DNOW Inc. (DNOW) Earnings Call Transcript

Hi, I'm Sean Meakim, the Oilfield Services and Equipment Analyst for JPMorgan. Thanks for joining us for our fifth annual JPMorgan Energy Conference. Up next, we're pleased to spend some time with DistributionNOW, otherwise known to investors as DNOW. And we have DNOW's newly appointed Chief Executive Officer, Dave Cherechinsky, back at the energy conference. Dave, I'm probably one of the first to introduce you as such, so congrats on the title change.

Thank you, Sean. I appreciate that.

So just by way of introduction, DNOW is one of the largest energy distributors with a countercyclical cash flow profile and net cash balance sheet, two characteristics help one environment that the one we're currently in. Dave has spent his entire career at National Oilwell and DNOW since the spin-out of the company in 2013. And after serving as CFO in the last few years, as I just mentioned, the Board just announced Dave will serve as its newest CEO. So Dave, again, I guess, congrats on the appointment, great to have you back at the conference. So I'll open it up to you for just a couple of minutes of opening remarks, and then we'll do some chatting fireside.

Okay. Thank you, Sean. Yes, very glad to be here. Wish we were there in person. I want to start off with, like you alluded to, so we start -- or we're really 6 quarters into a downturn, which really -- again, precipitous decline late in the first quarter. We -- so we've been planning along the lines of the market shrinking over 6 quarters to improve our balance sheet. So we've worked aggressively. We made a few acquisitions, but we focused on beginning a cost transformation and paying off our debt and improving our cash position for -- until the market would come back, and it did not, of course, with COVID and demand destruction, et cetera. So we want to build on our balance sheet position, enable acquisitions in this downturn. But like we've talked most recently, Sean, we're focused on a cost transformation, which is really something we should have been more focused on in the past. We've been strong in terms of gaining market share over the last few years. We've been able to maintain pricing in a very difficult environment. And we've been -- we have a solid balance sheet. But today, we're focused on -- and it's obviously more urgent side of the business, making us much more agile, depending on what -- depending on the market dynamics. So my focus recently has been focusing on -- moving away from pure balance sheet management, cost transformation by focusing on growing the business. And we're kind of focused on that in 2 ways. The upstream space, DistributionNOW has historically been far away #1 in that space. We want to build on that. Even though the market's struggling, we want to build our position in upstream. As we've said on our most recent earnings call, we've got 1,400, 1,500 people. We're doing more cost cuts as we speak. So we're keeping our top salespeople and our best operations folks to focus on making inroads in the downstream and midstream space. So that's a big part of our focus right now, is building on our position in upstream and then venturing out into really the second fiddle kind of end markets that we focus less on over the years, and that's downstream and upstream in terms of DigitalNOW. So we're focused on -- as we close branches, lay off people, reduce our workforce, our ability to touch customers and to be close to customers locally is hobbled in that process. So we're introducing distribution centers, redistribution centers, building on those, pulling the inventory out of our locations and reducing our personnel, like we've talked about, to enable close touch points to customers but a lot less cost required to manage the business as we grow and as we contract. So that's been a focus. That will continue to be a focus during the downturn. In the second quarter, rig counts will probably be down 50% sequentially, same with completions. So that puts a lot of pressure on pulling the cost out but being able to seize the opportunity when it comes. Finally, M&A, that's always been a big focus for us, especially in the downturns. We tend to make our acquisitions in the markets slump like this. In this downturn, we're being a lot more selective because we don't know when am I going to hit bottom and what kind of recovery contours we'll see in the future, so in terms of DigitalNOW. So that's a big part of our ability, like I said, to touch customers, make it easier for them to do business with us. So some of that's internally focused, where we're introducing technology to make using SAP a more difficult tool to use, much easier for our employees, significantly reducing the amount of computer activity related to customer fulfillment, which will enable further cost reductions by that technology. We're introducing a tank battery ordering for customers. So they can order complete tank batteries online. Most of it, so far, is specific to customers. We want to be able to scale back to more customers, make it easier for them to do business with us, less costly for us to do business with them and to enable the kind of agility and scalability I talked about earlier. So that's kind of an opener on what we're focused on and would love to take any questions you have.

Sure. So thanks, Dave. That's a really good overview. So withal those vision and a bit more granularity, I guess so just to open, we've been asking everyone, just given the obvious, what everyone's been facing globally in the last few months. How have you been handling COVID-related issues as it pertains to your supply chain? As it relates internally with your own people, on the customer? And we obviously know the macro factors that are impacting the business, but how about those other factors, maybe a little bit harder for investors to see, and for where things stand now as we're mid-June versus when you reported first quarter earnings.

Okay. In terms of managing the supply chain, so in a market like this, what I said earlier, rig counts and completions are down 50%. Access to product hasn't been a big issue. We're really in a liquidation mode in terms of inventory. So product availability has been strong. Lead times with suppliers is very low, and so it's easy to get product. In the area of COVID-related products, hand sanitizer, gloves, masks, et cetera, that's been a little more challenging, although we've done some innovative things to get products to our customers where we can. But that's been one area where it's been difficult to get the product. But really, the primary products we sell, pipe, valves, fittings, pumps, et cetera, that's been -- we've had ample supply. And our competitors, our manufacturers have that as well. So internally, mid-March, we sent our corporate staff home. So it was probably, I think, March 14 or March 17, our entire workforce from the corporate perspective were sent home. Most of our branch personnel, all of our locations that remained open are still operational. But we've tried to keep as many people as we can working from home. And we -- and during the first 10 weeks of COVID, we've had very few incidents, and more recently, since states like Texas have opened up. But still, we've been very lucky that we've not had to close any facilities or customer-facing facilities down in the process.

That's really helpful. So then just to kind of tie out the very near term, you highlighted what we've seen in terms of overall rig activity, completions activity. Investors have now gotten a good sense of that in the last couple of months. Just how would you say your business has performed relative to expectations, maybe if you think back to when you were coming out of the one -- first quarter conference call?

Yes, that's a good question. So normally, in a downturn -- in the early parts of the downturn, our revenues hold a little stronger than the decline in revenues -- our rigs. So counts decline, our revenues in the past would decline at a lesser rate. And then when rig counts or completions came back, our revenues have recovered at a slower rate. In this downturn, it's been a lot more dramatic in terms of the revenue decline. So we talked on our earnings call about our April revenues being down about 1/3 from the first quarter revenue of monthly average, which is a little more -- a little deeper than the rig count decline. So we're tracking pretty close to rig counts and completions. It's a pretty dramatic reflection of what's happening in the market. I think COVID's played a big part of that. It's hard to discern what's COVID -- how much is customer budget, how much is demand destruction. But we're feeling it. We feel it pretty directly as it relates to those key barometers, rig counts and completion.

That's really helpful. And then so just thinking about the rest of the picture from a top line perspective, interesting that you guys have been showing more emphasis around the mid and downstream. It's an area where your largest competitors has built free sizable moat into those businesses and has that real scale. Can you just talk about how the competitive dynamics and those streams differ from what you see in upstream, which I would perceive, generally speaking, have lower barriers? Of course, you guys have some other avenues that are differentiated, but thinking about upstream versus mid and down. And we also see some changing dynamics in terms of competitors went out of business the last couple of years, particularly in downstream. It is great to get a little bit more of your perspective on how -- strategically how you're going to go about taking market share in that business and who's expanding at that and what are the means to do so?

Okay. I'll start with downstream. So downstream has been -- we're probably -- 2/3 of our revenues are upstream-focused, and that's been the case for some time. And then midstream is probably the second large end market, and then downstream is one of the smallest. So over the years, our downstream business has been largely focused on mill tool safety products, low value, high transaction, low operating margin kind of point for that business. So the last few years, that's been an area where we've been making cost cuts, branch closures because that kind of mill tool safety product line has been profitable for us. So part of that's going to be we're still going to focus on those tools safety. We're going to move a lot of that from branch-sourced or branch-fulfilled kind of activity to more of a DC-fulfilled model, where we could still do that business but a lot more cheaply -- handle large transactions more cheaply than running them through our branches. So that's part of that strategy. In the downstream, we want to also shift that focus from primarily mill tool safety to also pipe valves and fittings. Now we buy plenty of pipe valves and fittings. We use the same manufacturers to supply to the downstream. That's just a part of the business we want to grow. So like I said earlier, we're laying off some really solid salespeople. We're keeping the best, and we're going to shift their focus from primarily upstream to downstream. So that's how we grow there. Most of our recent acquisitions have been midstream-oriented, primarily in the process solutions arena. The companies we're looking at today are, again, process solutions, kind of differentiated model opportunities, who are primarily midstream-focused. So we'll bolster our midstream position through acquisition, and again, through directing our best people who are surviving the upstream decline and haven't shift their focus to the midstream.

Got it. I think that's really helpful. And then as we sort of work our way down the income statement, gross margin has been a point of relative resiliency. Again, there's always a quarter-to-quarter mix shifts that can take place. But just can you talk about your confidence level in terms of being able to sustain within a band gross margins here, even through a difficult activity environment?

Yes. So gross margins, there are 2 main components to gross margins. One is product margins, which is simply the difference between what we pay for the goods and what we sell the goods for. We've been pricing very resilient on that part of gross margin. So in fact, we talked on our first quarter call that our first quarter to first quarter product margins improved, and they improved from the fourth quarter to the first quarter. Part of that's mix. We're selling a lot less pipe, and pipe margins are down. So that's helping from a mix perspective. But like we've also been talking, we've been focused on high grading, higher-margin customers, higher-margin orders, higher-margin businesses and locations. So that's been part of that, too, although we are getting a little more scrappy from a price perspective to buttress revenues with lower margin activity. So we are entertaining some of that today. So that's product margins, pretty resilient. Now in an environment where your revenues are declining, we kind of glimpsed that earlier in the conversation about how's all the decline in rigs and completions happened. That puts a lot of pressure on revenue. And we talked about on our last call about we're in a period now where we'll see elevated levels of inventory charges as more products become idle or the replacement cost drop, et cetera. We'll make inventory adjustment charges, which will negatively impact gross margin. So that revenue, the denominator is shrinking. And we'll be at a higher elevated levels of inventory charges despite relative product margin success and resiliency, and we'll see some negative impacts to gross margin. Now how much that will be, it's hard to tell. We've talked about the possible range. In 2016, our gross margins dropped to 16.4%. We don't see that happening, part of that's due to high grading like we talked about. Today, our inventory levels are much lower going into the steep part of the downturn than they were going into 2015 to 2016. So it would be downward pressure on gross margins. That will largely be driven by inventory charges and a lower, smaller denominator in terms of revenues. What that low point is, I'm not sure, but it will decline.

Right. That's very fair. So now getting to WS&A. Key focus in the near term. You're not -- spent the years talking about this opportunity set. It looks like management is really going to attack the cost structure in a way it's going to potentially really change through-cycle margins. So just curious to hear about how that's progressing, given as an opening at the outset, but just how do we think about exit rates and run rate basis where you want to end up from a cost perspective, and then how that positions you when we do see upturn in activity at some point in the future.

Okay. So we -- like we had said in the past, we initially started 2020 same. We're going to pull $40 million in WS&A out of business. Then recent call said, it's going to be $100 million reduction. And we said the exit rate, the 4Q '20 versus 4Q '19 kind of annualized difference will be $140 million in savings. Well, naturally, because the market has shrunk as much as it has, we'll have to take more costs out there. So we're talking structural changes, which we'll elaborate on in our next call. We're talking about DigitalNOW and centralization as a means to significantly be able to pull more cost out despite what happens to the market over time. So I don't have a new estimate for what that number will be. It will be a more -- it will be a bigger reduction than $140 million fourth quarter run rate, and it has to be given how the market's shrinking and our revenues are declining.

Okay. Makes a lot of sense. Anything else that you would elaborate on in terms of how you're getting there? So part of why I'm asking, you mentioned in terms of moving towards a centralized and maybe distribution model for downstream, let's say, around mill tools and safety. Anything else around that in terms that you can elaborate, in terms of operational changes that are helping to drive the cost down?

Yes. So if you think about it, now some of this is variable cost and some of the large reductions we made are variable, but they're pulling our current structure. As we -- so today, we had 210 branches early May, and that number is declining. I don't know what that's going to be by August, but we're closing branches. But we're also -- we're still in 200 locations. So our traditional model, and these are averages, would be a local branch would have $300,000 to $1 million in inventory. We'd have 10 employees and 6 trucks and a certain number of square footage and a 3-year lease. So over the last few years, we've begun changing this. We've talked about this from time to time, but nothing [indiscernible] much shorter leases. In a downturn like this, a lot of our -- probably more than half of our leases today are month-to-month. So we have the exit ability that we didn't have in 2015 and 2016. Smaller locations, fewer trucks, a lot less local inventory. We're going to have high moving stuff locally, and that's it, and a very few people and fewer trucks. So a lower cost structure long term, even when the market "comes back". And we'll have more amply inventory redistribution centers in key parts of the country, in key parts of the world. We'll use our distribution centers in Houston, Dubai, Aberdeen and Edmonton. So it's really how do we maintain proximity to customers with a lot fewer people, lot less inventory and use means to make it easier for our customers to do business with us, order on the fly using apps with suggested products of peripheral demand and then using the -- and then replenish those or fulfill those orders from those more regional, cheaper, high revenue kind of locations. So our branch footprint will ideally shrink, but still we want to be close to our customers. That's what we -- at least in some capacity, salespeople, for sure, branches or walker or pickups for inventory, whatever it takes to be close to the customer. But the cost of doing business will be one step back in the supply chain in a lot fewer kind of redistribution areas that enable a much more efficient model despite the fluctuations in our business.

And then just thinking about how DigitalNOW fits into that, you gave a lot of good feedback around that initiative. I think directionally, it seems very obvious to investors that this is a great opportunity for a company like DNOW. But how do investors over time track that progress? Or how do we tie it back to something around even WS&A costs or head count or even just from a top line perspective? What's incremental versus kind of taking from the natural branches? Just trying to think about ways in which you can kind of deliver some numbers to investors to really show the teeth of that initiative.

Well, I think that's a good question because we do want to start giving a glimpse into, at least for internal purposes, how do we metric, how much of our business is transacted regionally, centrally through a digital process. We talked a little bit on our last few calls about how much of our activity today is digital or e-commerce or simple ERP, customer ERP connections to our system. So ideally, we'll start reporting on that and talk about a number of transactions, number of customers adopting to various models. We'll be building -- or our solutions, we'll build. So I'd like to speak about that publicly, what's evolving. And now we're to be able to measure that is in a number of branches, WS&A expense and revenue, key traditional things that help you say, "Yes, these guys are getting more efficient. It is a big market", but also without conveying too much to our competitors about what we're doing, some data points on how technology is helping us be close to our customers in a far less costly way.