, artificial lift, pumping solutions, valve actuation and modular process, measurement and control equipment), is driven in large part by the absolute level of the North American rig count and to a lesser extent the global rig count.

To put it bluntly, DNOW’s financial results over the past seven years have been horrible. From 2014 to 2020, DNOW’s revenue dropped 61% as the average annual North American Rig Count dropped from over 2,200 to ~500. From 2015 to 2020, DNOW lost money in four out of six years with a cumulative pretax EBIT loss of ~$400mm (including inventory impairments). In addition, they impaired over $800mm of goodwill and acquired intangible assets (the company was built as a roll up). They also deployed over $750mm in net acquisitions (mostly in 2015/2016) for which there is seemingly little benefit in the financial statements. I cut management some slack on the historical financial results and on the acquisitions as I believe they did a pretty good job with bad hand after bad hand.

Fortunately, DNOW entered the 2015 downturn well capitalized, and has been able to weather the ‘15/’16 downturn storm and Covid without diluting shareholders. As of 6/30/21 they have net cash of ~$300mm on their balance sheet; however, all of that cash and then some will be required for working capital in the coming up cycle.

Importantly, over the past six years, DNOW has transformed into a much more efficient organization. These efficiency gains have been obscured by poor financial results driven by the brutal deterioration in DNOW’s customer base’s business activity levels. This transformation was accelerated by Covid. When DNOW was spun off from NOV in 2014, it was an inefficient roll up with multiple ERP systems, overlapping/duplicative branches, and a bloated G&A structure. In addition, there was boatloads of capital funding DNOW’s competition. Conventional wisdom at the time was shale growth to the moon. Oil and gas focused distribution companies were earning extraordinary profits.

The business environment could not be more different today. DNOW has cut a lot of the fat that inevitably accumulates with a roll up strategy in an industry that has been rapidly expanding for a number of years (2010-2014). DNOW has rationalized the number of branch locations from 300 to 195 and employees from 5,000 to 2,450. They have standardized branch design in order to lower operating costs and allow more flexibility to expand and contract with the market. At the same time, they are centralizing their operations around larger and fewer regional distribution centers and structurally decreasing headcount through automation. They have made significant investments in technology both on the front end customer experience (DigitalNOW) and the back end order fulfillment modernization. In addition, over the past several years, management has consistently shortened their cash conversion cycle by decreasing net working capital as a % of sales and increasing inventory turns.

At the same time that DNOW was transforming into a more efficient company, many of its competitors were either closing up shop or struggling just to survive. Oil and gas focused industrial distribution is an extremely fragmented industry. There are a large number of mom and pop distributors with either one location or just a handful. In between DNOW and the mom and pops there are a handful of larger but still sub scale distributors that have been decimated (e.g. WB Supply https://cases.stretto.com/wbsupply/court-docket/court-docket-category/843-voluntary-petition/). Since 2014, with a few exceptions, private equity has focused on funding industrial distributors without major oil and gas exposure and thus less cyclical earnings. The large public industrial distributors that do have oil and gas exposure (MRC Global, Grainger, Ferguson, HD Supply, Fastenal) are not keen to invest additional $ in an industry where they have been burned before and where their ESG mandates actively encourage them to shrink their exposure.

In short, DNOW is in pole position for the coming oil and gas up cycle.

I have created three cases to frame DNOW’s profitablity through the cycle (Low, Mid, High). The key assumptions underpinning these cases are:

1.      Average Drilling Rigs in the U.S.

2.      DNOW Revenue / Rig

3.      DNOW Gross Margin

4.      DNOW Locations Required

5.      Warehousing, selling and administrative expense (WSA) per Location

You can see my case assumptions and cash flows laid out in the Appendix.

Based on my assumptions, DNOW is trading at 4.2x High Cycle pre-tax unlevered free cash flow (UFCF) and 7.4x Mid Cycle. I estimate Low Cycle cash burn assuming current location count and 19% gross margin to be ~$20mm/yr. Note that gross margin gets depressed in low cycles due to inventory impairments. 

DOWNSIDE:

Downside in Low Cycle is supported by ~$700mm of book equity value, which includes ~$300mm of cash, versus current market cap of ~$1.0bn. If we were to enter a world of 400 rigs forever, I believe that DNOW could generate ~$40mm of cash flow per year at 21% gross margin and 175 locations. That level of earnings could support a $400mm TEV which would be ~45% downside from the current share price. 

UPSIDE:

Assuming we are on our way to an up cycle environment, DNOW could double within 18 to 24 months and still trade at a single digit multiple of pre-tax free cash flow (excluding the one time WC investment required to support the increased revenue). 

APPENDIX 1:

Catalyst

Continued increase in North American rig count driving better DNOW financial results