Now Inc. (NYSE: DNOW) hit $11.85 today and I began to build a position. This document contains an independent analysis of the company. Information on my investment philosophy can be found here.
Disclaimer: The author is currently long DNOW. All of the views expressed in this document are solely those of the author and do not reflect the view of any other person or company. I am not receiving compensation for it. I have no business relationship with the company whose stock is mentioned in this document. All investments involve the risk of permanent capital loss. I encourage everyone to do their own due diligence and to reach their own conclusions. Under no circumstances should this document be considered an offer to buy or sell any securities mentioned within.
- DNOW is currently selling below asset value and we are basically getting a free option on any future earnings that may materialize if the oil and gas industry doesn’t completely disappear.
- The market is incorrectly trading DNOW as a proxy for oil prices. The viability of DNOW’s business model is largely dependent on oil volumes, which are more a function of demand than price.
- During the downturn, DNOW converted its working capital into cash and used that to fund acquisitions at depressed valuations. While competitors were deleveraging or going out of business, DNOW positioned itself to capture market share in the event of a rebound.
- DNOW’s low maintenance CapEx, strong balance sheet, and countercyclical cash flows should provide it with a buffer in the case that the rebound takes multiple years.
- Management has a long, successful track record. Merrill Miller, the executive chairman, helped grow National Oilwell Varco from a $500M to a $20B company before moving to DNOW in its spinoff. Miller currently takes home a $1 dollar salary and his entire economic interest in the company is tied to his $11M stock position. Similarly, all high-level management’s compensation is predominantly tied to the long-term performance of DNOW’s stock.
- DNOW’s growing scale as a distributor will provide it with a strong moat of low prices and wide-ranging inventory.
Long time readers of this blog will know that I like scour out of favor industries for ideas. As far as the markets are concerned, optimism and pessimism are two sides of the same coin — they both lead to extremes, which in turn leads to opportunity — but only the pessimistic side creates a margin of safety along the way.
Today, the energy equipment and services industry is soaking up all the pessimism in the market (down 25.48% YTD versus an up 10.06% S&P500). Since late 2014, the story surrounding energy has been the supply side. During 2011-2014, exploration and production companies realized that they could extract oil in the U.S. for about $50 per barrel and then turn around and sell it for about $100. They did what we would expect and borrow as much money as they could and started digging. Thus, the shale revolution flooded the market with oil and gas. Oil prices collapsed and high-cost producers (think offshore) began to fail. Suddenly, the market had too many rigs and the companies that supplied their parts and services weren’t looking too hot. New orders collapsed as parts from idled rigs were cannibalized. Even old orders collapsed as customers filed for bankruptcy. To get a sense of the magnitude, in the U.S. alone, Rig counts fell from a high of 1931 to a low of 404 over the course of two years. An 80% drop:
Things basically got really bad but does that mean there’s any opportunity here? As Howard Marks likes to say, “There’s little I’m certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever. Trees don’t grow to the sky. Few things go to zero. And there’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future.” Assuming that the demand for liquid fuels doesn’t completely disappear over the next few years (EIA sees demand growing steadily over the next decade); we can probably rule out the market going to zero. As far as rebounding, let’s look at how these cycles have played out in the past:
This downturn has been brutal and it is understandable why pessimism is so high. But the downturns of the past eventually recovered, and odds are this one will too. That could take a year, or a decade, but there is money to be made in the gap between short and long-term market prospects. That brings us back to DNOW which is uniquely positioned to gain from a market recovery.
NOW Inc. (NYSE: DNOW) was spun out of National Oilwell Varco, Inc. (NYSE: NOV) on May 30, 2014, with the goal of providing one-stop-shop products and services to the energy industry. With them came an executive team that had an average industry tenure of 27 years, including former NOV CEO Pete Miller. Miller had a reputation for navigating NOV through multiple industry downturns and emerging stronger from each. The management team was ready to reproduce those results at DNOW. The timing couldn’t have been worse.
In late 2014, the industry quickly deteriorated. Crude oil prices plummeted from about $100 per barrel to about $26. Rig counts were cut in half. DNOW had just doubled the size of its company through two large acquisitions, implemented a new global ERP system, spun itself off, and was now facing the worst downturn in industry history. Accordingly, their stock fell from about $30 in 2014 to about $12 today.
DNOW is fundamentally a distribution business. The company buys products from multiple manufacturers and then resells them to their customers for a small margin. Think Home Depot, but completely concentrated on supplying the oil and gas industry. The value proposition is simple, by aggregating demand on the national level, DNOW acts as an outsourced inventory management agent for manufacturers and as a purchasing and quality control agent for end users. Through increased scale, distributors are able to better provide one-stop-shop solutions for all maintenance, supply, and operational needs — reducing search and transaction costs.
DNOW’s distribution business is primarily levered to upstream rig completion but it also provides midstream pipelines and downstream refining services. Their customers include drilling contractors like Diamond Offshore, exploration and production customers like ConocoPhillips, Midstream customers like Kinder Morgan, and downstream customers like ExxonMobil.
During the downturn, DNOW expanded their product offering to include Process Solutions and Supply Chain Services. Process solutions provide rotating equipment solutions in the form of engineering, design, installation, and maintenance. Supply chain services provide on-site customizable products to upstream and downstream markets. The goal of all this was to promote high-value solutions that reinforce customer loyalty and diversify the customer base.
In 2016, the energy distribution segment accounted for 52% of sales, Supply Chain 36%, and Process Solutions 12%. Sales were geographically concentrated in the United States with 69%, International 19%, and Canada 12%. Speaking on the Second Quarter conference call, CEO Robert Workman noted, “In U.S. Supply Chain Services, we saw 22% growth with our upstream operator customers, mainly driven by the Marathon implementation, as well as general activity increases with Devon and Hess. Some of this growth is related to the early days of a recent long-term commercial win, which is a multi-year pipe, valves, and fittings, or PVF contract with Pembina Pipeline out of Canada. Pembina is proving to be an excellent partner as we progress through this implementation.” Recent long term contract wins should help DNOW ride out the remainder of the downturn.
All of this would not have been possible without an aggressive acquisition push. Management has been clear that it seeks acquisitions that: (1) expand exposure to the midstream and downstream segment of the market; (2) expand the number of physical branches internationally, and (3) expand the number of “product-line solutions” the company offers. Since the downturn began, DNOW has purchased 12 companies that fit these criteria and positioned itself to capture market share in the event of a rebound. That brings us to today.
Historically, the market that DNOW operates in has been highly fragmented, but due to the downturn, it is trending towards consolidation. Market share in the industry can be measured by revenue per operating rig (RPOR). Basically, how much of a rigs parts and services were purchased from DNOW and not a competitor. DNOW has increased its RPOR from $1.147M in 2014 to $1.322M in 2016. The eroding of prices and rig cannibalization during this period probably means that those gains largely came from market share growth. DNOW and its main competitor, MRC Global, now account for about 40% of the market.
But what good is market share in an unprofitable industry? For a distribution business, scale is the most important competitive advantage that a company can have. End users typically want to deal with a distributor who has a wide network of suppliers, stock keeping units, and most importantly low prices. As end users flock to a distributor’s low-cost one-stop-shop, the distributor is able to make larger volume purchases from its suppliers. This, in turn, leads to even lower prices. Fixed costs such as warehousing and delivery are spread across larger and denser networks. As both sides of the network grow, competitors are unable to match prices and during a downturn, when end users demand price concessions, the competitors go out of business. Margins expand and the cycle reinforces itself.
This is the world that DNOW finds itself in.
We will break our valuation up into four parts: asset value, earnings power value, growth value, and relative value. As we move through the value chain, numbers become less reliable.
Asset Valuation: $11.87
Some adjustments have been made to the balance sheet. Allowance for doubtful accounts was adjusted up to 10% as a buffer to further customer defaults. Inventories were adjusted up to reflect rising steel costs and the weakening dollar (over the past few years inventories were written down because of steel dumping). The depreciation rate was lowered to represent longer asset lives. Goodwill and intangibles were largely discounted and a new intangible asset was created to reflect management and customer relationships using industry excess EV/Sales. All in all, a competitor seeking to enter the market would need to spend about $1.3B to recreate DNOW’s business.
Earnings Power Valuation: $19.29
Cash flows for a distribution business tend to be countercyclical. In good times, cash is consumed as inventories are built up and the opposite in bad times. Looking at the last market cycle from 2011-2016, DNOW managed to produce an average free cash flow to the firm of $131M. This number is based on the last cycle, which includes the worse downturn in a generation but does not include the efforts the company has made to scale up their market position. It is possible that the upturn in the past cycle was too generous, so let’s further discount the cash flows to $122M. Obviously, assumptions start to get questionable here.
Growth Valuation: $36.50
And here’s where the assumptions get really questionable. Using the average cash return on invested capital over the past cycle (12%) and a 90% reinvestment rate (historically 100%), we get a growth rate of 10%. Apply this to our earnings assumptions from above and we get our growth valuation.
Relative Valuation: $21.10
This is just a sanity check to see how the market is valuing DNOW’s peer group. Since DNOW is currently operating at a net loss, we will use the industry median P/B value of 2.51 and median P/S value of 0.76. The result is a relative valuation that is a bit higher than our earnings power valuation.
Margin of Safety
It is fairly conservative to say that given an industry rebound DNOW will trade up to its earnings power value of $19.29. However, to add some margin of safety to the equation, we should only purchase shares below our estimated asset value of $11.87. Thus, we limit our downside to the asset base and create a free option on the earnings power of a larger and more efficient company emerging from the downturn. It seems like a good risk/reward tradeoff.
In my opinion, DNOW is a buy below $11.90 with a price target of $19.29 and a 3-year time horizon. This would represent a 17% annualized return.
(Update 11/20/2017: I doubled my position today at $9.80 and I’m comfortable adding more with the price well below a concervative estimate of replacement value. As far as the recent quarter, they are gaining market share and improving margins, but not at the pace I originally imagined. I thought the downturn would continue to provide an opportunity for acquisitions, but management has signaled an inability to find deals that clear their hurdle. I guess it’s nice that management is disciplined, but without larger consolidation in the industry, it may just be more of the same until the cycle turns.