DNOW Stock: Good Long Term Driven By Energy Transition Projects (NYSE:DNOW)

The Thesis

DNOW Inc. (NYSE:DNOW) continued to see double digit decline primarily in its Canada segment as it entered 2024 mainly due to unfavorable weather events during the quarter. However, the delayed project due to weather impact are anticipated to be done in coming quarters of 2024 which should drive the regions sales in going ahead. The activity in the U.S. segment also remains healthy, which along with benefits from addition of Whitco should drive the company’s topline in 2024. The longer term demand on the other hand should be driven by rising no of projects associated with energy evolution and the company’s strong customer base and products and offering related to it. Margin also looks good in the longer term with anticipated benefit from volume leverage in the coming years and focus on improving operational efficiencies. Since my last article, the stock has climbed approximately 13%, however, is still available at an attractive price point, which makes me stay with the buy rating considering the company’s promising long term outlook.

Last Quarter Performance

As the company entered 2024, its International segment, which delivered strong double-digit growth throughout 2023 turned negative as the segment reported a 16.2% contraction in its revenue during the first quarter of 2024. This sales decline in the International segment was primarily due to non-repeating projects and tougher comps, which along with a double-digit decline in the Canada segment’s sales more than offset single-digit growth in the United States segment resulting in an overall topline contraction of 3.6% to $563 million versus the prior year quarter.

The Canada segment was down approximately 20.5% during the quarter primarily due to a decrease in rig count in the region as well as from adverse impact from weather events in January, where the company halted its activities due to extreme temperatures in the region delaying the start of joint season. While both Canada and the International segment were down during the quarter, activities remained stable in the United States which along with the benefit from the recent acquisition of Whitco Supply resulted in year-on-year sales growth of approximately 2% to $435 million.

As the topline growth turned negative, the company margin was also down significantly as the company’s adjusted EBITDA margin contracted 110 bps year on year to 6.9% during the quarter. The decline was primarily due to the impact of lower sales in the Canada segment and the International segment as well as higher WSA cost mainly related to the recently closed acquisition.

Outlook

Despite a bad start to 2024 primarily due to bad weather impact in the Canada region during the quarter as well as double digit decline in the International segment largely due to tougher comps, the company revenue should experience growth in the remaining part of the year as these headwinds were temporary. This along with, the benefit from recent addition of Whitco Supply should fuel revenue growth for the company in the coming quarters.

As we discussed, the Canada segment experienced delayed activity in the region due to weather events. However, these delayed activities are expected to come back in the coming quarter of 2024 which should benefit the company’s revenue. Another factor that should drive the segments revenue is the selection of DNOW by a major Canadian producer to provide pipe fitting and MRO products, which should further support the segments topline in the quarter ahead. The decline in the Canadian segment was a major concern for me, which is now expected to improve in the quarters ahead.

Talking about the International segment, demand for the company’s electrical and safety products remains healthy in Europe and the U.K. associated with brownfield and modernization investment projects. Additionally, the company saw investment growth in Norway as it supplied electric cable to offshore drilling contractors. in addition to this, the company is also seeing increase in FID projects as a result of growing investment in hydrogen and CCS, and as these type of project involves usage of products that DNOW provide, the company International business should grow in the 2024 and beyond. Australia business of the company is also seeing growth in project activity related to CO2 injection, LNG, and biofuel projects.

Moving to the U.S. segment, market activity remains healthy with another supply customer in Eagle Ford and Bakken. In the U.S. process solution side of business, the company is seeing strong demand for its industrial package offerings as well as FlexFlow horizontal pump products which along with the benefit from addition of Whitco supply should drive the company’s overall topline growth in 2024.

With favorable near-term prospects, the company’s long term outlook also appears to be good as the company continues to focus on diversifying its market mix and capturing additional revenue from the fast-growing energy evolution market. In addition to this, the company is working towards diversification of its customer base by targeting opportunities from the adjacent industrial markets. Under the company’s long-term strategy, DNOW is primarily working towards unlocking new revenue sources as well as developing the existing ones through customers’ investment in midstream, energy evolution, and industrial markets including water, mining, and chemical processing, which should benefit the company’s top line in the coming years.

In the energy transition activities, the company is basically associated with projects related to carbon capture utilization and storage as well as RNG. And, currently, the company continues to focus on increasing the number of projects as they are tracking projects in this particular targeted market that is suitable for the company’s core product offerings. The majority of the projects are supported and funded by DNOW’s existing customers who are already aware of the company’s product services and solutions. In my opinion, this familiarity with the customer involved in such projects should act in favor of the company and drive the company’s sales in the longer term.

Apart from this energy evolution landscape, the opportunities, particularly from the water infrastructure investment due to rising population across the United States and migration of population towards warmer places should benefit the company’s business going forward. Additionally, the mining market also looks strong due to continued investment by the company’s customers to bring some rare earth elements to the market which are required in certain types of technology and AI applications, which should further drive the company’s top line in the coming years.

Finally, apart from DNOW’s strong position to grow organically in the future, the company continues to focus on quality companies for acquisition purpose that provides value addition to the company’s solution and help in end market and customer base diversification. The company recently completed the $185 million acquisition of Whitco Supply, one of the largest yet for the company, however, the company still ended the quarter debt-free with a significant free cash flow amounting to $188 million and a total liquidity of $564 million. The company’s liquidity position remained solid, and, in my opinion, this should continue to support the company in its future acquisition, further fueling the company’s topline growth in the coming years.

Valuation

Since my last article on DNOW in the month of February, the stock is up approximately 13%, but still the stock looks attractively priced. Currently, the company stock is trading at an forward price to earnings ratio of 14.59 times the FY2024 EPS estimates of $0.98. When compared to its five year average of 40.60, the company stock appears to be at a significant discount of approximately 64%.

Even on comparison with forward P/E ratio of sector median, that includes some of the company’s closest peers like (DSGR), (OTCPK:RUSMF), (GIC), (TRNS), the stock is still at a notable discount of over 24%. As we can see in the table, below, the DNOW’s stock might have margin growth in mid-single digits as compared to double digit growth for some of its peers, however, as compared to these companies, DNOW’s stock valuation looks more reasonable to me with a balanced EBITDA growth going ahead making it a better option versus its peer companies.

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I anticipate that the company’s topline should grow in the coming quarter across all the segments resulting in strong volumes across the segments. The benefits from strong volume along with company’s continued focus on improving operational efficiencies should help the company in margin expansion in the latter half of 2024, resulting in bottom line expansion which should further enhance the company’s valuation going forward.

Risk

The company’s margin experienced contraction during the quarter mainly due to lower sales volume. However, I expect the company’s overall margin to improve in the latter half of the year as topline grow resulting in FY24 margin in at least inline with the FY23 margin despite a weaker 1H24. My thesis is also built upon this anticipation of market recovery across the regions going forward. However, if these segments, primarily the Canada segment continue to be under pressure further, the company’s overall margin might be impacted significantly which could potentially deteriorate the company’s valuation, leading to poor stock performance in the future.

Conclusion

As we discussed above, the despite an approximately 13% rise in the company stock price in recent months, the stock is still trading at an attractive valuation, discounted significantly to both its historical average and sector median. While the start for 2024 was not good, I am expecting the company’s topline to benefit from recent addition of the Whitco Supply acquisition and various new project associated with energy transition in the coming years. For 2024, I expect margin growth to be almost flat, however, continued focus on improving operation efficiencies and as well as strategic M&As, that are aligned with the company’s focus on end-market diversification while earnings growth should support the company’s margin on the longer term. Therefore, Considering the promising longer-term prospects of the company, and an attractive valuation, I would recommend a “BUY” rating on this stock.