DNOW - DistributionNow

[farbelow]

Judging by Peter Miller's history at National-Oilwell Varco, share buybacks are highly unlikely. He did do well on acquisitions.

[Txvestor]

Judging by Peter Miller's history at National-Oilwell Varco, share buybacks are highly unlikely. He did do well on acquisitions.

 

Agree, but whoever he is, or what his past was, if he is not judging every single acquisition against the opportunity cost of a share buyback, he is not serving shareholders well. shareholders are not interested in empire building. That said, the downturn is so deep that the acquisition opportunities are likely to be very good indeed.

They have not disclosed too much about the valuations paid on the acquisitions to date.

[MrB]

http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9NjAwMDk4fENoaWxkSUQ9MzExMjAwfFR5cGU9MQ==&t=1

 

The case study on the left on page 17 is interesting. Aerospace. Who would have thought.

[spartansaver]

I would much rather the company make acquisitions than repurchase shares at this time. Long-term, the company creates much more value in this downturn by adding to their distribution network than by repurchasing shares. That is the main competitive advantage of a distributor; scale. While I feel the company is cheap, they are most likely paying less for small private companies who don't have as pristine of balance sheets.

[farbelow]

I would much rather the company make acquisitions than repurchase shares at this time. Long-term, the company creates much more value in this downturn by adding to their distribution network than by repurchasing shares. That is the main competitive advantage of a distributor; scale. While I feel the company is cheap, they are most likely paying less for small private companies who don't have as pristine of balance sheets.

 

+1

[gym97]

Why do you guys prefer DNOW to MRC?

 

MRC has a much cheaper valuation, is more sound operationally, is more focused on MRO, the midstream and downstream and has a management team that already achieves higher EBITDA margins of ~7% despite having an old ERP system. MRC is more levered but given their recent preferred share offering and some of the working capital run-off, leverage is comfortable and forces management to be disciplined.

 

We are assigning a premium to DNOW because DNOW has the potential to become an MRC. Why not just buy MRC for a cheaper valuation?

 

I should point out that Pete Miller is the Chairman but that the CFO and CEO of DNOW seem to have far less experience doing roll-ups whereas MRC's CEO is more proven. I'd also point out that DNOW has some tough legacy issues, i.e. its relationship with NOV makes it less attractive to other suppliers.

 

The other thing that bothers me is that after DNOW acquired Wilson, they de-emphasized Returns on Capital and emphasized Margins. They criticized Wilson for being too returns focused historically. Wouldn't you rather have lower margins but higher returns on capital?

 

 

[spartansaver]

I would still consider that preferred as leverage. It still comes before you as an equity holder.

 

I prefer their position, can't beat that beautiful balance sheet and the oil universe is their oyster.

 

Both businesses seem like a reasonably good bet and I have a a very hard time seeing DNOW become permanently impaired down the road.

[Sionnach]

Why do you guys prefer DNOW to MRC?

 

MRC has a much cheaper valuation, is more sound operationally, is more focused on MRO, the midstream and downstream and has a management team that already achieves higher EBITDA margins of ~7% despite having an old ERP system. MRC is more levered but given their recent preferred share offering and some of the working capital run-off, leverage is comfortable and forces management to be disciplined.

 

We are assigning a premium to DNOW because DNOW has the potential to become an MRC. Why not just buy MRC for a cheaper valuation?

 

I should point out that Pete Miller is the Chairman but that the CFO and CEO of DNOW seem to have far less experience doing roll-ups whereas MRC's CEO is more proven. I'd also point out that DNOW has some tough legacy issues, i.e. its relationship with NOV makes it less attractive to other suppliers.

 

The other thing that bothers me is that after DNOW acquired Wilson, they de-emphasized Returns on Capital and emphasized Margins. They criticized Wilson for being too returns focused historically. Wouldn't you rather have lower margins but higher returns on capital?

 

I think this is a very important question. MRC is the market share leader with lower upstream exposure and higher MRO. So it's important to understand why DNOW over MRC.

 

I would argue the valuations are relatively similar - EV/Next year sales is ~.55 for both. Assuming the same ebitda margin (lets say 6%) and capex (lets say .6% of sales). They are both selling for about 10x EV/Ebitda-capex. This assumes DNOW makes more acquisitions than MRC over the next year (reasonable assumption).

 

The three main benefits of DNOW are: 1. greater future capital deployment opportunities (B/S) and 2. they've already built out their ERP system whereas MRC is just starting and 3. operational improvement post-spin

 

The downside is that MRC has more scale and DNOW is catching up. I think the clean B/S outweighs being #2, especially w/ opportunities during a downturn

 

[gym97]

Thanks for the responses. I think the capital deployment opportunities are worth paying for IF you believe that they can create shareholder value but there is a real risk that that they overpay, after all, they are looking for bigger deals and are not necessarily targeting distressed assets.

 

My main issues with both MRC and DNOW:

 

1) They have historically earned sub-10% ROE so in my mind, they should be worth approx. book value and they currently are not trading substantially below that.

 

2) Their customers already procure a lot of inventory directly from the manufacturer. This threat will grow, not shrink, in my opinion and I suspect that manufacturer's will try and become one-stop shops making the distribution function less useful.

 

3) Their gross margins - I am uncomfortable with how much gross margins can move around. Commodity prices (steel) and capacity issues significantly affect gross margins which tells me that they are not really offering a true value-added services.

 

4) Book value can get impaired if people start discounting heavily, if there is excess capacity or if commodity prices like steel fall.

 

All in, I think you can draw up some scenarios where you lose money and that they are not that far fetched. The upside is less clear as I'm not convinced that these are good businesses.

 

Would appreciate any further thoughts.

[AzCactus]

I won't be able to touch on all your points.  However, one thing worth mentioning in terms of acquisitions at a reasonable price is that during the time that Merrill Miller ran NOV they trounced the S&P 500 by a huge margin.  From the information I have read this management team seems responsible and has a long term focus. 

[Sionnach]

You raise very good points. I think risk of overpaying in the current environment is unlikely, but it's always a possibility with M&A. There is an element of trust in management here. I think one of the main theses on DNOW is the changes in the supply chain business. They detail this in their slideshow.

 

From what I understand they are serving their customers at their place of business rather than their customers coming to their branches. They are becoming much more of an integrated service-provider than a retailer in order to manage their customers costs more effectively and add value to their customers.

 

Lastly, I think counter-cyclical cash flows, market share gains, and acquisition opportunities during any sort of further oil downturn (or potentially steel) is where the downside protection comes from.

 

I think the firm has strong staying power - the biggest resistance to competition via manufacturers is the value-added servicing through supply chain management and just-in-time delivery. Manufacturers simply do not have the distribution network to do this on their own.

[RadMan24]

I think the revenues have declined by a third on a YoY basis, and perhaps 2-3% on 2nd to 3rd Q sequential basis.

261m of FCF year to date probably from reduction of working capital and general shrinkage of the business which they can now put towards favorable acquisitions in this environment is about the only positive I see, that as well as their vague promise to address their cost structure.

They sure have a lot of spare capacity on their balance sheet and as low as their stock price has fallen, it would be nice to see them put in a 100M or so share buyback as well, to give shareholders some solace while awaiting the firming of the market.

 

Disagree, acquisitions would be a much stronger use of capital, and if they pay off, it will result in a higher share price likely when the cycle reverses in a few years. Then, if needed, they can issue shares to use as currency or clean up balance sheet to prepare for next down turn with ample cash to deploy again and repeat. That way, 10 years or so from now you have a much broader, scalable company, with a strong market share generating significant value to the ecosystem as well as being supplemented with strong cash flows. Once the market awards that presence, I'd sell. But if something breaks that general theory, I'll wait and seen what happens till then. Not opposed to them, but buying back shares in case could deprive the company of a lucrative acquisition.

[rkluwer]

Thanks for the responses. I think the capital deployment opportunities are worth paying for IF you believe that they can create shareholder value but there is a real risk that that they overpay, after all, they are looking for bigger deals and are not necessarily targeting distressed assets.

 

My main issues with both MRC and DNOW:

 

1) They have historically earned sub-10% ROE so in my mind, they should be worth approx. book value and they currently are not trading substantially below that.

 

2) Their customers already procure a lot of inventory directly from the manufacturer. This threat will grow, not shrink, in my opinion and I suspect that manufacturer's will try and become one-stop shops making the distribution function less useful.

 

3) Their gross margins - I am uncomfortable with how much gross margins can move around. Commodity prices (steel) and capacity issues significantly affect gross margins which tells me that they are not really offering a true value-added services.

 

4) Book value can get impaired if people start discounting heavily, if there is excess capacity or if commodity prices like steel fall.

 

All in, I think you can draw up some scenarios where you lose money and that they are not that far fetched. The upside is less clear as I'm not convinced that these are good businesses.

 

Would appreciate any further thoughts.

 

Point 2) - I think u are totally wrong, as retailers and big producers/clients of distribution Networks, get closer connection to Companies like DNOW, as the make them "a part" of the firm, as the help integrate fater and leaner accecs to there products and reduce there own storage and cost controlling this. DNOW has a big distribution netwrok, and are able of providing the Companies with a much better and higher service and cost reduction, then the Companies can do for them self, so i think u will see the totally uppeset of what u say. Companies will focus on what the do best - there product, and let others optimize there storage and distribution channels, also why - when DNOW becomes a part of a firm, the seldomly Loose this client Again, as the over time becomes an Integrated part of them..... this i value for DNOW and there clients.

[gym97]

Thanks for all the useful feedback.

[MrB]

http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9NjAwMDk4fENoaWxkSUQ9MzExMjAwfFR5cGU9MQ==&t=1

 

The case study on the left on page 17 is interesting. Aerospace. Who would have thought.

 

Probably Triumph Aerospace mentioned in the call.

Decent size; almost $4Bn in revenues.

http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9NTg0MDIwfENoaWxkSUQ9MjkxMzA0fFR5cGU9MQ==&t=1

[MrB]

NOW Inc. Completes Challenger Industries Acquisition

http://www.businesswire.com/news/home/20151105005112/en/

[AzCactus]

Wasn't it Mark Twain or Joseph Wittreich who said that history doesn't repeat itself but it does rhyme.  A lot of the negative attention on DNOW seems to be regarding their ability to pay a fair price for and effectively integrate acquisitions.  Well if Pete Miller and his team "rhyme" their performance at DNOW with NOV I think that as shareholders we will see a satisfactory return. 

[gym97]

I think acquisitions are a big issue. The bigger issue is simply that this business has historically earned very poor returns on capital however way you measure it, i.e. ROE, ROIC, etc. Can this business, in the future, earn higher returns on capital via consolidation, better margins, less working capital, etc.

 

Well here are the changes that will happen in the future which may help improve returns:

1) Consolidation via acquisitions

2) Better ERP systems

3) More Supply Chain Branches

4) General pickup in commodity prices

 

I am doubtful that this will ever be a 15% ROE business and think that something like 10% to 12% is the most this business will ever do through an entire cycle which would imply that this business is worth roughly book value which is where it is trading today. I have no doubt that EBITDA will grow over the next few years but it will take a substantial amount of capital to do that.

 

 

[KCLarkin]

Gym, let's assume that ROE is 11% over the cycle. Why do you think that is only worth book? Distributors are very defensive business with low cost of capital. Why do you think there should be a 9% 'spread' over treasuries for such a safe, though cyclical, business?

 

 

[MrB]

Dshachory - Granted they did hit the cycle at exactly the right time going in and out. However, if you look at a) how effectively Miller & team rolled up and b) how they influenced customer behaviour (of NOV) then it leads to interesting SPECULATION on what they can do at DNOW.

 

gym97 - Somewhat related to the above and your comments is the observation that there are higher margins/ROE to be had in the "distribution" industry. Look at FAST. The question to ask is why the difference? One way of pushing margins higher is to become more of an industrial distributor than a pure oil/gas play and to be more of a supply chain manager than just a distributor, hence my earlier observation of the aerospace client and conference call comments that they are looking to push more into the industrial space. Also if you look at their Q and the calls then you will note supply chain is now something like 24% of revenue rather than the 18% mentioned in all the presentations. The 18% is not incorrect, they just keep on mentioning the 2014 year end number. Finally they also are increasing value/sales per rig.

 

Anyway in MY OPINION (you can stop reading now) the above is credible observations considering the team's history, unless we eventually find out they were just looking smart due to the cycle. However, at today's price you are paying for it. If they just put together another oil & gas distribution company then you will probably compound at around 10%. However, if the above plays out you will start compounding at mid to high teens. I've started buying in the low 20's and will keep on going as the price drops and will only hit full position in the low teens. I think at that price the above does not have to play out for you to compound in the mid to high teens. People like Mecham seems to disagree and he is smarter than me.

[AzCactus]

Dshachory - Granted they did hit the cycle at exactly the right time going in and out. However, if you look at a) how effectively Miller & team rolled up and b) how they influenced customer behaviour (of NOV) then it leads to interesting SPECULATION on what they can do at DNOW.

 

If I'm not mistaken they also outperformed their peer group as well.  And all those companies benefited/dealt with the same cycle that they did. 

[gym97]

Good comments. I am still intrigued by DNOW but it strikes me as neither cheap nor a particularly great business but my views are not strong at this point.

 

In terms of the 10% ROE, I think it is fair in absolute terms. Interest rates move around and this is a cyclical business (unlike some other MRO distributors which are less cyclical) so I think 10% is fair but feel free to disagree. Anything less than 8% just seems too low intuitively.

 

 

[MrB]

Dshachory - Granted they did hit the cycle at exactly the right time going in and out. However, if you look at a) how effectively Miller & team rolled up and b) how they influenced customer behaviour (of NOV) then it leads to interesting SPECULATION on what they can do at DNOW.

If I'm not mistaken they also outperformed their peer group as well.  And all those companies benefited/dealt with the same cycle that they did.

 

 

+1

[RadMan24]

Good comments. I am still intrigued by DNOW but it strikes me as neither cheap nor a particularly great business but my views are not strong at this point.

 

In terms of the 10% ROE, I think it is fair in absolute terms. Interest rates move around and this is a cyclical business (unlike some other MRO distributors which are less cyclical) so I think 10% is fair but feel free to disagree. Anything less than 8% just seems too low intuitively.

 

Let's not overly focus on one metric. One that doesn't even remotely describe the overall long term success of the business and management's strategy. Which they have followed through on, buying assets that are stressed, rather than fully priced. Room to improve, upside reward for shareholders. They have kept the balance sheet clean and ample for growth. Track Record at NOV has been documented. But in the 2nd inning, I don't really care about ROE. Maybe if it was the 8th or 9th.

[AzCactus]

Anyone know what's behind today's drop?