NOW Inc (DNOW) is a distributor of equipment and services for the oil & gas industry. They have a network of energy centres spread around the World, and also work on their clients site to handle all supply chain logistics.
Since its IPO in H1 2014 its business has shrunk. Its inventory has declined, as has its receivables. As a distribution business this means, quite simply, there has been less volume of business. Revenues peaked in 2013 at $4.2 billion. Trailing 12 months revenue is $2.3 billion. However, net property, plant and equipment has stayed steady at just over $100 million, hence DNOW has the capacity to take on considerable more volume of business than is currently being executed.
As a result of the difficult environment of the traditional energy industry, value has been destroyed within the company, visible via the book value per share decreasing from $18.43 in 2014, to $6.83 in its latest quarterly results (Q2 2020).
In the energy industry global spending by exploration and production firms is likely to hit a 13-year low in 2020, analysis from Rystad Energy shows capital expenditure in the industry is likely to fall by $100bn this year to around $450bn – a 17% decline from 2019 levels. However, capital outlay could reach as low as $380 billion for the year, and $300 billion in 2021 depending how low oil prices go. A more recent study shows how these figures keep falling, with 2020 estimates now at $328 billion.
As the above suggests, the issue is one for the entire industry, not company specific. Competitor MRC Global (MRC) has also had a similar price performance but Now INC, but with even more volatility. I suspect primarily because it is more financially leveraged.
The Investment Opportunity
Now Inc is now a net net investment. This means the stock trades for less than its tangible assets minus all liabilities. Benjamin Graham famously said a business trading at such a valuation is worth more dead than alive (i.e. liquidating the business will give the shareholders more cash in hand than the current market cap). When a stock trades at such a valuation, less assumptions need to be made about the earning power of the business, hence reducing the risk of making a mistake via your earning assumptions. As a result in this article we shall not spend ample time studying the income statement. The focus is on the balance sheet.
The main numbers are as follows using Q2 2020 results:
- Working Capital (WC) $618 million
- Net Property Plant & Equipment (PPE)$109 million
- Non Current Liabilities $44 million
- So WC + Net PPE – non current liabilities = $687 million
At $4.88, the market cap is just over $500 million. Hence the companies equity trades for considerably less than net tangible assets.
Looking at the facts, and making some basic assumptions
Your author has no crystal ball of how the traditional energy sector will evolve. What we do know the following facts:
- All intangible assets have been written off NOW Inc’s balance sheet. Hence only tangible assets are left.
- The current stock price of $4.88 is trading at 0.71x book value, a book value made up only of tangible assets.
- The company continues to be free cash flow positive, a characteristics of distributors during difficult times as they reduce inventory, which releases cash.
- The business has a net cash position.
- The business has a large positive working capital. In essence, the company has been built to survive armageddon.
Your author is willing to make the following assumptions:
- We do not know how big the traditional fossil fuel energy sector will be in 5 years time, but we doubt the energy provided by fossil fuels will drop by 30% in 5 years time. We think this due to the lack of predictable, scalable alternatives supported by the consensus. Hence, investment will have to be made to ensure new oil & gas supply helps offset the supply that has been used during the last few years. This requires investment, hence requires NOW to provide services to make that supply up and running
- DNOW in a normalised environment generates a net income margin around 2 to 3% historically.
- In an environment with 10 year US Treasury Bond yields under 3%, a 2 to 3% net income margin merits a multiple on sales of 0.3-0.4x.
- Considering NOW’s current depressed revenue of $2.3 billion, this suggests a fair value market cap of around 800 million. At $4.88, DNOW trades just above $500 million, hence at a large discount to potential normalised margins on current depressed sales. We can see the current valuation requires very conservative earning estimates compared to its historic earnings,
- Any improvement in the energt industry, and NOW will change from being valued at a discount to current net tangible assets, to being valued on its potential earning power. This would led to a large re rating of the price of NOW Inc stock, which seems excessively cheap at the moment
Again, we don’t know how the traditional energy market will evolve in future years, but considering the current price, we don’t have to assume much. The stock price assumes:
- Revenues will continue to decline by double digits in the foreseeable future
- Yet the price is fully backed by tangible assets
- The business is managed by a competent team that holds no debt on their balance sheet
If your investment portfolio holds a number of investment ideas bought under the above criteria, you are likely to generate a net result that is satisfactory.
Disclosure: I am/we are long DNOW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.