Description

I am short NOW Inc. (NYSE: DNOW WI).  The stock is at $31.50 and I think it is worth $19, or maybe less.  I believe it is overvalued on the fundamentals, and a decent amount of stock will soon be subject to forced selling.  This idea is best suited for your P.A. given the small amount of stock available to short, but it is available cheaply at ~1% from Interactive Brokers.

This is the oilfield distribution business that was just spun out of National Oilwell Varco (NYSE: NOV).  Holders of NOV will receive 25 shares of DNOW for every 100 shares of NOV they own (1:4 ratio).  DNOW common stock will be distributed to NOV shareholders after the close tomorrow and start trading regular way on Monday.  Once that happens, index funds that own NOV will need to start selling the DNOW stock they receive.  By my math over 8% of NOV’s stock is owned by index products, and that includes over 6% owned by S&P 500 products.  DNOW will be ineligible for the S&P 500 as its $3.4 billion market cap is below the minimum threshold of $4.0 billion.

I originally looked at this as a potential long for some of the reasons typically associated with spinoffs.  In this case, an underappreciated business was being spun off in order to highlight its value on a standalone basis, a well-respected manager from the parent (former NOV CEO Pete Miller) was joining the spinco as executive chairman, the business would be free to pursue growth opportunities unavailable to it as part of the legacy organization, and finally you have the forced selling for non-economic reasons by shareholders of the former parent. 

Before this security started trading I hoped that those conditions would give me the opportunity to invest in a decent business at a cheap price on historical results, with a free call option on upside levers that management can pull to improve their results going forward.  What I found after it started trading was a stock whose share price was overvalued even if management executed the plan at a high level.

What happened?  First, it appears many other investors had the same idea I had.  More than one sell-side analyst told me that they were seeing an unusual amount of interest in the spinoff.  Meetings with large buyside firms where normally only the analysts would attend were now joined by their portfolio managers.  The low interest rate environment and elevated level of the stock market is probably contributing to the interest – there just aren’t that many opportunities competing for people’s attention right now.

Second, management has done a good job of marketing the company to investors who don’t normally focus on energy, and these investors appear willing to pay higher multiples than energy investors and may lack an appreciation of the cyclicality inherent in the oil patch.

Third, JP Morgan came out with a wildly optimistic initiation of coverage report last week that had a $39 price target by virtue of placing a premium EBITDA multiple on top of the cycle earnings.  It didn’t help (or hurt?) that the EPS estimates in the report were too high because of a hard coding error in their model that understated income tax expense.  The report sent the stock from $30.40 to $33 the next day.

The Business

NOW Inc. is the second largest distributor of equipment and consumables to the oil and gas industry.  The North American (NAM) procurement market is roughly $50 billion, of which approximately ½ goes through distributors and ½ is purchased direct, for a $25 billion market opportunity.  MRC Global (NYSE: MRC) is the biggest player with $4.0 billion of their $5.2 billion 2013 revenues coming from North America, for 16% NAM share.  MRC is a 2007 rollup that was sponsored by Goldman and taken public in 2012.

DNOW got $2.9 billion of their $4.3 billion 2013 revenues from NAM, for 12% market share.  Over $2 billion of the $4.3 billion came from two companies they bought in 2012 – C.E. Franklin and Wilson.

So, MRC and DNOW have ¼ of the market now, which is a big increase in a short period of time.  Before MRC was created in 2007 the two biggest players probably had a sub-10% combined market share.

Pricing power is a foreign concept in this industry.  The margin is in the buying not the selling.  More scale means these two guys can take costs out of the system in a way that mom and pops can’t.

DNOW doesn’t break out the portion of their business coming from upstream vs. midstream vs. downstream.  MRC does; they got 44%, 29%, and 27% of their revenue from those sources last year.  That’s probably a good starting point for understanding DNOW’s business mix, although DNOW is #1 in the upstream so they probably have more exposure than MRC to that area.

In terms of revenue breakdown by product, DNOW gets ¼ of its revenues from drilling and production equipment and consumables.  They get 20% from pipe, 20% from valves, 15% from fittings and flanges, and the balance from other stuff.  Crucially, they don’t sell well casing like MRC does, which eliminates some exposure to steel price volatility.

The leading indicators for upstream are of course oil and gas prices, but more specifically E&P capital budgets along with the Baker Hughes rig count and well count.  A good leading indicator for the midstream might be the number of miles of pipeline built.  The leading indicator for the downstream business is Nymex crack spreads.

DNOW has only published a few years of standalone financial data, but the distribution business used to account for 80-90% of the old NOV distribution & transmission segment’s revenues.  That data is available going back to the mid-1990s.  What the data tells us is that back in 2009 revenue fell 25% and EBITDA margins fell from 7.8% to 4.3% YoY.  Clearly this is a cyclical business, although it does have some secular tailwinds in the form of ongoing consolidation and the desire by customers to reduce the number of vendor relationships they have.

Normalized economics are 6-8% EBITDA margins, high single digit ROICs and 10%+ ROEs.  ROICs on net tangible operating assets are much higher, but the goodwill from acquisitions dilutes returns.  I do not adjust for acquisitions because they are a central element of the business plan, so they have to be taken into account when evaluating the economics.

DNOW generated a 5.6% EBITDA margin and a 7.9% ROIC in 2013.  Management is targeting a return to 8% EBITDA margins by 2015.  There are some levers they can pull to achieve that goal.  First, DNOW, Wilson and C.E. Franklin were on different ERP systems.  The ERP integration was just completed, so past results do not reflect the potential efficiency gains they should experience going forward.  Now the company doesn’t have to have overlapping AP staffs, AR staffs, inventory groups and warehouse staffs.  DNOW generated just $860,000 revenue per employee last year compared with $1.1 million a MRC, so clearly there is room for improvement. 

The company can also rationalize excess facilities space and improve their cash conversion cycle.  I estimate that by bringing their payables cycle in line with peers they can improve their ROIC by 50-100 bps. 

Offsetting these levers is the company’s expectation for $45 million of incremental costs as a standalone public company (27 cents/sh).  Capitalized at 13x means $3.50/sh of value leakage. 

Management will be on the prowl for M&A.  They think they can buy mom and pops for low to mid single digit multiples of EBITDA.  They intend to pay cash unless something really big comes along.

Employees will be compensated on hitting EBITDA margin targets.

3% of DNOW’s sales are to NOV, and NOV also sells OEM spare parts through DNOW.  They executed two master service agreements – one where NOV is the customer and one where DNOW is the customer – that lay out pricing terms and tenor.  The agreements don’t have an expiration date, but the first opportunity to change anything is after 2 years.

The Bull Case

JP Morgan laid out the bull case in their initiation of coverage report on May 21.  DNOW generated $4.3 billion of revenue and $240 million of EBITDA in 2013.  A combination of factors like increased efficiencies and organic growth will drive revenue to $4.9 billion (4.5% CAGR) and EBITDA to $416 million (8.5% margin) by 2016.  M&A would represent incremental upside.   They will be free to pursue M&A without having to compete for funding with NOV’s other segments.  NOV’s total shareholder return was 374% during Pete Miller’s tenure, compared with 155% for the OSX and 90% for the S&P 500.  He’s going to work his magic at DNOW.

The analyst says a 12x multiple on his 2015 EBITDA estimate of $335 million would result in a $39 share price.  (That’s actually wrong.  A 12x multiple would mean an EV of $4.0 billion.  Add his estimate of $333 million of net cash at YE2014 and you have a market cap of $4.4 billion.  On 107 million shares that’s $40.70 per share.)

There was another error in the report.  They accidentally hard coded income tax expense at a fixed level of $75 million over the entire forecast horizon.  This led to an EPS forecast that was vastly overstated.  They issued a corrected report later that day, but the stock had already made its move. 

Variant Perception

At $31.50, the stock is already priced at 16.4x and 13.1x JPM’s corrected EPS estimates of $1.92 and $2.41 for 2015 and 2016.  Since MRC went public it has traded at an average of just 13.0x NTM earnings, and it is currently priced at 13.7x and 12.0x 2015 and 2016 earnings.  DNOW is a good company, but is it worth 2.7x and 1.1x more?  Over the last 7 years, MRC’s average EBITDA margin of 7.5% was better than NOV’s D&T segment margin of 5.9%, and MRC’s average operating margin of 6.0% was better than NOV’s D&T segment margin of 5.0%.

I want to highlight again the fact that DNOW is a cyclical business and the stock is priced at an elevated multiple on earnings that are probably much closer to the peak than the trough.    

In addition to being currently priced at multiples that are out of line relative to its main comp, these multiples probably aren’t mathematically justified on an absolute basis. Book value per share was $16.80 at YE2013.  At $31.50 the stock is priced at 1.9x book value.  JPM’s corrected 2014 EPS estimate of $1.59 implies an ROE of 12%.  Using JPM’s forecasted growth rate of 4.5%, DNOW’s implied cost of equity is 8.5%, or just 600 bps over the 10 year Treasury. 

Moreover, I think there is an unappreciated risk that commodity prices, and therefore E&P capex levels, will experience a slowdown before DNOW can get back to an 8% EBITDA margin.  Simmons estimates that U.S. oil production averaged 7.5 mmboe/d in 2013, rising to 8.6 mmboe/d in 2014 and 9.7 mmboe/d in 2015.  As you may know, almost all oil exports are prohibited under federal law (although refined product exports are allowed).  It seems almost inevitable that this aggressive production growth will have an impact on prices.  WTI is currently at $103/bbl.  Simmons estimates $90 as the threshold below which E&P capex budgets start to get curbed. 

My High Case model grows DNOW’s 2013 baseline revenue of $4.3 billion by 6% in line with NAM E&P capex growth this year, putting 2014 revenue at $4.6 billion.  For perspective, DNOW’s pro forma revenue grew 8.3% in 2012 and fell 6.9% in 2013. 

I assume a 7.2% EBITDA margin (top quartile margin for NOV’s D&T segment over the last 10 years, just to give them a huge benefit of the doubt for 2014) for EBITDA of $327 million.  Take out D&A of $18 million and that gets you to pre-tax income of $309 million.  There is no debt, so no interest expense, i.e. EBIT = EBT.  Apply a 34% tax rate and you’re at net income of $204 million.  Divide by 107 million shares out to get 2014 EPS of $1.90.  Put a compressed multiple of 10x on that since they’re peak earnings and you get a stock price of $19.

If I used a 6% EBITDA margin instead they would earn $1.57.  Put 10x on that and the stock would be at $15.70.

Catalyst