Description

DNOW was written up short by Snarfy in an excellent write-up last May.  It is worth noting that not only did s/he successfully look past the spin-off dynamics that often tempt investors into a stock prematurely, s/he also basically called the oil crash.

-40% later, I am recommending DNOW as a long. This write-up will be qualitative in nature as I make no attempt to bridge from the present to the future.  If you think that makes for a bad write-up, you will be best served by marking it 2 and moving on. If you are interested in quantitative, you can refer to Snarfy’s write-up because the business hasn’t changed much, and there is a good chance the stock will continue to trade lower to Snarfy’s original $19 target in the near term. 

However, if you have the ability to withstand volatility and negative momentum (perhaps better said as if you have LPs that understand the power of patience and the difference between volatility and risk) I think DNOW represents an attractive opportunity to own an asset light, well capitalized company led by management with a strong track record of M&A at the best possible time: when the industry is at its worst.

From 40,000 feet

“Tough periods allow the strong and capable to strengthen. Over time the stock price will gain if you build business value. Carnegie Steel built its business during bad times. Opportunities happen with trouble.”

~Charlie Munger, 2009 Berkshire Hathaway annual meeting

Howard Marks refers to this type of thought process as second level thinking.  Its really just simple economics.  As it pertains to DNOW, there is no way to know when oil prices and rig counts will rise, and there is no way to know if they will ever return to the levels seen before the recent crash so I don’t waste time thinking about it.  What is certain however is that oil is cyclical, and cycles have ups and downs.  Eventually (3-5 years?) oil supply (maybe at a lower level?) and demand (likely at a higher level?) will once again converge and oil prices will go up.  In the meantime, DNOW has a rock solid balance sheet, access to a billion+ dollars in liquidity, and a management team with an eye for consolidating an industry filled with over-levered and/or under-scaled competitors. When the oil pricing environment mean reverts to some reasonable extent, DNOW will be much larger and more profitable than before.  Essentially, the worse things get in the short term, the better they will be in the long term for DNOW. This is akin to downside protection if you can focus on the value of the business, rather than the price of the stock.

Competitive Advantages

Generally speaking, distribution is a great business.  Once your two sided network is built out, your cap-ex is almost nothing.  How much does it cost to keep the lights on in a warehouse? Almost nothing.  In DNOW’s case they believe MCX is around $10-15 million.

 The build out is the hard part b/c scale matters for distributors. The end users want to deal with a distributor who has a large supplier network and thus a wide assortment of SKUs for convenience sake, and the products are essentially commodities, so price matters. Low prices of course come from a wide network of end users, so that you can buy in bulk from your suppliers and thus get volume discounts.  Fixed costs such as home office etc. benefit from operational leverage at the top level, and fixed costs such as storage and delivery benefit from operational leverage at the regional level, further contributing to pricing advantages. The bigger the two sided network gets, the deeper the moat becomes as competitors are unable to compete on price. The worse the environment gets, the better it is for the low cost providers because end users push harder and harder for price concessions, and the low cost providers can withstand more pain and thus lower prices than the competition.  This leads to market share gain. Market share gain reinforces the cycle.  Overtime, the big boys have more money to throw around, which means they can spend more money and time integrating themselves with their customers through on site locations and coordinated IT systems, which raises switching costs.

Importantly, the bad times are when the end users most appreciate the fact that they have a distributor rather than sourcing their own supplies, b/c using a distributor essentially lets them keep their inventory off balance sheet which frees up cash from working capital for the lean times.  At the same time, distributors also benefit from working capital release during the bad times because they simply do not replenish inventory as it is consumed by their end users.

The oil field distribution industry is extremely fragmented, with DNOW and MRVC together representing about 50% of the business, and subscale competitors representing the other 50%.  MRVC is bigger than DNOW, but they currently have limited liquidity due to an already 4x levered balance sheet.  That means that the competition is either under-scaled or over-levered, leaving DNOW as the most capable consolidator in the space as others get squeezed out.

Why now?

Psychologically it is difficult to catch a falling knife, and as mentioned in the intro, one needs to be comfortable with a short term price decline in order to own this name.  Why not wait for things to get worse/cheaper?

Once the M&A starts, it may be too late.  It is impossible to know when this will happen, but my guess would be sooner rather than later.  Recent capex by the drillers etc was set a few months or even quarters ago.  They may be slashing, but there is certain stuff that was already locked in.  That won’t be the case in the 2^nd half of 2015, as those budgets were developed in a lower oil price environment.  The 2^nd half is when the services and suppliers are going to really feel the pain, and some of them will wind up living on little more than working capital release, which will give them very little bargaining power in a sale.  Thus, the deals are likely being talked about as you read this.  Management seems to confirm that things are starting to happen.

“These new challenging market conditions have started to have a positive effect on [our M&A] efforts. Not only are we continuing to aggressively pursue opportunities, we're receiving calls from past targets that have declined our offers. Based on current due diligence, as well as other discussions that are underway, we believe our ability to use cash and leverage to grow DNOW in our target markets and product lines looks very promising.” 

-          Robert Workman, Q4 2014 Earnings Call

That being said, I recommend sizing the position in such a way so that you will be able to add to it if the stock continues to go down.

What will acquisitions look like?

Historically the company has paid .3x - .4x sales for acquisitions.  They have more than a billion in liquidity, so conservatively taking the high end, that implies the company can double 2014 revenue through M&A. I realize of course this is “fluff” but with an estimated $50B market, picking up another $4B may not be that difficult, although the timing / integration costs etc. are highly uncertain.  They obviously won’t be able to do it one fell swoop – management has indicated they aren’t seeing potential billion dollar deals the way they did with recent acquisitions C.E. Franklin and Wilson. Further, there needs to be some EBITDA / cash flow to support the debt load due to customary covenants, and EBITDA margins are depressed at the moment, and wouldn’t be able to support $1B in debt.

Theoretically however, if the company were able to double revenue even with no margin expansion (unlikely from these levels) and no multiple expansion (unlikely from these levels) that obviously leads to a doubling in share price.

More likely, what will happen is the company will do some amount of M&A significantly less than $1B, and then the market will get away from them before EBITDA margins expand to the point where they can support taking on more debt and thus funding more acquisitions. However they will be paying lower multiples on less than normalized revenue potential for the revenue streams which they are able to buy… and if the market gets away from them, that means the oil patch is recovering, capex spending is up, and multiples are expanding, all of which are good things for the stock.

The key takeaway is that it is impossible to know what M&A will look like, but the worse things get, the better they will be because the company has the balance sheet and low capex intensity necessary to easily weather the storm, and at the same time they will be able to pursue M&A at better prices.

Integration risk

Rollups have a bad rap. However, for a low tech business like distribution, the challenges are relatively limited.  M&A is really about purchasing relationships and expanding SKUs.  The people that matter in a distribution business are the sales people.  Typically they are thrilled to have access to more SKUs because it gives them a better selling opportunity, and thus higher potential paycheck.  Additionally, being part of a bigger platform means they can be more competitive on pricing, which translates to more sales, an dthAdditionally, in many cases acquisitions are geographically remote, so there is no real cultural integration necessary.  Its as easy as getting everyone on the same ERP system.

Additional upside

Further upside comes from the company’s target of 8% EBITDA margins longer term (vs 4.8% FY14 and 3.1% in Q4 2014), and an obvious expansion of multiples when the world is no longer terrified of the energy patch. EBITDA margins will expand based simply on operating leverage as the oil price environment improves, but there are also ample opportunities to take costs out.  For example, the company has a number of duplicate facilities in certain geographies due to past M&A. The relatively simple act of consolidating facilities increases operating leverage, although it takes time (and money). Additionally, ERP implementation costs will roll off in the future.  Depending on how you play with your M&A assumptions, wider margins on significantly higher revenues could lead to a tripling or more of the stock price given that asset light distributors command high multiples in normalized environments.

The company is also exploring other growth opportunities in the form of supplying other industrial sectors outside of the energy patch. 

Final thoughts

Returning to the fluff comment – doubling normalized revenue potential through M&A in the next 3-5 years probably won’t happen… unless things get significantly worse and the weaker competition is really forced out of the space (again, the worse things get, the better they will be).  When a negative environment creates positive opportunities, that is a good thing.  It is worth repeating that if things get significantly worse in the near term the company could lose money – however with $200m in cash and the benefits of working capital release – not to mention the flex in their OPEX and the billion in unused revolver and credit facility – DNOW is well prepared to weather the storm.

You can model potential scenarios a million different ways, but none of them show a bad outcome for DNOW longer term.  Some of them will show massive upside.

A potential double or more in a negative environment is pretty nice if you have the stomach for the stock price volatility.  If things don’t get worse, that is just fine too.  The stock will benefit from increased utilization rates and higher multiples as the market recovers and likely outperform vs indexes etc.  The point is that the downside value of the business (not the stock price) is protected. If you can buy this and just put it in a drawer for 3 years or so, there is very little chance of losing money, and a good chance of making a lot of money.

Catalyst

M&A

cyclical oil recovery